## Department of "Huh?!": John Cochrane III

Paul Krugman wrote about a credit-worthy family that decides to trigger a contractor to build a $100,000 house, and then to borrow the purchase price to pay the contractor. He says that this decision boosts aggregate demand: A Note On The Ricardian Equivalence Argument Against Stimulus: If the house is newly built, that’s$100,000 of spending…. But the family has also taken on [$100,000 of] debt…. Its annual mortgage payment will be something like$6,000, so maybe you would expect a fall in spending by $6000 [under Ricardian Equivalence]; that offsets only a small fraction of the debt-financed purchase… Paul Krugman then wrote that this situation is, in its essentials, very much like that of a government that decides to build a bridge. [T]his family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge… its reaction involves very little offset to the initial spending. The household decided to boost its spending on structures this year by$100,000. It took on $100,000 of debt. The debt triggered a reduction in other household consumption spending of$6,000/year. Similarly, suppose we have a government that decides to boost spending on infrastructure structures this year by $1,000,000,000. It issues$1,000,000,000 of bonds. Those bonds are then the future tax liabilities of its taxpayers. And so, under full Ricardian Equivalence, the taxpayers cut back their consumption spending by $60,000,000 a year. In both cases the decision to spend on structures boosted demand. John Cochrane, responding to this, writes: The Grumpy Economist: [W]hat about the extra$100,000 of "spending"? Doesn't the new house contribute to "aggregate demand?" What, in the classic view, goes down by $100,000? The question is not the family's spending, but where did the$100,000 come from, and what were they going to do with the money?… If this family didn't take out the loan, another family would have…. These are where the $100,000 offset in aggregate demand comes from, and why the family's decision to take out the mortgage need have no effect on aggregate demand… Note that John Cochrane has just committed himself to the full Friedrich von Hayek: that nobody's decision--private or public--to spend or save can ever affect the flow of spending. The right way to think of it, of course--whether we are talking about a family hiring a contractor to build a house or a government hiring contractors to build a bridge--is that at the start of the scenario there are an awful lot of unemployed workers out there, and there are let's say$2,000 in dollar bills in the bank vault. The family promises the contractor that it will borrow money. The contractor promises the workers that he or she will pay them. The contractor and the workers start building the house. Every week the family goes to the bank and borrow an extra $2,000. Every week the family pays the contractor. Every week the contractor pays the workers. And every week the workers who then have extra incomes take those extra incomes and save them: they deposit their cash in the bank, and so return the dollar bills back to the bank vault. This goes on for fifty weeks. And then everybody takes two weeks off at the end of the year to celebrate the booming economy. We thus have an extra$100,000 of production, income, and spending in the year in which the house was purchased. This is Econ 1-level stuff.

And then Cochrane gets it completely wrong:

To me, this example illustrates beautifully how Krugman "got this wrong." He never asked where the $100,000 loan came from! In his analysis of government borrowing and spending, he does not ask, who lent the money to the government, and what were they planning to do with it otherwise. People "with an economics training" are supposed to remember lesson one -- follow the money and pay attention to budget constraints. His stimulus is manna from heaven, not borrowed money… He gets it completely wrong because Krugman knows very well who lent the money to the government: it's the workers who would otherwise have been employed and the shareholders who would otherwise have had no dividends who lent the money to the government. Where did they get the extra money? From their extra income. Why do they have extra income? Because there is extra demand. Why is there extra demand? Because the government borrowed-and-spent the money? What money did the government borrow? The money lent out by the workers who got the extra work and the shareholders who got the extra profits. It's a circular flow. Five things: (i) the credit-worthy family's decision that it could afford to buy a newly-built house, (ii) the contractor's decision to trust the family to pay, (iii) the workers' decision to trust the contractor to pay, (iv) the workers' decision to trust the bank with their savings, and (v) the bank's decision to lend to the credit-worthy family. If any of those fail then the cash stays in the bank (or under the mattress) and the workers stay unemployed. As I say, Econ 1-level stuff. The interesting thing from my perspective is that everybody out there today says that if only businesses had greater confidence then employment would be higher. Everybody except John Cochrane, that is. Here we have something happening concretely on the ground to give businesses justified better confidence--a credit-worthy household that was going to say doubled-up living in somebody's sister's basement deciding to extend itself--and Cochrane claims it will have no effect on employment. I would ask that Cochrane turn his last paragraph around: Good advice to anyone: If you get up one morning with the brilliant insight, "Paul Krugman is wrong when he thinks that a family that decides to buy a$100,000 house will boost economy-wide aggregate demand," have a cup of coffee, settle down and think, "Wait, Paul's a pretty smart guy. Did I get this wrong somehow?" before hurling insults Paul's way.

Krugman is right.

Cochrane is wrong.

Econ 1-level stuff.

That's all that can be said.