## Understanding the Chicago Anti-Stimulus Arguments: A Response to Kantoos

Kantoos claims that I did not deal with the real arguments underlying John Cochrane's February 2009 claims that fiscal stimulus would be counterproductive:

three years ago, in early 2009, when I read John Cochrane’s piece on fiscal stimulus . It is a little convoluted, unfortunately, but an interesting read nonetheless. I would have loved to read a proper response by Paul or Brad DeLong, but only found unjustified rants that had little to do with John’s arguments – if you actually read the whole piece.

I thought I had. But let's try again. The problem is that I have a hard time pulling a coherent argument out of it. But I had thought that I had tried hard to deal with it, and I focused on the arguments that Cochrane had placed in the traditional places you put your main thesis--at the start and at the end:

[L]et’s think of a “fiscal stimulus” in which the government borrows money and spends it, but with the clear plan that the debt will eventually be repaid with future taxes, not just by printing money. Can this kind of stimulus work, and if so how?… First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of “crowding out” is just accounting, and doesn't rest on any perceptions or behavioral assumptions. Second, investment is “spending” every bit as much as is consumption. Keynesian fiscal stimulus advocates want money spent on consumption, not saved…. Third, people must ignore the fact that the government will raise future taxes to pay back the debt. If you know your taxes will go up in the future… the net effect of fiscal stimulus is exactly zero…. The classic arguments for fiscal stimulus presume that the government can systematically fool people.

And:

The government should borrow to finance worthy projects, whose rate of return is greater than projects the private sector would undertake with the same money, spreading the taxes that pay for them over many years, after making sure its existing spending meets the same cost-benefit tradeoff. Just don’t call it “stimulus,” don’t claim it will solve our current credit problems, “create jobs” on net, or do anything to help the economy in the short run, and don't insist that we have to pass this monstrous bill in a day without thinking about it.

If you want to say that those aren't the major points, you need to tell me where in Cochrane's piece the major points are--and why they aren't in the places where one puts the major points of one's argument.

But I'm willing to go through it in some detail:

First, however, note that John Cochrane comes out not just against fiscal policy but against expansionary monetary policy as well--against the Federal Reserve's expansion of the monetary base from $1 trillion to$2 trillion, an expansion that is permanent unless and until the market's appetite for risk and safety shifts again and we find ourselves worrying not about too little nominal spending in the economy but rather too much.

John Cochrane:

(A): [T]he Federal Reserve has already more than doubled the money supply and is widely announcing its intention to do much more…. The inflation that will result from a trillion dollars of money permanently dropped on the economy, and the real economic dislocation of such a major inflation, is frightful to contemplate…

Well, the Fed has now raised the monetary base not from $1 trillion to$2 trillion but from $1 trillion to more$3 trillion--has done more than twice as much as Cochrane said was too much--and, so far, no major inflation, no economic dislocation. The problem seems to be that the markets don't think that the monetary expansion is permanent enough, not that too-loose monetary policy has set us up for "the real economic dislocation of… a major inflation".

It seems to me fair to say that Cochrane's view back in the winter of 2009 of the way that U.S. economy was going to work was simply wrong.

Cochrane continues:

(B): Let’s think of a “fiscal stimulus” in which the government borrows money and spends it, but with the clear plan that the debt will eventually be repaid with future taxes, not just by printing money.  Can this kind of stimulus work, and if so how?… [I]f money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend…. Every dollar of increased government spending must correspond to one less dollar of private spending.  Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of  “crowding out” is just accounting, and doesn't rest on any perceptions or behavioral assumptions…. [T]he economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.

This argument that makes sense only if we are in a cash-in-advance economy with a technologically-fixed velocity of money.

But we aren't.

And so the claim that such "crowding out" is "just accounting" is simply and completely wrong.

Cochrane continues:

(C): Third, people must ignore the fact that the government will raise future taxes to pay back the debt. If you know your taxes will go up in the future…. Now the net effect of fiscal stimulus is exactly zero, except to raise future tax distortions…

This is wrong as well.

The government purchases $100 billion of goods, issues$100 billion of bonds, and raises taxes by $3 billion a year in order to amortize the bonds. Government purchases go up by$100 billion this year. Private consumption goes down by $3 billion this year. Net fiscal impetus is not$0 but rather $97 billion. Cochrane doesn't understand the Ricardian Equivalence argument he is trying to make. Cochrane just does not know what he is talking about. Going further: (D): The baseline question is whether the multiplier exceeds zero…. The classic argument for fiscal stimulus presumes that the central cause of our current economic problems is… people and our government, are not doing nearly enough borrowing and spending…. The government must step in force us all to borrow and spend more. This diagnosis is tragically comic once said aloud. Why is it comic? Cochrane does not say. It would be nice if he did, because he seems to flirt with this "we as a country are not doing enough borrowing and spending" argument further down, in what I have labelled (E) and (I). Cochrane does say: (E): The institutions that channel your and my savings into consumer and business borrowing are not working…. New issues of securitized debt have dropped to next to nothing, unless they are guaranteed by the Federal Government. Savings is going to low-interest Treasuries and guaranteed agency debt, yet consumers and businesses who need credit face a small supply at very high prices…. [Right now] the Treasury and Fed are issuing huge amounts of Government debt, and they are turning around and lending the proceeds to consumers and businesses. This basic idea makes sense, though there is plenty to worry about in the details…. If the Treasury borrows and the Government uses the proceeds for investment, then the government is in some sense acting as the missing intermediary. The focus on investment spending in the Obama plan reflects some of this thinking, though investment is anathema to the traditional Keynesian insistence that stimulus be channeled to consumption spending… The beginning of the passage seems to me to be largely right. In the last sentence, however, Cochrane goes off the rails. There is nothing in "traditional Keynesian" thinking to say that you ought to boost consumption rather than, say, infrastructure investment. Nothing at all. Cochrane does not know what he is talking about. Then comes a paragraph that I can make no sense out of at all. It claims that the largely right (E) is in fact wrong: (F): However, this is a poor argument, since stimulus “investment” spending is on much different projects than the private sector would have funded. Fiscal stimulus investments make fuel oil, not gasoline. Moreover, the extra issues of Treasury debt will largely come from the few dollars that are flowing from savings to private investment, just what the “credit crunch” does not need. To “intermediate,” additional government borrowing would have to come out of consumption. People would have to be attracted to postponing a trillion dollars of consumption by slightly higher treasury yields. Cochrane's argument in (F) appears to be: 1. Private-sector financial intermediation is broken. 2. Thus businesses with positive NPV projects cannot match themselves with the savers who would ordinarily lend to them. 3. Hence businesses can't put people to work expanding their capital stocks. 4. But savers will lend to the government. 5. You might think that because people will lend to the government the government can borrow from the savers who would ordinarily lend to businesses and then put people to work expanding human capital and physical infrastructure. 6. But "the extra issues of Treasury debt will largely come from the few dollars that are flowing from savings to private investment, just what the 'credit crunch' does not need. To 'intermediate', additional government borrowing would have to come out of consumption. People would have to be attracted to postponing a trillion dollars of consumption by slightly higher treasury yields." The way I see it, this is an Econ 1-level mistake. Fiscal stimulus is assumed to be ineffective, and so additional government borrowing must out of reduced consumption, thus fiscal stimulus is ineffective. But unless you are in a rigid cash-in-advance economy with a technologically-determined velocity of money, that's simply wrong. The additional government borrowing comes out of increased income--out of the savings of those the government is hiring to work on infrastructure--and so consumption is not reduced, and fiscal stimulus is effective. If anybody has any way to interpret Cochrane's (6) that does not see at as an Econ 1-level mistake, I would be anxious to hear from them. Then comes: (G): A monetary argument for fiscal stimulus, logically consistent but unpersuasive… [S]uppose the Government could borrow money from people or banks who are pathologically sitting on cash, but are willing to take Treasury debt instead. Suppose the government could direct that money to people who are willing to keep spending it on consumption or lend it to companies who will spend it on investment goods. Then overall demand for goods and services could increase, as overall demand for money decreases. This is the argument for fiscal stimulus because “the banks are sitting on reserves and won’t lend them out” or “liquidity trap.” This argument seems to me to be correct. But what follows it is not: (H): In this analysis, fiscal stimulus is a roundabout way of avoiding monetary policy. No, fiscal policy is not a roundabout way of avoiding monetary policy. It is a necessary way of making monetary policy effective when short-term safe nominal interest rates are very close to zero. The Federal Reserve has raised the monetary base from$1 trillion to $3 trillion. But banks and firms haven't tried to spend their extra$2 trillion in liquid high-powered money balances but instead, "pathologically" says Cochrane, sit on them. Expansionary fiscal policy is a way of getting banks and firms to spend their cash balances buying Treasuries, and the government then gets to use those spent cash balances to hire people to do useful things.

Understood as a way not of avoiding expansionary monetary policy but of making the expansionary monetary policy that the Fed has already done effective, this sounds to me like a correct analysis of our current situation.

But Cochrane does not think that it is a convincing analysis of our current situation.

Why not? It is not clear.

But it is clear that he does not think that (G) is correct. That's what he says next:

(I) This is not a convincing analysis of the present situation….

Bank excess reserves… have increased from $2 billion in August [2008] to$847 billion in January [2009]. However, our Federal Reserve can create as much more money as anyone might desire and more…. If money demand-induced deflation is the problem, money supply is the answer…. [But t]his monetary story also does not ring true…. People are trying to shift their portfolios out of stocks and especially out of anything with a whiff of credit risk, and into cash or treasuries…. [T]he private sector has become much more averse to holding risks…. The bottom line, then, is that people want to hold more of both money and government debt – and don’t particularly care which. Trying to get it, we are trying to buy less of both consumption and investment goods…. [M]onetary policy is impotent…. The Fed can arbitrarily exchange Treasury debt for money…. But nobody cares if it does so, since the “flight to liquidity” is equally towards all forms of Government debt….

Looking at it this way gives us a logical reason that fiscal stimulus might work. It leaves the private sector with a trillion more dollars of government debt in their pockets. But the Fed’s many facilities also issue government debt and money, which helps to satisfy the demand for government debt…

By the end of (I), however, Cochrane seems to have turned himself around. He started (I) saying that (G) was wrong. He appears to end it seeming to say that perhaps (G) is a convincing analysis of our current situation.

Thus by the end of (I) I believe Cochrane's argument has lost coherence:

• In (B) he claimed that the argument that expansionary fiscal policy could not work was "just accounting"; now at the end of (I) he says that there is a "logical reason" that expansionary fiscal policy might work--but does not explain what was wrong with his "just accounting" argument.

• In (C] he got Ricardian Equivalence wrong, and came up with another reason why expansionary fiscal policy could not work--another reason that seems inconsistent with his claims at the end of (I).

• In (D) he called the argument that the government needs to provide financial intermediation services to get us as a society to lend and borrow and spend more "tragically comic once said aloud"--but the end of (I) might say (it is not clear) that there is a logical argument that expansionary fiscal policy will get us to lend and borrow and spend more because households and financiers will buy Treasuries at high prices but will only buy corporates at much lower prices.

• In (E) Cochrane raised the themes that he later raised at the end of (I)--but did so only to rebut them in (F) as a "poor argument". I cannot see how (E) can be a poor argument without making the end of (I) a poor argument as well.

• And Cochrane says at the beginning of (I) that (G) is "not a convincing analysis", in apparent contradiction to the end of (I) where it appears it might be.

So by the end of (I) I don't know where we stand at all

Cochrane is just not coherent to me.

Cochrane then begins criticizing the Fed and the Treasury for setting the stage up for a smaller version of the same disaster that he thinks expansionary fiscal policy would produce:

(J): [T]he Fed and Treasury’s current actions are not so clear. The Fed and Treasury are essentially running the world’s largest hedge fund: short treasuries and long a lot of obscure credit risk…. When it’s time to unwind, will these assets be worth anything?… “Troubled asset” purchases from banks at above-market values can make those banks look better, but these are simple subsidies to banks shareholders and debt holders at the expense of future taxpayers or inflation. The government is also guaranteeing trillions of dollars of credit…. If the government has to make good on any of these guarantees, there will be even less available to unwind all our new credit…. The Government’s borrowing and taxing ability is limited. When the crisis fades, we will need fiscal resources to unwind a massive increase in government debt…. If the Fed’s kitty and the Treasury’s taxing power or spending-reduction ability are gone, then we are set up for inflation; essentially a default on the debt…. Some say, “we’re in a crisis, we can’t worry about the long run or inflation.” However, the inflation can happen much sooner than you might expect, and it can happen long before the economy recovers. We are in a credit crisis,  as well as experiencing a fall in aggregate demand. Even with perfectly managed aggregate demand, output will be lower while we rebuild credit markets, and there will be unemployment as people move from building houses to other jobs. We can easily have stagflation of monstrous proportions, and it can happen very soon after stimulus spending gets going…

Three years later, it is worth pointing out how wrong all of Cochrane's empirical claims in (J) are.

Markets are not expecting a rise in inflation at any time horizon. Markets are not expecting a default on U.S. Treasury debt. Markets are not expecting the U.S. economy's taxing and borrowing and spending-reducing power to be gone. Markets are telling us that U.S. debt capacity is enormous. We do not have stagflation of monstrous proportions. And if John Cochrane had gone short 30-year Treasuries in the middle of 2008, he would have lost 30 cents on every dollar invested.

Cochrane's view of the way the economy must work has not applied over the past three years.

That should provoke a major rethink.

But, at least to my knowledge, there has been no rethinking of Cochrane's High Trimphalist mode of the winter of 2009:

"Well," I'm often asked, "we have to do something. Do you have a better idea?" This is an amazingly illogical question. If the patient has a heart attack, and the doctor wants to amputate his leg, it's perfectly fine to say "I know amputating his leg is not going to do any good," even if you don't have a five-step plan to cure heart attacks…

I don't think that this (K) needs any comment at all.

Then comes:

(L): Fiscal stimulus can be great politics…. The beneficiaries of government largesse know who wrote them a check…. My analysis is macroeconomic…. If it’s a good idea to build roads, then build roads. (But keep in mind the many roads to nowhere, and ask why fixing Chicago's potholes must come from Arizona's taxes funneled through Washington DC.) If it’s a good idea for the government to subsidize green technology investment, then do it…. The government should borrow to finance worthy projects, whose rate of return is greater than projects the private sector would undertake with the same money, spreading the taxes that pay for them over many years, after making sure its existing spending meets the same cost-benefit tradeoff. Just don’t call it “stimulus,” don’t claim it will solve our current credit problems, “create jobs” on net, or do anything to help the economy in the short run, and don't insist that we have to pass this monstrous bill in a day without thinking about it.

What do I see here? A bunch of overheated and largely false rhetoric. A bunch of apparently false claims about the way the world works. A bunch of false claims about pretty basic economic theories. Occasionally correct claims that are then--almost invariably taken back--by something that claims (for reasons I do not understand) to be a refutation.

Overall, it does not seem to me to add up to a coherent argument.

Kantoos, what else do you want me to do with this?