Econ 1: Spring 2012: U.C. Berkeley: March 19, 2012 Labor Market Lecture Audio
Trying to Function on Chocolate-Covered Espresso Beans...

"Understand": I Don't Think That Word Means What John Cochrane Thinks It Means Department...

John Cochrane, 2012:

The Grumpy Economist: Stimulus and Etiquette: This is all ridiculous, of course. No, I -- and certainly Bob Lucas and Gene Fama -- am not making the "Say's law" fallacy. We all understand the difference between [accounting] identities, budget constraints, and equilibrium conditions…

John Cochrane, 2009:

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…

Eugene Fama, 2009:

There is an identity in macroeconomics... private investment [PI] must equal the sum of private savings [PS], corporate savings (retained earnings) [CS], and government savings [GS]....

(1) PI = PS + CS + GS....

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt.... The added debt absorbs savings that would otherwise go to private investment.... [S]timulus plans do not add to current resources in use. They just move resources from one use to another.... In a "fiscal stimulus," the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work.... Unfortunately, there is a fly in the ointment.... [G]overnment infrastructure investments must be financed -- more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount...

Robert Lucas, 2009:

[I]f we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash. It has no first-starter effect. There's no reason to expect any stimulation. And, in some sense, there's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn't going to help, we know that...

"Must", "are offset", "just accounting", "must be financed… private investment goes down by the same amount", "it's just a wash".

All three of these statements seem, to me at least, to try to use the national income identity as an equilibrium condition in a way that only people who do not understand the difference between them could possibly do.

Somebody who understood the difference would say, instead, something like: "Were we in a cash-in-advance economy, the fact that money demand in such an economy is interest-inelastic means that increases in government purchases would be offset…"

If there is another explanation for what these paragraphs mean, let's hear it: I have been listening for three years now, and heard nothing.

I can do no better than to quote Milton Friedman on how increases in government purchases are not necessarily fully and completely offset by reductions in private spending. Here's Uncle Miltie talking about the effects of a contractionary fiscal policy--an increase in taxes:

Milton Friedman: [H]igher taxes would leave taxpayers less to spend. But this is only part of the story…. [T]he government would have to borrow less. The individuals, banks, corporations or other lenders from whom the government would have borrowed now have more left to spend or to lend…. If they spend it themselves, this directly offsets any reduction in spending by taxpayers. If they lend it to business enterprises or private individuals--as they can by accepting a lower interest rate for the loans the resulting increase in business investment… and so on indirectly offsets…. To find any net effect on private spending, one must look farther beneath the surface. Lower interest rates make it less expensive for people to hold cash. Hence, some of the funds not borrowed by the Federal government may be added to idle cash balances rather than spent or loaned…

That is how you do the analysis. The flow-of-funds national income identity is an identity. It must be satisfied. Income equals expenditure.

But that does not mean, as Cochrane, Fama, and Lucas all claimed back in 2009, that the total of income and expenditure must remain the same when individual pieces of it--in this case government purchases--change. That does not mean that "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". This does not mean that "bailouts and stimulus plans… funded by issuing more government debt… means private investment goes down by the same amount". This does not mean that "if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash".

The right way to do the analysis is the way Milton Friedman did it back at the start of the 1970s.

This is not a mistake that anybody who has done their homework should make, or that anybody who understands the difference between accounting identities, equilibrium conditions, and behavioral relationships can make.

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