Ah now Kevin Drum wrote about something I know something about. He notes a post by John Cochrane and said he was licking his lips waiting for the Delong/Krugman demolition which, however disappointed him.
I was a little disappointed in their responses. They have plenty of detailed issues with Cochrane, many of which strike me as well taken. But I didn’t feel like they ever addressed Cochrane’s core argument. He isn’t insisting that stimulus doesn’t work.1 Instead, he’s taking aim at the stories economists use to explain why they think stimulus works.
He hands the mike to Cochrane
In his words, here’s the Old Keynesian multiplier story:
More government spending, even if on completely useless projects, “puts money in people’s pockets.” Those people in turn go out and spend, providing more income for others, who go out and spend, and so on. We pull ourselves up by our bootstraps. Saving is the enemy, as it lowers the marginal propensity to consume and reduces this multiplier.
“But Cochrane says that New Keynesian models don’t support this story at all. When you take a look into their guts, NK models posit an entirely different underlying mechanism for why fiscal stimulus works:”
If you want to use new-Keynesian models to defend stimulus, do it forthrightly: “The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow’s consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based “multiplier,” sorry, our new models have no such effect, and we’ll stand up in public and tell any politician who uses this argument that it’s wrong.”
The problem here is that Cochrane’s fantasy has so little connection with reality that it is hard to discuss. Consider Krugman’s New Keynesian model of fiscal stimulus here [update please click this link before criticizing my assertions about New Keynesian models] a. Notice there is no mention of inflation or real interest rates.
It is true that New Keynesians talk about expected inflation and real interest rates. But they do that when they discuss monetary policy at the lower bound. In contrast, if one modified a New Keynesian model with the assumption that the inflation rate is a known constant (this means setting a parameter in the new Keyensian Phillips curve to zero) then the model would imply that there is a government spending multiplier of 1. It just isn’t true that, in New Keynesian models, fiscal stimulus works only through expected inflation.
Expecting a reasoned critique of Cochrane’s claim is like expecting a reasoned critiqque of the claim that 2+2=5.
Now Cochrane is an intelligent person. How does he manage such regular howlers ? Well we have the ambiguity of “no spending multiplier” here this ambiguously means that the government spending multiplier is one (there is no effect on private consumption) and that it is zero. This is typical of fresh water fanatics when confronted by models and or evidence. They argue that the multiplier at the ZLB is zero (as say Krugman believes it is off the ZLB) and then a model or data which suggests that it is 1 is presented as proof that they were right.
I mean really saying this is like 2+2=5 is over charitable. Cochrane’s argument is an exposition of the result that 1=0.
DeLong and Krugman do not have the reputation of being over polite, but they are too polite to point out the arithmetic error which is the heart of Cochrane’s argument.
That’s not all. New Keynesians have no presumption as to the sign of the effect of real interest rates on the level of consumption. This is because they have some respect for data and there is essentially no evidence that real interest rates affect consumption. This can be reconciled with utility maximization (anything can) but by making assumptions about parameters so the effect of real interest rates on consumption is tiny in the model as it is in the data.
Anyone who has the slgightest interest in reality knows that real interest rates are negatively correlated with GDP growth because they are negatively correlated with investment. Someone who thinks that the effect of real interst rates on consumption has an importnt role in any calibrated New Keynesian model demonstrates complete ignorance. They are pure fantasies. This explains why the DeLong and Krugman do not seem to take his claims seriously.
update: I corrected some typos because it seems someone read this recently.