For Kevin Drum to Be "Expecting a Reasoned Critique of John Cochrane’s Claim Is Like Expecting a Reasoned Critique of the Claim that 2+2=5": Hoisted from Robert Waldmann’s Archives from a Year Ago

Brad DeLong points us to a archived posts by Robert Waldmann and Paul Krugman:


Robert Waldmann: Why does Fiscal Stimulus Work ?: “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. 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]

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. By 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 critique 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 [no effect on real GDP]. 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). [They] then [take] a model or data which suggests that it is one 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)… 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 slightest 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 interest rates on consumption has an important 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.


Paul Krugman: The New Keynesian Case for Fiscal Policy: “It’s been a bit funny on the academic front…

…being a Keynesian during a Keynesian crisis. Much of the academic profession decided more than 30 years ago that the whole thing was nonsense and what we needed was an equilibrium model of the business cycle. By the time the utter failure of the equilibrium project became apparent, you had a whole generation of economists who knew that Keynesianism of any form was nonsense based on what they had heard somewhere, so they didn’t read any of the stuff, old or new–and were flabbergasted to learn that there was in fact an extensive New Keynesian literature that provided a justification for fiscal policy at the zero lower bound.

So some props to John Cochrane for at least trying to catch up. Unfortunately, he’s still working from the baseline assumption that people like me (and Mike Woodford, whom he really should be reading) must be kind of stupid, and so he can’t be bothered to actually figure out how the models work. At least I think that’s what’s happening.

As Robert Waldmann says, Cochrane’s latest seems to be driven by a confusion between the effect of fiscal expansion on GDP–which is positive in just about any NK model–and the effect on consumption, which isn’t at all the same thing. I won’t try to figure out the roots of this failure of reading comprehension; let me instead try to explain what’s really going on.

In the simplest NK models of fiscal policy, we think of an economy that faces an adverse shock in the current period, but will return to a steady state thereafter. (Maybe not in reality, but that’s another topic.) Given this setup, consumption in the current period is tied down by an Euler condition:

(Marginal utility of consumption in period 1)/(Marginal utility in period 2) = (1+r)/(1+d)

where r is the real interest rate and d the rate of time preference. If we’re up against the zero lower bound and prices are sticky, this means that r doesn’t change, so we can take first-period consumption as fixed.

But now suppose that the government expands its purchases of goods and services. Consumption is fixed, so there is no crowding out; the increase in G leads to a one-for-one expansion in real GDP. The multiplier is 1.

That looks a lot like old Keynesianism to me–an increase in government spending leads to a rise in output. Inflation has nothing to do with it.

Now, is there a way to get a rise in consumption, and a multiplier bigger than 1? Yes. That Euler condition is based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate. If some of them are instead liquidity-constrained, the increase in income from the rise in G will lead to some increase in C as well, and we have a story that is even closer to the old Keynesian version.

This isn’t hard–at least it shouldn’t be for anyone with a graduate training in economics. Just try actually reading what New Keynesians write.