Chicago's John Cochrane: Still Certifiable

by: Brad DeLong

Couldn't PBS get a stimulus opponent who would make some sense?

The last real economist to make Cochrane's argument that fiscal policy must be ineffective because "the stimulus... is taking money from one place and giving it to another place" was R.G. Hawtrey in the mid-1920s.

With respect to Hawtrey, there are two conflicting traditions. The first is that he relatively rapidly came to the realization that he had been in error. The second is that he had never believed the argument, but that he had made it as a dutiful civil servant because he needed to set forth an argument that both justified the policies of the Conservatve government and was simple enough that then-Chancellor of the Exchequer Winston S. Churchill could remember it.

From One Year Later, Stimulus Appears to Yield Mixed Results:

JOHN COCHRANE, professor of finance, University of Chicago Booth School of Business: Well, it may have been politically effective, but the idea that it was going to raise output or increase employment, I don't think has panned out. So, I would give it a net zero on -- on those questions.... I mean, the stimulus, in the end, is taking money from one place and giving it to another place. And it's too easy to forget that you had to take money from somewhere in order to do any stimulating....

LAWRENCE MISHEL, president, Economic Policy Institute: Professor Cochrane has a theory, but the evidence, I would offer, suggest that it did have an effect. If you go to the economic forecasters, who make their money doing this, they confirm that the -- you know, we have saved around two million jobs in the process. If you look at what actually happened in the economy, in the beginning of 2009, we were losing 750,000 jobs a month. In the last three months, we were losing about 35,000. This wasn't by accident that we went from a deep, you know, decline in the economy to an actual growing economy....

JOHN COCHRANE: Like any time the government spends money, it has to come from somewhere. So, you get to see the jobs that the stimulus -- I don't want to say created, but the jobs supported by the stimulus. What you don't see is every dollar of stimulus had to come from somewhere....

JEFFREY BROWN: What was the -- staying with you, what was the alternative? What did you want to see? What do you want to see?

JOHN COCHRANE: Primarily, get out of the way. Now, let me say, even if there wasn't an alternative, that doesn't rescue the stimulus. If you have a heart attack and the doctor wants to cut your arm off, you can say, cutting the arm off isn't going to work, even if you don't know how to fix a heart attack.... The economy can recover very quickly from a credit crunch, left on its own, with stable, low-taxes, pro-growth policies in place. It doesn't need trillions of dollars of government spending to get it going again. That leads to grease....

LAWRENCE MISHEL: The situation we were in is that monetary policy had already driven interest rates down to basically zero. That wasn't getting us much growth. There was no hiring going on. There was lots of people being laid off. You know, the idea that we should just sit there and do nothing, and we just have to tough it out, and the market will take care of us is exactly the thinking that got into this deep mess. All administrations, Republican and Democrat, tend to, in a deficit -- in recession, you're supposed to run a deficit. And the reason why you run a bigger deficit is to pump demand up, so that there's more good and services being bought and jobs being created. You know, that's -- that's what was done. That's what needs to be done. And we actually need to do much more of that, because we're going to see unemployment at 8 percent two years from now. And that's quite unacceptable. That's higher than it ever got to in the last two recessions...

Let me make two and only two brief comments.

First, Cochrane's claim that the "economy can recover very quickly from a credit crunch left on its own..." seems to me at least to be completely wrong, for reasons well laid out by Bernanke and Gertler. A credit crunch destroys a great deal of the intermediation capacity of the financial system--of its ability to match savers seeking returns with investing firms seeking funds in a way that assures savers that they are going to get a reasonable rate of return. The skin in the game provided by the invested capital and the reputations of financial intermediaries are key in this process. And both of those are gravely damaged by a credit crunch. It takes a long time to recover--as everyone who is sufficiently up to speed on the literature to have read Reinhart and Rogoff knows.

Second, we occasionally sit around and try to imagine what model of the economy John Cochrane is working in.

He certainly isn't working in any of the models that people who make a living forecasting the economy use--those all suggest substantial effects from fiscal stimulus.

He certainly isn't working in Milton Friedman's model--Friedman was a critic of fiscal policy not because he thought it was ineffective--not because "stimulus... is taking money from one place and giving it to another place"--but because he thought that it was weak in normal times: monetary policy was more powerful except under those rare conditions in which the interest elasticity of money demand was very high.

He's not working with Irving Fisher's quantity theory of money--in Fisher's quantity theory the velocity of money and thus the flow of spending depends on the configuration of interest rates, and when the government issues debt it changes the configuration of interest rates.

He's not working with Knut Wicksell's model of natural and market rates of interest--because in Wicksell's model in a depression fiscal stimulus raises the natural rate of interest and so reduces the gap between the natural and market rate.

He's not working in a von Misen or Hayekian Austrian model, for in those models fiscal stimulus is effective (it boosts employment) but destructive (it boosts employment in the wrong places so that the fundamental disequalibrium of the economy becomes greater).

The closest we can come is that Cochrane is working in a pure cash-in-advance economy in which the velocity of money has not only a technological upper limit but also a technological lower limit--that spending is by assumption proportional to the quantity of money and to nothing else.

But even in that model fiscal stimulus will almost always alter the quantity of money: the Federal Reserve would have to take active steps to raise interest rates as an offset in order to keep it from doing so. And the Federal Reserve right now is not--as a matter of empirical fact--not in the business of raising interest rates to offset the effects of fiscal stimulus on demand.

Thanks to Larry Mishel for exposing himself to the stupidity rays. It's appreciated.