Cameron Langford: Investors Say Supply Sider Arthur Laffer Backed a Ponzi Scheme
Econ 1 Spring 2012 U.C. Berkeley: Topics

Chicago Macro: Will It Ever Stop?

There are a bunch of email requests that I go through Cochrane again, at a somewhat more formal level, especially given continued claims that seem to me to be highly frivolous that it is not stupid at all...

So here goes…


(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.

The model underlying this paragraph is the simple quantity theory of money:

(1) MV = PY

where P is the price level, Y is the level of production, V is the "velocity" of money, and M is the economy's money stock. The hidden assumption in Cochrane's paragraph is the--false--claim that the velocity of money is a technological constant rather than an economic variable. Without that assumption Cochrane's claim that expansionary fiscal policy cannot be effective is not a manner of "just accounting".

(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…

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. The $100 billion of extra government demand this year comes along with a $100 billion reduction in private household wealth, but that does not mean that the net effect of fiscal stimulus is exactly zero. 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 what the Ricardian Equivalence argument is.

(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.

Later on, Cochrane himself flirts with this "we as a country are not doing enough borrowing and spending" diagnosis further down, in what I have labelled (E) and (I). He calls it "logically consistent". It is not clear how that is consistent with his labeling it "tragically comic" here.

(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…

Cochrane appears to be trying to build up--from scratch, without plans, and on his own--the framework of Knut Wicksell's Interest and Prices. I&P looks for equilibrium in the flow-of-funds through financial markets: the stock of bonds that households want to hold equals the current stock of bonds B plus households' desired savings. The stock of bonds that borrowers want to have outstanding equals the current stock of bonds B plus business investment I plus the government deficit D:

(2) B + S = B + I + D

If these are equal at full employment, then everything is fine. If the left side is greater than the right, we have depression.

This "basic idea makes sense", Cochrane says. Cochrane is correct.

Cochrane then says, fiscal policy can be effective inasmuch as increasing the government deficit D when I is depressed due to the collapse of financial intermediation. This is correct, for expansionary fiscal policy then balances the flow-of-funds through financial markets with "government… in some sense acting as the missing intermediary".

But then, in the last sentence of (E), Cochrane loses the thread. There is nothing in "traditional Keynesian" thinking to say that you ought to boost consumption rather than, say, infrastructure. Nothing at all.

At this point, it is useful to take stock, to step back and consider where Cochrane is.

He has made arguments based on two equations:

(1) MV = PY, the quantity theory of money

(2) B + S = B + I + D, the Wicksellian flow-of-funds through financial markets

Cochrane presents these two equations as contradictory. the first--as Cochrane interprets it--says that fiscal policy cannot be effective as a "just accounting". The second says that fiscal policy can be effective.

Cochrane takes no steps to reconcile this confusion in his argument.

And Cochrane spends the rest of his paper wobbling back and forth between arguments based on (1) and arguments based on (2), grabbing each one when it is convenient, never attempting to reconcile why his conclusions from (2) aren't upset by his arguments from (1), and never attempting to reconcile why his conclusions from (1) aren't upset by his arguments from (2).

The right step to take at this point would be to point out:

  • that the velocity of money V depends on the (short-term safe nominal) interest rate i--that the higher is i the larger will be the velocity of money
  • that the level of savings S depends on production Y
  • that the level of private investment I depends on the the long-term risky real interest rate r
  • that the long-term risky real interest rate r depends on (i) the short-term safe nominal rate i, (ii) the expected inflation rate π, and (iii) the risk spread ρ, itself a product of investor risk tolerance, the riskiness of the market, and the ability of the private financial system to grade, classify, and manage risks.

Had Cochrane done that, he would have simply rederived the IS-LM framework that Hicks (1937) originated and that is in the front of Paul Krugman's, Olivier Blanchard's, Stan Fischer's, and a good many other economists' minds right now.

Then Cochrane could have started thinking coherently about the issues...

But because he does not know Hicks, does not know Wicksell, he does not understand that he is in the middle of rederiving IS-LM from scratch. And so he backs away. (E) is the closest that his paper comes to shedding light on the issues.

Cochrane's next move is to conclude that his 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.

This appears to be a return to:

(1) MV = PY

with its false ancillary assumption that the velocity of money is not an economic variable but a technological constant. That, he says, makes (E)'s--correct--argument based on (2) invalid.

If anybody has any way to interpret Cochrane's (F) that does not see at as an Econ 1-level mistake, I would be anxious to hear from them.

Cochrane's next move is to modify (1). Back at the start he was very firm that expansionary fiscal policy simply could not work as a simple matter of accounting: claims that fiscal policy could work were on the order of 2+2=5.

Now he muses that perhaps he was wrong--that fiscal policy is not ineffective as a matter of metaphysical necessity. What, he asks himself, if the velocity of money is not a technological constant at all?:  

(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 (G) is completely correct. That the velocity of money is an economic variable is how you can have an economy in which both (1) and (2) hold.

But then Cochrane says that (G) is wrong:

(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…

Note that nowhere in (I) is there any argument that the (correct) (G) is wrong: there is just an assertion.

Note also that here Cochrane says that it is not the case that the velocity of money is a technological constant. He says, in fact, that it is indeterminate--that it falls or rises one for one with open market operation-induced rises or falls in the money stock. If the Federal Reserve buys $100 billion of 30-Year Treasury bonds for cash, Cochrane says, this has no effect on spending or the economy because "people want to hold more of both money and government debt – and don’t particularly care which".

And note that if you take this paragraph (I) to be Cochrane's final answer--his main argument--that (B), (F), and (L) below are complete tripe.

Note, last, the end of (I), which says that fiscal stimulus "might work" because as the government issues bonds to finance infrastructure and education spending it creates the safe assets that investors want to hold in their portfolios. But, Cochrane says, "the Fed’s many facilities also issue government debt and money, which helps to satisfy the demand for government debt".

How does this work?

Suppose the Federal Reserve embarks on quantitative easing, issuing $500B of reserve deposits and using them to buy up $500B of Fannie Mae-guaranteed mortgage-backed securities. There are now an extra $500B of safe government liabilities out there--government debt plus Federal Reserve deposits--for those who want to hold safe assets in their portfolios to hold. But there also are $500B less of Fannie Mae-guaranteed mortgage-backed securities for those who want to hold safe assets to hold. Maybe government liabilities are 11.1% safer than GSE-guaranteed MBS--that those who had been holding the $500B in GSE-guaranteed MBS are happy putting $50 billion of that in equities and only soak up $450B of the additional reserve deposits in their portfolios. But if they do, all that this $500B episode of quantitative easing has done is create a net $50B of safe assets for those who had been uncomfortable with the risk level of their portfolios to buy.

By contrast, a $500B fiscal expansion would have seen the government put unemployed people to work to buy $500B of useful stuff--bridges, road repairs, human capital for 12-year olds, research in to global warming, vaccinations, etc.--and have created a net $500B of safe assets for those who had been uncomfortable with the risk level of their portfolios to buy.

At this point, I would expect to see Cochrane make an argument to justify his claim that quantitative easing--Federal Reserve facilities--are a better way to boost the supply of safe assets than having the government issue debt and buy stuff.

But Cochrane doesn't make such an argument. He, instead, writes:

{I'): I would be happiest if the Fed and Treasury5 satisfied the large demand for government debt and money by transparently buying or lending against high quality corporate and securitized debt, at market prices. I am happiest of all when they buy newly-issued commercial paper and securitized debt, acting as the missing intermediaries to help address the “credit crunch,” as well as supplying government debt. These actions are easiest to unwind. When investors get sick of holding so much money or government debt, the Government can, in effect, take back in government debt in exchange for this private debt, and probably make a good profit.

This seems to me to be a declaration that the Fed and the Treasury need to boost the supply of safe assets by not boosting the supply of safe assets.

And then he goes into a rant. Why? Because the Fed and the Treasury have been using their facilities to actually take risk onto the government's balance sheet, and thus to actually boost the net supply of safe assets:

(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…

There are, I think, two things to note here:

First, it seemed to me at the time--three years ago--that this argument was incoherent. If the point is for the Fed and the Treasury to use their facilities to boost the net supply of safe assets, then they have to use their facilities to boost the supply of safe assets. They have to issue safe liabilities and use them to buy unsafe things. For Cochrane to say that they need to increase the net supply of safe assets and then to complain when they do so because they have bought unsafe things with their money seems to me a sign that he has lost the thread of his own argument.

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

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.

And this High Triumphalist mode is something to see:

(K) This is not fancy economics. Most of my arguments come from simply asking where the money is going to come from, simple arithmetic. Why are so many economists said to support fiscal stimulus? Am I some sort of radical? No. In fact economics, as written in professional journals, taught to graduate students and summarized in their textbooks, abandoned fiscal stimulus long ago. Keynesians gave up by the 1970s…. The equilibrium tradition which took over professional academic economics in the mid-1970s has even less room for fiscal stimulus…. [M]acroeconomics was revolutionized starting in the 1950s, by the realization that what people think about the future is crucial to understanding how policies work today…. [T]he classic Keynesian analysis of fiscal stimulus falls apart. In textbooks and graduate curriculums across the country, stimulus is presented at best as quaint history of thought with no coherent defense that one should believe it in the context of modern economics.  (For example, David Romer’s classic graduate text Advanced Macroeconomics.) At worst, it is presented as a classic fallacy. (My view of the treatment in Tom Sargent’s Dynamic Macroeconomic Theory  and Sargent and Ljungqvist’s Recursive Macroeconomic Theory.)… Keynesian economics was a failure in practice…. Keynes left Britain 30 years of miserable growth…. Fiscal stimulus advocates are hanging on to a last little timber from a sunken boat of ideas, ideas that everyone including they abandoned, and from hard experience…. Empirical work is hard…. If you bleed with leaches when you have a cold, empirical work might say that the leaches cured you…. [N]othing in recent empirical work on US data has revised a gloomy opinion of fiscal stimulus…. The Administration's estimates for the effect of a stimulus plan cite no new evidence and no theory at all for their large multipliers…. [T]hey state that every dollar of government spending generates 1.57 dollars of output always! If you've got magic, why not 2 trillion dollars? Why not 10 trillion dollars? Why not 100 trillion, and we can all have private jets?… "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 (K) needs any comment at all.

Then comes the conclusion:  

(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.

A return to the quantity theory of money (1) with a technologically-determined velocity--which we thought he had abandoned in (I).