Grasping Reality on TypePad, by Brad DeLong

Here is his January 2009 root-and-branch opposition to the Recovery Act:

Oliver Staley and Michael McKee: John Cochrane, a finance professor at the Booth School of Business at the University of Chicago, said that while [James] Tobin made contributions to investing theory, the idea that spending can spur the economy was discredited decades ago. “It’s not part of what anybody has taught graduate students since the 1960s,” Cochrane said. “They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn’t make them less false.” To borrow money to pay for the spending, the government will issue bonds, which means investors will be buying U.S. Treasuries instead of investing in equities or products, negating the stimulative effect, Cochrane said. It also will do nothing to unlock frozen credit, he said…

Here is John Cochrane in January 2012:

John Cochrane: Let's be clear what the "fiscal stimulus" argument is and is not about. It is not about the proposition that governments should run deficits in recessions. They should, for simple tax-smoothing, consumption-smoothing, and social-insurance reasons…. Nor is it about debt financing of "infrastructure" or other genuine investments. If the project is valuable, do it. And recessions, with low interest rates and available workers, are good times to do it…. The "stimulus" proposition is that additional spending -- whether needed or not -- raises output and general welfare. Pay people $1 to dig ditches and fill them up again, and the whole economy gains $1.5…. Stimulus [is] still an economically interesting proposition, and there is a great deal of uncertainty about whether, when, and how well it might work. There is a huge academic literature being produced right now…. Here are the facts. Some economic models do predict a fiscal stimulus effect. Some don't…. The facts are far from decisive…. So, there is a lot of uncertainty and a lot we don't know about how the macroeconomy works…

Ideas that back in 2009 were discredited decades ago--that are "fairy tales" are by 2012 "economically interesting propositions… [about which] there is a good deal of uncertainty. Belief in one of these statements prohibits belief in the other in a very strong sense indeed. And if you are going to say "A" in 2009 and "Not A" in 2012, at the very least you owe people an explanation of why you have changed your mind--and people like Businessweek who quote you owe their readers at least a note that you have changed your mind.

Businessweek could have noted that Robert Lucas also appears to have a similar very deep intellectual consistency problem. He claims, in March 2009--without talking to Christina Romer beforehand, without even reading the newspaper, without knowing that she was one of the architects of the Recovery Act, thought it was worth trying, and thought it should be bigger--that:

Christina Romer--here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this--in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.... [I]t's a very naked rationalization for policies that were already, you know, decided on for other reasons…. 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... 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...

Yet by September 2011 he is saying that:

If you think Bernanke did a great job tossing out a trillion dollars [via expansionary monetary policy purchases of bonds for cash], why is it a bad idea for the executive to toss out a trillion dollars [through the Recovery Act]? It's not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that...

If the important thing is "to push money out there and try to keep spending from falling too much" there's no warrant for calling policies in 2009 that try to achieve that "just a wash… there's nothing to apply a multiplier to". No warrant at all. If Christina Romer's recommendations on fiscal policy are, as Lucas says in 2011, "not inappropriate" it is hard to see in what sense they can be, in 2009, "shlock economics". Belief in one statement once again prohibits belief in the other in a very strong sense indeed. Once again, if you are going to say "A" in 2009 and "Not A" in 2012, at the very least you owe people an explanation of why you have changed your mind--and people like Businessweek who quote you owe their readers at least a note that you have changed your mind.

It would have been nice if Businessweek noted that a third member of the Chicago Foursome of 2009, Judge Richard Posner, appears to have gone the full road-to-Damascus-street-called-Straight-scales-fall-from-eyes apostate route and become a "Keynesian":

[Milton] Friedman’s macro theory, along with [Robert] Lucas’s macro theory, did not have a clue as to what had happened. That was pretty bad. Also, and more interesting to me, [the financial crisis] called into question a whole approach to economics—one that is very formal, making very austere assumptions about human rationality: people have a lot of information, a lot of foresight. They look ahead. It is very difficult for the government to affect behavior, because the market will offset what it does. The more informal economics of Keynes has made a big comeback because people realize that even though it is kind of loose and it doesn’t cross all the “t”s and dot all the “i”s, it seems to have more of a grasp of what is going on in the economy…

That leaves only one of the Chicago Foursome of 2009--Eugene Fama--without what looks, to me at least, like a recantation and abjuration of their early-2009 interventions in American civic discourse--strong and definitely impolite and uncollegial interventions in opposition to the Recovery Act in particular and to Obama administration economic policy more generally.

And it would have been very nice had Businessweek noted either how far out in the Gamma Quadrant Fama is.

Businessweek could have mined John Cassidy's interview with Eugene Fama to show its readers that Fama's opinions on a number of issues are… rather unusual, shall we say:

[The efficient market hypothesis] did quite well in this episode [of 2008]. Stock prices typically decline [and interest rate spreads rise] prior to and in a state of recession…. There was nothing unusual about that. That was exactly what you would expect if markets were efficient…

I don’t even know what that [term, credit bubble,] means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning…

[W]e had a so-called "credit crisis". It wasn’t really a credit crisis. It was an economic crisis. I don’t think [the credit crisis began before the recession]. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession…. [The recession] had to [have started not in 2008 but in 2006], to be showing up among people who had mortgages. Nobody who’s doing mortgage research—we have lots of them here—disagrees with that…

Everybody talks about a credit crisis. The variance of stock returns for the market as a whole went up to, like, sixty per cent a year—the Vix measure of volatility was running at about sixty per cent. What that implies is not a credit market crisis. It would be stupid for anybody to give credit in those circumstances, because the probability that any borrower is going to be gone within a year is pretty high. In an efficient market, you would expect that debt would shorten up. Any new debt would be very short-term until that volatility went down…. [That] is exactly how you would expect the [efficient financial] market to work…

I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it…

I’m a student of Merton Miller, after all. In the Modigliani-Miller view of the world, it’s only the assets that count. The way you finance them doesn’t matter. If you decide that this type of activity should be financed more with equity than debt, that doesn’t particularly have adverse effects on the level of activity in that sector. It is just splitting the risk differently…

Krugman wants to be the czar of the world. There are no economists that he likes…. [Larry Summers] What other position could he take and still have a job? And he likes the job…

[T]here is no evidence [that periods of high asset returns are followed by periods of low asset returns]…. The expected return on stocks is just a price—the price people require to bear the market risk. Like any price, it should vary from time to time, and maybe it should vary in predictable ways. I’ve done a lot of work purporting to show there’s a little bit of predictability in overall market returns, but that branch of the literature has so many statistical problems…

They could have cited Fama's original claims that increases in government spending always and everywhere induced immediate and complete offsetting falls in private spending.

Here it is, complete and unedited:

Eugene Fama: Bailouts and Stimulus Plans: There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),

PI = PS + CS + GS(1)

In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole. For example, in recent years private investment in the US has been greater than the sum of private, corporate, and government savings in the US. This means the US has been importing savings from the rest of the world (by selling US securities to the rest of the world). But the equation always holds for the world as whole.

The quantities in the equation are not predetermined from year to year, and government actions affect them. The goal of government policy is to expand current and future incomes. When I analyze the auto bailout and the stimulus plan below, I judge them on whether they are likely to achieve this goal.

Government bailouts and stimulus plans seem attractive when there are idle resources - unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another. And bailouts and stimulus plans only enhance future incomes when the activities they favor are more productive than the activities they displace. I come back to these fundamental points several times below.

A Bailout of the Auto Industry

The bailout of the auto industry is a good place to cut one's teeth on the effects of government action.

Most politicians favor the auto bailout. They fear that if the big three automakers fail, millions of jobs will be lost. Many people have pointed out that U.S. bankruptcy law makes this outcome unlikely. When a big company goes into (Chapter 11) bankruptcy, it is not liquidated. Instead, the company continues to operate, while reorganizing under court supervision.

There is, however, an important point, never mentioned by those in favor or those against a bailout. I phrase it in terms of the equation above. Bailouts of auto firms will be financed with government debt. The government deficit gets larger; that is, government savings, GS, become more negative. If private and other corporate savers do not save more in response to additional government debt, the auto bailout displaces productive investments elsewhere. If private and other corporate savers do save more in response to additional government debt, private consumption must go down by the same amount. This lost consumption and investment, and the incomes they would create, are the big costs of a bailout.

The real question posed by the auto bailout is then clear. Will the benefits, in terms of higher current and future incomes in the auto industry, fully offset the incomes lost as a result of the lost consumption and investment that the bailouts displace?

We are all moved by the visible prospect of lost jobs in the auto industry. We tend to forget the unnamed people who lose jobs or don't get jobs, the businesses that close or the new businesses that don't start, because the bailout displaces productive activities elsewhere.

The Sad Logic of a Fiscal Stimulus

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, either directly on government investment projects or indirectly through the consumption and savings decisions of the recipients of government spending. The current stimulus plan adds up to about $750 billion. Will it work?

Unfortunately, there is a fly in the ointment. Like the auto bailout, government 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.

Government infrastructure investments benefit the economy if they are more productive than the private projects they displace. Some government investments are in principle productive. The government is the natural candidate to undertake investments that have widespread positive spillovers (what economists call externalities). For example, a good national road system increases the efficiency of almost all business and consumption activities. Because all the benefits of a good road system are difficult for a private entity to capture without creating inefficiencies (toll or EZ Pay booths on every corner), the government is the natural entity to make decisions about road building and other investments that have widespread spillovers.

Like all government actions, however, government investments are prone to inefficiency. To survive, private entities must invest in projects that generate more wealth than they cost. Public investments face no such survival threat. Even good government investment projects can become wealth burners because their implementation is captured by interest groups (for example, minority or gender set asides, or insisting on unionized labor). Moreover, a $750 billion stimulus package will draw a feeding frenzy by public (state and local) and private interest groups, to pressure for their favored projects, which might not otherwise meet the market test. If the interest groups win, the country will be poorer, and future incomes will be lower.

But we're talking about future benefits. "Stimulus" spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today. If you want to build roads or do other investment projects, defend them by standard cost/benefit calculations. And don't use the misleading "s" word.

Suppose the stimulus plan takes the form of lower taxes, another proposal of the incoming administration. Alas, we can't get something for nothing this way either. If the government doesn't also spend less, lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes.

The details of the effects of lower taxes depend on how the public uses the proceeds. If taxpayers understand that lower taxes now are exactly offset by the current market value of the future tax liabilities implied by the current increase in government debt, they may simply save the proceeds from the tax windfall. Private savings then substitute for the fall in public savings due to the government debt issue, and there is no effect on private investment or economic activity more generally. (This is what Robert Barro dubbed Ricardian Equivalence.)

Suppose the recipients of the tax reduction from the stimulus don't know about Ricardian Equivalence, and they use the windfall to buy consumption goods. Does this increase economic activity? The answer is again no. The composition of economic activity changes, but the total is unchanged. Private consumption goes up by the amount of the new government debt issues, but private investment goes down by the same amount.

I must shade my arguments a bit (but just a bit). Remember that the (investment equals savings) equation above holds for the global economy but not necessarily for an individual country. If we can get foreigners to buy the additional debt to finance bailouts and a stimulus, we can have additional government spending without reducing private spending. This is how we have financed government deficits for at least the last eight years, so perhaps we can do it for another year or so, and on a grand scale. At the moment, however, most countries are deep into their own bailout-stimulus games. More important, this "cure," if available, is temporary. When foreigners transfer savings to us now in exchange for our government bonds, they take back the resources plus interest later. If the government expenditures generate less wealth than they cost, the wealth loss is borne by future taxpayers, when the government debt is repaid.

A common counter to my arguments about why stimulus plans don't work is to claim that the current situation is different. Specifically, the investment equal savings equation doesn't work because savers currently prefer to invest in low risk assets like government bonds rather than in potentially productive but more risky private investment projects. In other words, there is a "flight to quality." Sorry, but this is a fallacy. A flight to quality does raise the prices of less risky assets and lower the prices of more risky assets. But when new savings are used to buy government bonds, the people who sold the bonds must do something with the proceeds. In the end, the new savings have to work their way through to new private investment, and equation (1) always holds.

The Bottom Line

The general message bears repeating. Even when there are lots of idle workers, government bailouts and stimulus plans are not likely to add to employment. The reason is that bailouts and stimulus plans must be financed. The additional government debt means that existing current resources just move from one use to another, from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment. And stimulus plans only enhance future incomes when they move current resources from less productive private uses to more productive government uses - a daunting challenge, to say the least.

Businessweek might have noted that this passage from Fama does contain a great deal of statements that have no coherent interpretation as anything but Econ 1-level errors.

And it would have been nice if Businessweek had noted that neither Tyler Cowen nor Scott Sumner appears to have any substantial quarrels with Krugman's analytics but rather just with his "tone".

But Businessweek does none of those things.