Grasping Reality on TypePad, by Brad DeLong

And here  is John Cochrane, also a professor at Chicago, and someone who has made important academic contributions to macroeconomic thinking.

Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work.  Spending supported by taxes pretty obviously won’t work:  If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off.

Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises. But surely very clever people cannot make simple errors of this kind? Perhaps there is some way to re-interpret such statements so that they make sense. They would make sense, for example, if the extra government spending was permanent. The only trouble is that both statements were made about a temporary fiscal stimulus package….

I prefer to just note that if any undergraduate or graduate student in the UK wrote this in an exam, they would lose marks. The more interesting question for me is why the errors were made…. I think… we cannot imagine members of a physics department making such errors. What is different about macro?

I want to suggest two answers. The first is familiarity with models. I cannot imagine anyone who teaches New Keynesian economics, or who talked to people who teach New Keynesian economics, making this mistake. This is because, in these models, we do have to worry about aggregate demand. We focus on consumption smoothing, and Ricardian Equivalence, and teach it from the start. I often tell my first year undergraduate students that if they write anything like ‘Ricardian Equivalence says fiscal stimulus will never work’, they are in danger of failing….

In a separate piece, Cochrane writes: "'New-Keynesian' thought is devoted to defending the importance of monetary policy… incorporating specific frictions… not to rescuing the ancient view that fiscal stimulus is important"…. This is broadly true for New Keynesian theory when monetary policy is unconstrained… but not when interest rates are stuck at a lower bound. Cochrane is not saying New-Keynesian theory is wrong, but implies incorrectly that it suggests fiscal stimulus will not work….

The second difference between physics and macro that could lead to more mistakes in the latter is ideology. When you are arguing out of ideological conviction, there is a danger that rhetoric will trump rigour. In the next paragraph Cochrane writes

These ideas changed because Keynesian economics was a failure in practice, and not just in theory. Keynes left Britain 30 years of miserable growth. Richard Nixon said, “We are all Keynesians now,” just as Keynesian policy led to the inflation and economic dislocation of the 1970s--unexpected by Keynesians but dramatically foretold by Milton Friedman’s 1968 AEA address. Keynes disdained investment, where we now all realize that saving and investment are vital to long-run growth. Keynes did not think at all about the incentives effects of taxes. He favored planning, and wrote before Hayek reminded us how modern economies cannot function without price signals. 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.  If we forget all that, we could repeat the economics of postwar Britain, of spend-and-inflate Latin America, and of bureaucratic, planned India.

Let’s not worry about where the idea that Keynes disdained investment comes from, or any of the other questionable statements here. This is just polemic: Keynes=fiscal expansion=planning=macroeconomic failure.  It is guilt by association. What on earth does fiscal expansion have to do with planning? Well, they are both undertaken by the state…. The problem too many macroeconomists have with fiscal stimulus lies… with the fact that it represents intervention by the state designed to improve the working of the market economy. They have an ideological problem…. But the central bank is part of the state, and it intervenes… so this ideological view would also mean that you played down the role of monetary policy in macroeconomics. So… an ideological view that distorts economic thinking can lead to mistakes.

And Chris Dillow:

Simon Wren-Lewis writes:

Simon Wren-Lewis asks a good question about Robert Lucas‘s and John Cochrane‘s… silly errors…. He suggests two good answers. I’d like to suggest a third. There are two different ways of thinking about economics--the model paradigm and the mechanism paradigm, and the former has crowded out the latter.

Simon['s points]… would be obvious to anyone using the mechanism paradigm. If you ask “What is the mechanism whereby higher taxes reduce consumer spending?” you pretty much walk into the notion of consumption smoothing…. But lots of brilliant economists don’t think merely in terms of mechanisms but rather build impressive models. And like photographers, they tend to fall in love with their models which distracts them both from others’ models and from mechanisms. This matters, because the importance of particular mechanisms varies from time to time….

A good example of this lies in the idea of expansionary fiscal contraction. The virtue of this idea is that it draws our attention to mechanisms (a falling exchange rate, better corporate animal spirits, whatever) whereby fiscal contraction might boost the economy. The drawback is that these mechanisms are just unlikely to operate here and now. Yes, there’s a model that tells us that expansionary fiscal contraction can work. And there are models that say it can’t. But arguing about competing models misses the practical point.

Now, there is an obvious reply to all this. Models have the virtue of ensuring internal consistency, and thus avoiding potentially misleading partial analysis. However, I’m not sure whether this is an argument against mechanisms so much as against poor thinking about them…. When I became a practising economist, I found [models] to be less useful in thinking about the economy than Elsterian thinking about mechanisms…. Insofar as [models] have uses other than as mental gymnastics for torturing students, it is because of the mechanisms contained within them.

And Simon Wren-Lewis today on those who cling to their gods and guns RBC models and claims of the impotence of fiscal policy at the ZLB:

ZLB Models?: There was a little interchange between Noah Smith and Paul Krugman… on… Japan’s stagnation, and… the Great Recession…. In NK models recessions last for as long as it takes for prices to fully adjust. So how can NK models explain a lost decade or more?… Often the implication is that this is implausible, so the explanation must be supply side. The answer… is the Zero Lower Bound (ZLB). Noah replied…. I was unhappy about how his discussion was framed… [a] framing is common to a lot of macroeconomists….

It is often said that NK models just add price stickiness to RBC models, and if prices are sticky in the short run, aggregate demand matters in the short run…. I like to express it differently…. The mechanism by which we can or cannot ignore aggregate demand… is monetary policy…. [In] NK models… price adjustment induces a monetary policy response… that ensures demand shortfalls are not persistent. Break the monetary policy response, because you hit the ZLB, and you break the correction mechanism…. The ZLB therefore allows NK models to generate much more persistent recessions, if the recessionary shock is itself large and persistent….

The implications of the ZLB for RBC models are just as profound…. If the correction mechanism is broken because of the ZLB, then the foundation on which the model is built becomes problematic…. You cannot assume that the real interest rate will always be at the natural level if there is no way that real interest rate can be achieved….

Of course you can ignore this… try to use RBC models…. But there are two huge problems with this. First, it ignores a big piece of evidence--these economies are at the ZLB!… [Second] the model is not microfounded. Thinking about mechanisms rather than models helps you see that….