John Cochrane: Getting Krugman Right
Last week, I offered some reactions to Paul Krugman's New York Times magazine article. One of the economists coming in for direct criticism as a representative of the Chicago School was John Cochrane. Through the magic of the internet, he responds. One of my favorite passages:
If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. Seriously. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he really borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.
Read the whole thing.
And he got away with it for over a decade
and could have gotten away with it indefinitely if he could print his own money. Arguments Keynesianism can't work are obviously false. Madoff proved it. The market had no problem believing him.
Cochrane's failure to distinguish between commercial and investment banks, and between insurance and guarantees and those without such but too big to fail anyway undermines his understanding of the crisis. Then he fails to address the most important idea, that finance will have to be incorporated into these models. While Keynesian models have been and are central to the modeling undertaken, the Neoclassicals have been influential at the decision making and regulatory level. They were at the heart of Greenspan's regulatory avoidance, that bubbles don't exist, and that regulators can't second guess the market. And far from arguing against data, Paul is arguing the data has been neglected in favor of prejudgments and that it had nothing to offer after the failure of conventional monetary policy. The failure to work out those before being needed is probably the worst indictment of economics. For all Bernanke's faults, I still trust his judgment more than the rest of the lot.
Missing the elephant
Like the 6 Wise Men of Hindustan* economists have got hold of the leg of the elephant and pronounced it is "like a tree". Recent monetary policy has focused on employment rate and prevention of wage-price spirals. However, since the 1980s, substitutions of capital for labor and the globalization of the labor market have kept wage inflation in check.
The large inflationary pressures are asset and commodity price inflation. Commodity price inflation (oil shocks especially) are difficult to address with monetary policy. Volcker tried it in 1980 but the real damper on oil shocks was the Carter energy policies that reduced oil demand in the US by over 20%. It is not until 2000 when oil demand surpassed 1978 levels that we once again see oil shocks. The high oil prices were increasing food prices world-wide and led to the collapse of the American Auto industry. The corrective for oil price inflation is a new round of efficiency and conservation standards plus oil alternatives that back demand for oil away from capacity. Keep a large enough gap between demand and capacity is essential to discourage speculators and other price manipulation.
We saw a tech stock bubble and crash followed by a housing bubble and crash. While monetary policy could have been used to address these "inflated assets", monetary policy tight enough to have an effect on asset inflation would have had negative consequences for the rest of the economy. It would not be an appropriate level of the money supply.
Old school economists are horrified at the thought of using regulation and fiscal policy to address asset inflation. However, this ignores the fact that markets already operating under a set of existing regulations. Speculators and those who would game the system exploit loopholes in the regulations, so the regulations continually need to be modified to address "speculators" and "innovations" that escape regulation. Those wishing to "game the system" will always work to undermine the rules for transparency and fairness in the markets (because they make their money from information asymmetry and they want excessive returns, not fairness). Economists need to "get over it" and promote improved (fair, high compliance, high ease of compliance) regulations instead of taking a strictly anti-regulation stance that in practice freezes the status quo in place. Unwillingness to regulate and enforce regulations allowed energy companies to inflate their energy prices and gouge CA customers and businesses in 2001. Unwillingness to demand adequate equity allowed people to purchase houses they could not afford.
Inflation of asset prices and commodities is the current threat to economic stability. Too many old school economists are fighting the last-century battles against wage-price spirals.
Monetary policy works best for micromanaging the economy within a relatively narrow rage of inflation and unemployment. Regulations and fiscal policy interventions are necessary to keep an economy in a range where monetary policy is optimal. We need a new breed of economists willing to improve the regulatory tools for managing the economy in a way that complements monetary policy.
* http://homepage.usask.ca/~wae123/misc/prose/hinustan.htm
Madoff
Madoff is an entirely inappropriate comparison to taxation and wealth distribution. Madoff took money from investors in a manner that was unfair to the investors and a way that greatly reduced spending by many of the investors.
No set of economic rules is perfect. Therefore, some economic outcomes will be unfair. Some people benefit more from the economic rules in place while others are harmed. Wealth redistribution recognizes that the economic rules are imperfect. At the end of the day, redistribution is an attempt to correct some of the distortions created by imperfect rules.
All economies need some level of public property and public investment in order for private investment to thrive. Public investment and spending is not all bad as many libertarians like to imply. There is a balance that needs to be struck between public and private investment. An informed debate would be about what levels of public spending are optimal.
An uninformed debate argues that all government spending is bad and refuses to accept cost benefit analysis of government spending versus privatization.
Ummm... Andrew: Is this as
Ummm...
Andrew: Is this as stupid as it seems? I mean, the *point* of stabilization policy is not to always boost spending but rather to match spending to aggregate supply...
Cochrane's Response
Cochrane doesn’t say, at least not in this article, what he would do in the face of the financial crisis. To my knowledge there were few, if any, “serious” (and by that I mean respected, academically credentialed, from whichever water) economists who advocated doing nothing. But if government always makes matters worse, that’s what is implied.
If “government regulators failed just as abysmally as private investors” to see the storm coming, it’s because they drank the free market Kool Aid like everyone else.
To sum up anyone's position as “the market got it all wrong” and “the government can put it all right…to Federal control of stock and house prices and allocation of capital,” is partisan, talk-radio level hyperbole.
The problem with the Ricardian equivalence theorem is the assumption that “people, seeing the higher future taxes that must pay off the debt, will simply save more.” This is gives “the people” way to much credit for fiscal savvy. Do you really think in a country where half the population don’t know who their congressmen or senators are, or what the century the civil war was in, people even know what a “deficit” is, much less its implications, the average consumer will say uh-oh, higher taxes coming, I’d better save money? And yes, I’m being “elitist” (gasp!)
The centerpiece of the crash was not the stock or real estate markets, it was regulated commercial banks? No, it was an absurdly leveraged, largely unregulated banking system trafficking in derivatives so complex that not even the wood-be regulators understood them, evaporating responsibility for high-risk securities that passed through so many financial incarnations that nobody was exactly sure who owned what.
It’s one thing to compare Krugman to Will, Krauthammer, and Rich, but saying he want to the Rush Limbaugh of the left is a cheap shot. The former are respected, if partisan, commentators; Limbaugh is a carny-barker who shovels silly caricatures and ad homonym attacks to bumpkins and yahoos.