Toward a run-free financial system

November 4 2014. In Martin Neil Baily, John B. Taylor, eds., Across the Great Divide: New Perspectives on the Financial Crisis, Hoover Press. This is an essay about what I think we should do in place of current financial regulation. We had a run, so get rid of run-prone liabilities. Technology and financial innovation means we can overcome the standard objections to "narrow banking." Some fun ideas include a tax on debt rather than capital ratios, the Fed and Treasury should issue reserves to everyone and take over short-term debt markets just as they took over the banknote market in the 19th century, and downstream fallible vechicles can tranche up bank equity.

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Challenges for Cost-Benefit Analysis of Financial Regulation.

Journal of Legal Studies 43 S63-S105 (November 2014). Is cost benefit analysis a good idea for financial regulation? I survey the nature of costs and benefits of financial regulation and conclude that the legal process of current health, safety and environmental regulation can't be simply extended to financial regulation. I opine about how a successful cost-benefit process might work. My costs and benefits expanded to a rather critical survey of current financial regulation. It's based on a presentation I gave at a conference on this topic at the University of Chicago law school Fall 2013, with many interesting papers. JSTOR link with HTML and nicer pdf. The JLS issue with all conference papers.

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Monetary Policy with Interest on Reserves

Journal of Economic Dynamics & Control 49 (2014), 74-108. ( ScienceDirect link to published version, html and pdf) I analyze monetary policy with interest on reserves and a large balance sheet. I argue for the desirability of this regime on financial stability grounds. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy -- buying and selling government debt with no effect on surpluses -- can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though not with the usual signs in this model. Figures 2 and 3 are the best part -- the effects of monetary policy with and without fiscal coordination. I address theoretical controversies, and how the fiscal backing of monetary policy was important for the 1980s disinflation. A concluding section reviews the role of central banks. Matlab program.

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Comments on "Mortgage Risk and the Yield Curve"

Comments on Aytek Malkhozov, Philippe Mueller, Andrea Vedolin, and Gyuri Venter, "Mortgage Risk and the Yield Curve," slides presented at the NBER AP meeting, July 2014.

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Comments on "A Model of Secular Stagnation"

Comments on Gauti Eggertsson and Neil Mehrotra, "A Model of Secular Stagnation," slides presented at the NBER EFG meeting, July 2014.

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A mean-variance benchmark for intertemporal portfolio theory

Journal of Finance, 69: 1–49. doi: 10.1111/jofi.12099 (February 2014) (link to JF) (Manuscript) Applies good old fashioned mean-variance portfolio analysis to the entire stream of dividends rather than to one-period returns. Long-Run Mean-Variance Analysis in a Diffusion Environment is a set of notes, detailing all the trouble you get in to if you try to apply long-run ideas to the standard iid lognormal environment, and also discusses shifting bliss points a bit.

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Finance: Function Matters, not Size

May 2013 Journal of Economic Perspectives 27, 29–50 JEP link (Previous title "Is Finance Too big?" December 2012.) Is finance "too big?" Is this the right question? .

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Having your cake and eating it too: The maturity structure of US debt

November 12 2012 How the US Treasury can both lengthen and shorten its debt at the same time, to buy insurance against interest rate rises and provide "liquidity." A short paper diguised as comments on Greenwood, Hanson, and Stein “A Comparative Advantage Approach to Government Debt Maturity” at the Second Annual Roundtable on Treasury Markets and Debt Management , US Treasury, Nov. 15 2012

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Financial Markets and the Real Economy

In Rajnish Mehra, Ed. Handbook of the Equity Premium Elsevier 2007, 237-325. Everything you wanted to know, but didn’t have time to read, about equity premium, consumption-based models, investment-based models, general equilibrium in asset pricing, labor income and idiosyncratic risk. 

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This article appeared four times, getting better each time. (Why waste a good article by only publishing it once?) The link above is the last and the best. The previous versions were NBER Working paper 11193,  Financial Markets and the Real Economy Volume 18 of the International Library of Critical Writings in Financial Economics, John H. Cochrane Ed., London: Edward Elgar. March 2006, and in Foundations and Trends in Finance 1, 1-101, 2005.

Comments on "Volatility, the Macroeconomy and Asset Prices

Comments on "Volatility, the Macroeconomy and Asset Prices, by Ravi Bansal, Dana Kiku, Ivan Shaliastovich, and Amir Yaron, and “An Intertemporal CAPM with Stochastic Volatility” by John Y. Campbell, Stefano Giglio, Christopher Polk, and Robert Turley. Also slides. April 13 2012 Comments presented at the spring NBER asset pricing meeting. I took the opportunity to offer a sceptical apparisal of long-run risks, and whether stochastic volatilty really works as a state variable, especially in the long run.

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The Fiscal Theory of the Price Level and its Implications for Current Policy in the United States and Europe

The Fiscal Theory of the Price Level and its Implications for Current Policy in the United States and Europe November 19, 2011 This is the text of my presentation at the concluding panel of the conference, “Fiscal Policy under Fiscal Imbalance,” hosted by the Becker-Friedman Institute and Federal Reserve Bank of Chicago.

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Continuous-time linear models

Foundations and Trends in Finance 6 (2011), 165-219.  How to do ARMA models, opreator tricks, and Hansen-Sargent prediction formulas in continuous time.

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Inflation and Debt

National Affairs 9 (Fall 2011). html An essay summarizing the threat of inflation from large debt and deficits. The danger is best described as a "run on the dollar." Future deficits can lead to inflation today, which the Fed cannot control. I also talk about the conventional Keynesian (Fed) and monetarist views of inflation, and why they are not equipped to deal with the threat of deficits. This essay complements the academic (equations) "Understanding Policy" article (see below) and the Why the 2025 budget matters today WSJ oped (on oped page).

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Discount Rates

Joural of Finance 66, 1047-1108 (August 2011). My American Finance Association Presidential speech. The video (including gracious roast by Raghu Rajan) The slides. Data and programs (zip file) Price should equal expected discounted payoffs. Efficiency is about the expected part. The unifying theme of today's finance research is the discounted part -- characterizing and understanding discount-rate variation. The paper surveys facts, theories, and applications, mostly pointing to challenges for future research.

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Is QE2 a Savior, Inflator, or a Dud?

The Federal Reserve’s experiment with a second round of quantitative easing is nearing an end. Did it achieve its goal of lowering interest rates and stimulating the economy?

Should we remember QE2 as a brilliant innovation, a central piece of the Fed’s future recession and deflation-fighting toolkit? Or is it the first step toward hyperinflation? When the Fed stops buying government bonds, will interest rates rise sharply because no one else is buying?

In fact, QE2 didn't stimulate the economy, as the left had hoped, nor will it lead to the inflationary or bond-market disaster feared by the right. QE2 did basically nothing. But that is a deep and unsettling lesson: The Fed is essentially helpless in the current situation.

The chart attached to the left shows how interest rates behaved through the QE2 episode.

The red dashed line represents total Fed holdings of Treasury notes and bills. You can see the sharp rise starting in November 2010. The Fed purchased $600 billion of long-term government bonds, giving banks $600 billion more reserves in return. (Bank reserves are accounts banks hold at the Fed.)

The vertical lines mark the two big Fed announcements. On Aug. 10, the central bank announced that it would reinvest maturing assets in Treasuries. On Nov. 3, it announced the actual QE2 program.

QE2 doesn't seem to have lowered any interest rates. Yes, five-year rates trended down between announcements, though no faster than before. The November QE2 announcement and subsequent purchases coincided with a sharp Treasury rate rise. The five-year yields where the Fed bought most heavily didn't decline relative to the other rates, as the Fed’s “segmented markets” theory predicts. The corporate and mortgage rates that matter for the rest of the economy rose throughout the episode.

How should we interpret this apparently abject failure? In March testimony before the Senate Banking Committee, Fed Chairman Ben Bernanke saw it as evidence of the central bank's great power:

“Yields on 5- to 10-year nominal Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases.”

If yields go down, the Fed is successfully stimulating the economy with QE2. And if yields go up? Well, the Fed is successfully stimulating the economy with QE2. And Bernanke claimed almost miraculous additional effects:

“Equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation ...has risen to historically more normal levels.”

On the other hand, Philadelphia Fed President Charles Plosser warns that QE2 provides too much stimulus: The bank has "a trillion-plus excess reserves," he said, providing "the fuel for inflation."

Expected inflation could explain the sharp rise in long-term yields starting in November. But the rate for 10-year Treasury Inflation Protected Securities, or TIPS, rose in parallel, contradicting that interpretation. Simultaneously denying Bernanke, however, the five-year TIP rate didn't rise. An increase in that rate would have been a sign of a stronger economy in the next five years. The bond market is a tough critic.

Both sides ignore an inescapable conclusion: With near-zero short-term interest rates, and bank reserves paying interest, money is exactly the same thing as short-term government debt. A bank doesn't care whether it owns reserves or three-month Treasury bills that currently pay less than 0.1 percent.

This is what drove the Fed to QE2 in the first place. Conventional easing -- buying short-term Treasuries in exchange for reserves -– obviously has no effect now. Taking away your green M&Ms and giving you red M&Ms instead won't help your diet.

But if exchanging money for short-term debt has no effect, it follows inescapably that giving banks more money is exactly the same as giving them short-term debt. All QE2 does is to slightly restructure the maturity of U.S. government debt in private hands.

Now, of all the stories we've heard to explain our sluggish recovery, how plausible is this one: “Our big problem is the maturity structure of Treasury debt. If only those goofballs at Treasury had issued $600 billion more three-month bills instead of all these five-year notes, unemployment wouldn’t be so high. It’s a good thing the Fed can undo this tragic mistake.” That makes no sense.

For the same reason, when money is the same thing as debt, it doesn’t cause inflation.

Ineffective QE2 doesn't mean harmless QE2, however.

We are in danger of inflation for fiscal, not monetary reasons. If investors lose faith the U.S. will fix its long-run budget problems, they will try to sell government debt of all maturities. Rates will rise and stagflation will break out no matter what the Fed does.

Short-term debt dramatically increases this danger. If the U.S. were financed with long-term debt, bond prices would fall, but there would be time to fix the deficit and restore confidence in the debt. But the average Treasury maturity is less than a year. Every two years, the U.S. must find new borrowers to pay off most of our debt. If those investors depart, a stagflationary crisis must result. Our moment of low long-term rates is a golden opportunity to issue long-term debt, not to buy it back. QE2 was a small step in the wrong direction.

Moreover, QE2 distracts us from the real microeconomic, tax, and regulatory barriers to growth. Unemployment isn't high because the maturity structure of U.S. government debt is a bit too long, nor from any lack of “liquidity” in a banking system with $1.5 trillion extra reserves.

Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power, when it is basically helpless. If Bernanke had admitted to Congress, “there’s nothing the Fed can do. You’d better clean this mess up fast,” he might have had a much more salutary effect.

(John H. Cochrane is a professor of  finance at the University of Chicago Booth School of Business and a contributor to  Business Class.  The opinions expressed are his own.)

®2011 BLOOMBERG L.P. ALL RIGHTS RESERVED.

(Link to this article on Bloomberg)

Determinacy and Identification with Taylor Rules

Journal of Political Economy, Vol. 119, No. 3 (June 2011), pp. 565-615. Online Appendix B. JSTOR link, including html, pdf, and online appendix. Manuscript with Technical Appendix The technical appendix documents a few calculations. Don't miss starting on Technical Appendix page 6 a full analytical solution to the standard three equation model. I include the manuscript just so equation references in the Technical Appendix will work, the previous links to the published version are better.

Most people think Taylor rules stabilize inflation: Inflation rises, the Fed raises interest rates; this lowers “demand’’ and lowers future inflation. New-Keynesian models don’t work this way. In the models, the Fed reacts to inflation by setting interest rates in a way that ends up increasing future inflation. Inflation is “determined” as the unique initial value that doesn't set off accelerating inflation. Alas, there is nothing in economics to rule out accelerating inflation or deflation. I conclude that new-Keynesian models with Taylor rules don’t determine the price level any better than classic fixed interest rate targets. Price level determinacy requires ingredients beyond the Taylor principle, such as a non-Ricaridan fiscal regime. I survey the new-Keynesian literature to verify that no simple answer to this problem exists. All of the fixes slip in a commitment by the government to blow up the world at some point.

Even if the new-Keynesian model did work, The parameters of the Taylor rule relating interest rates to inflation and other variables are not identified. You can't measure "off equilibrium" behavior from data in an equilibrium. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a "passive" to an "active" policy in the early 1980s.

The appendix uncovers an interesting mistake in the classic Obstfeld and Rogoff (1983) attempt to prune inflationary equilibria, but also shows that reversion to a price level target can do the trick. The Techical Appendix has algebra for determinacy regions and solutions of the three-equation New-Keynesian model, as well as other issues.

This article supersedes the two papers titled "Inflation Determination with Taylor Rules: A Critical Review"and "Identification with Taylor Rules: A Critical Review" (September 2007).

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Quantitative Easing 2

March 3 2011 Comments on Jim Hamilton and Jing Wu, 2011, "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment", at the spring NBER Monetary Economics meeting. Slides. (The Op-ed section contains several op-eds and blog posts on qe2.)

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Understanding fiscal and monetary policy in the great recession: Some unpleasant fiscal arithmetic.

European Economic Review 55 2-30 ScienceDirect Link.
Why there was a big recession; will we face inflation or deflation, can the Fed do anything about it? Many facets of the current situation and policy make sense if you ask about joint fiscal and monetary policy. A fiscal inflation will look much different than most people think.  Slides that go with the paper. Appendix with the algebra for government debt valuation equations. A short simple version, my presentation at the Fall NBER EFG conference. A video of a short presentation given to the University Alumni Club in New York, October 2010. Slides for the New York talk if you were there

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Fiscal Stimulus, RIP

Was “fiscal stimulus” the central idea that saved us from a second great depression, with our only regret that is was not bigger? Or is this an old fallacy, tried and failed, and ready finally for the ash-heap of history?

Let’s be clear what this issue is not about.  Governments should run deficits in recessions, and pay off the resulting debt in good times. Tax revenues fall temporarily in recessions. Governments should borrow (or dip into savings), to keep spending relatively steady. Moreover, many of the things government spends money on, like helping the unfortunate, naturally rise in recessions, justifying even larger deficits.  Recessions are also a good time to build needed infrastructure or engage in other good investments, properly funded by borrowing.  For all these reasons, it is good economics to see deficits in recessions – and surpluses in booms.

We can argue whether the overall level of spending is too high; whether particular kinds of recession-related spending are useful or not; whether particular infrastructure really is needed; and we certainly face a structural deficit problem. But those are not the issue either.

The stimulus question is whether, beyond all this, the government should intentionally borrow and spend, or even give money away, on the belief that each dollar so borrowed and spent will raise output by $1.50, and therefore lower unemployment. This, and only this, is the Keynesian “multiplier” argument, and the true meaning of “fiscal stimulus.”

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 off2. 

“Stimulus” supposes that if the government borrows $1 from A and gives it to B we get a fundamentally different result, and we all are $1.50 better off.

But here’s the catch: to borrow today, the government must raise taxes tomorrow to repay that debt. If we borrow $1 from A, but tell him his taxes will be $1 higher (with interest) tomorrow, he reduces spending exactly as if we had taxed him today! If we tell both A and B that C (“the rich”) will pay the taxes, C will spend $1 less today.

Worse, C will work less hard, hire a bunch of lawyers, lobby for loopholes, or move to Switzerland. A will hire a lobbyist to get more stimulus. All this is wasted effort, so we’re worse off than before! The question for the “multiplier” is not whether it is greater than one, it’s how on earth it can be greater than zero? (Conversely, so far my arguments for the ineffectiveness of spending apply equally to tax cuts. But tax cuts can cut rates, which improves incentives.)

These statements are a theorem not a theory. I’m explaining (in very simple terms) Robert Barro’s (1974) famous “Ricardian Equivalence” theorem. “Theorem” means that if a bunch of assumptions, then borrowing has exactly the same effect as taxing. That doesn’t mean it’s true of the world, but it means that if you want to defend stimulus, you have to tell us which of the “ifs” you disagree with. That discipline changes everything.

Thoughtful stimulus advocates respond. Well, maybe people don’t notice future taxes. Does the man or woman on the street really understand that more spending today means more taxes tomorrow?

That’s an interesting position, but at this point, most of the battle is lost. Stimulus is no longer an “always and everywhere” law, it’s at best a “if people don’t notice that deficits today mean taxes tomorrow” idea. This qualification has deep implications.

First, it means that a “stimulus” policy can only work by fooling people. Is wise policy really predicated on fooling people? Also, people are unlikely to be fooled over and over again. If that’s how stimulus works, you can’t use it too often.

Second, it means that stimulus will work sometimes and not other times. Are American voters right now really unaware that larger deficits mean higher future taxes? Or is the zeitgeist of the moment exactly the opposite: Americans are positively aghast at the future taxes they think they’ll be paying? If you think people can be “irrational” they can be irrational in both directions. They can pay too much attention to future taxes corresponding to current deficits, and stimulus can have a negative effect!  When I compare tea party rhetoric to the actual reforms needed to cure America’s deficits, I think there’s a good chance we’re in this range.

Third, if this is the reason that stimulus works, then the current policy attempt, consisting of  stimulus now, but strong promises to address the deficit in the future, can have no effect whatsoever. If you think stimulus works by fooling people to ignore future tax hikes or spending cuts, then loudly announcing such tax hikes and spending cuts must undermine stimulus!  Augustinian policy, “give me chastity, but not yet,” will not work. Casanova is needed.

Well, maybe some other Barro assumption is wrong. Yes, there are many. (“Liquidity constraints” are a common complaint, keeping people from acting based on their estimation of the future.) But if you take any of them seriously, the case for stimulus becomes similarly circumscribed. Each specifies a channel, a “friction,” something fundamentally wrong with the economy that matters some times more or less than others, that restricts what kinds of stimulus will work, and that can be independently checked.  And in many cases, these “frictions” that falsify Barro’s theorem suggest much better direct remedies, rather than exploitation by fiscal stimulus.

Relaxing Barro’s assumptions can also lead to negative multipliers. For example, Barro assumed perfectly-efficient “lump-sum” taxes. In fact, we have proportional taxes with lots of loopholes. In the real economy, raising tax rates is an inefficient process, as is spending money. Recognizing this fact leads to my guess of a negative multiplier.  

So the biggest impact of Barro’s theorem is not whether it is “right” or “wrong” as a description of the world. The biggest impact is that, if you are at all intellectually honest, it forces you to deal with why it is wrong.  Many proponents do not do this; they just cite one assumption they don’t like, on the basis of intuition rather than real evidence, and go back to simplistic always-and-everywhere mulitipliers.  

There is a deeper problem with stimulus. Even if nobody notices future taxes, A was going to do something with the money.  Suppose, for example, A was a small business owner, and he was going to buy a forklift3. The government borrows the money instead, and gives it to B who buys a car.  Now the composition of spending has changed towards more “consumption.” But does the economy really care if B buys a car rather than A buying a forklift?  Barro’s theorem gives conditions in which nothing changes, including the split between consumption and investment. But his real point is deeper: Borrowing does not alter the “intertemporal budget constraint,” society’s overall wealth.

These two stories capture the central logical errors of Keynesian economics, and central advance of “equilibrium” or “inetertemporal” thinking that destroyed it and revolutionized macroeconomics in the 1970s. Some other big names in this effort are Friedman (1957), Lucas (1975), with Sargent (1979), Kydland, Prescott (1982). They pointed out two big mistakes in Keynesian economics:

First, Keynesian economics treats each moment in time in isolation. People’s consumption depends on their current income, not their future prospects. Investment decisions depend on current sales and interest rates, not whether companies expect future sales to be any good.  Modern macroeconomics extends across time. It recognizes that what people expect of the future is central to how they behave now.   Now, maybe people don’t “perfectly” or “rationally” evaluate the future. But that’s a far cry from saying they don’t consider the future at all!  And budget constraints – the fact that debt today must be paid off – are independent of your feelings.

Second, the “plans” of Keynesian economics4 ; how much we suppose people want to consume, invest, etc.; don’t automatically add up to their income, unlike the “demands” of regular economics  that must do so.  Keynesian economics ignores budget realities at each moment in time as well as the “intertemporal budget constraint” emphasized by Barro.

For these and other reasons, Keynesian ISLM models have not been taught in any serious graduate school since at least 1980, except as interesting fallacies or history of thought. I include my own graduate education at very liberal Berkeley starting in 1979. Even sympathetic textbooks, like David Romer’s Advanced Macroeconomics, cannot bring themselves to integrate Keynesian thinking into modern macro.  The “new Keynesian” economics, epitomized by Mike Woodford’s Interest and Prices has nothing to do with standard Keynesian thinking5 . Not a single policy simulation from a Keynesian model has appeared in any respectable academic journal since 1980. Not one. The whole business was simply discredited as being logically incoherent 30 years ago.

Now stimulus advocates may say “all academia lost its mind in about 1975.”  Paul Krugman’s New York Times article pretty much took that view. Maybe so.  I think most of academic macroeconomics lost its mind about 1935 and only started to regain it in the 1960s, so it certainly can happen.   But the claim “all academic economics from the last 35 years is wrong” is a far different form of scientific advice to policy-makers than is “sensible well-understood and widely-accepted economics supports my view.”  

I will admit to a bit of disappointment that so many economists revert to archaic Keynesian fallacies when under pressure. I have seen far too many well-trained Chicago Ph.D.s, whose entire professional career consists of exquisite intertemporal equilibrium modeling, fall apart when asked to explain policy, say to a Fed governor. Suddenly output becomes the sum of consumption “demand”, investent “demand” and government “demand,” ignoring that there is a supply in each case, and demand for one thing must come a the expense of another. I have seen the same economists forget that high interest rates are as likely to be a symptom of good times (high marginal product of capital) as a cause of bad times. In this sense, modern economics has indeed failed – we have failed to train our graduate students to really understand, apply and use the tools of modern macroeconomics, and to explain that analysis to slightly older economists trained in the ISLM tradition. But that doesn’t mean that good policy results by reverting to theories that were proved logically incoherent in the 1970s. 

Can’t the facts settle this argument? Alas, not easily – and both policy and economics would be better if they acknowledged this fact.  Some stimulus skeptics say “well, unemployment hit 10% after your stimulus,” and cite CEA chair Christina Romer and Jared Bernstein’s (2009) unlucky forecast that unemployment would stay below 8% if the ARRA “stimulus” package were passed.  This is unfair.  Stimulus advocates counter “without us, unemployment would have hit 15%” (or 20%, or pick your number, these are all made up out of thin air.)  Alas, cause and effect are hard to tease out in economics, because so much else is going on.

Stimulus buffs point to World War II, when the US borrowed and spent a lot, and output boomed. But skeptics point out that “everything else” is hardly kept constant in the middle of the greatest war ever fought, with price controls, production controls, direct command of much of the economy, rationing and a draft.  War economies can produce a lot, for a short while, and that fact is not only due to deficit spending.  Countries like the USSR that try to permanently run war economies don’t do so well.   

Skeptics might point to the Great Depression and Japan’s lost decade, in which stimulus seemed not to do much. But here advocates can point to other things going on, and claim again that things would have been worse without stimulus.

I can’t think of a single example in which a country attained prosperity and sustained growth by large deficit-funded social programs, make-work programs, or salaries and pensions for government workers, which is the issue here and a better precedent than WWII.  European and Latin American sclerosis come more to mind in this context. If stimulus leads to “growth,” why is Greece not superbly rich?

I am also dubious about empirical work in the absence of theory. If you don’t know how stimulus can work, can you productively look for it?  Is this like empirical work on the existence of UFOs?  Seriously, the violations of Barro’s theorem that might make stimulus work at one time or place are surely different than those which make it work in another time or place. Surely empirical evaluation must tie to measurement of which of Barro’s assumptions one feels does not hold.  

But the bottom line is that empirical work is hard.  21st century Economics is a lot like 18th century  medicine. The patient gets sick. The doctors come in, and bleed him, give leeches, and awful “medicines.”  “The Humors [“demand”] are out of whack.” “What humors?” “Oh, shut up and go read Galen [Keynes].” The patient gets worse, “we didn’t do enough,” and they bleed him some more.  He gets better, “we saved him.” Or maybe it was the toast with the strange mold that did it? Telling cause from effect is really hard.

And when you really don’t know,  “the patient is sick, we have to do something” is not wise policy or medicine.

Stimulus has all the telltale signs of bad, crackpot ideas. Already, I’ve mentioned repudiation of literally all macroeconomics taught in every Ph.D. program since 1980. Here are some more  “Bad Science Detectors:”

1. Stimulus supporters never say how it will work, and just cite authority. Ok, there’s this Barro theorem that says stimulus can’t work. Which one of the assumptions did administration economists or popular advocates disagree with? Let’s check. Instead, they simply assert it will work not even mentioning the classic theorem to the contrary.

2. They don’t take their own ideas seriously. Here are some examples.

a) If you really believe Keynesian Stimulus, you think Bernie Medoff is a hero. Seriously. He took money from people who were saving it, and gave it to people who were going to consume it. In return he gave the savers worthless promises that look a lot like government debt.

b) If you really believe in Keynesian Stimulus, then you don’t care if the money is spent properly or simply stolen. In fact, it would be better if it were stolen: thieves have a notoriously high propensity to consume, and their “spending” doesn’t wait for environmental impact statements unlike the unfortunate “shovel-ready” projects.   Keynesian Stimulus believers should advocate leaving the money around with the doors open.

c) Keynesian stimulus has nothing to do with “creating” or “saving jobs” directly, “green” industrial policy, or “infrastructure.”  If they believe their model, they should say loudly that it doesn’t matter how the money is spent. (And even here, there seems to be a view that the electorate can’t divide. Even if you believe that $800 billion saved something like 2 million jobs, that’s $400,000 per job!)

d) Berstein and Romer’s CEA report on the stimulus famously used a multiplier of 1.5 to evaluate the effects of the stimulus. They took this multiplier from models (p.12). But the multiplier is baked in to these models as an assumption. They might as well have just said “we assume a multiplier of 1.5.”

More deeply, why use the multiplier from the model, and not the model itself? These “models” are after all, full-blown Keynesian models designed purposely for policy evaluation. They have been refined continuously for 40 years, and they epitomize the best that Keyesian thinking can do. So if you believe in Keynesian stimulus, why use the multiplier and not the model?

The answer, of course, is that they would have been laughed at – nobody has believed the policy predictions of large Keynesian models since Bob Lucas (1975) destroyed them.  But how is it that one multiplier from the model still is a valid answer to the “what if” question, when the whole model is ludicrously flawed? If you believe the Keynesian model, let’s see its full predictions. If you don’t believe it, why do you believe its multiplier?

3.  More “Bad Science” detectors. One should always distrust advocates that have one fix (“more stimulus”) for everything, like the proverbial two-year-old with a hammer to whom everything looks like a nail. It sounds a lot like the old patent-medicine salesmen: “Recession got you down? Take some fiscal stimulus. Oh, a banking crisis is causing problems? Why it’s fiscal stimulus you need, son! Sclerotic labor markets? No problem, some fiscal stimulus will perk you right up. Nasty trade dispute? Why old Dr. Paul’s fiscal stimulus will perk you right up! Foreclosures giving a you headache? Why fiscal stimulus will solve that any day.”

A modern economy is a lot more complex than a car, and the answer to car troubles is not always “more gas.” If you see a solution being advocated for every problem, you begin to wonder how serious is the analysis that it solves any problem.

4. Finally, the desperation of recent arguments Keynesian stimulus advocates is a good indication of empty ideas.

Krugman and DeLong are blogging the idea that there is no model under which fiscal stimulus does not work. Well, how about Barro (1974) ? How about Kydland and Prescott (1981)? How about Baxter and King (1993)? These certainly are models, and classic models to boot. They are logically coherent – the “then” follows from the “if” and all the budget constraints and equilibrium conditions are right. The “if” might not describe the real world, so they might be wrong models. But they are models, they exist. And they are hardly obscure. They have been on every first year Ph.D. reading list since 1980, even at Princeton and Berkeley. The hard part has been to find on graduate reading lists any model in which stimulus does work.

How can one digest Krugman and DeLong’s “no model” assertions in light of this fact? There are only two logical possibilities: a) They don’t know about these classic works. b) They are deliberately lying to slander their opponents and mislead their readers.  As far as the strength of their argument, it does not really matter much which it is.

Similarly, Krugman now writes in his New York Times column that stimulus “wasn’t tried.” After $1.5 billion of deficit per year with $800 labeled “stimulus,” this claim is simply breathtaking. ($1.5 trillion: In the Keynesian model, all deficits count, not just the parts labeled “stimulus.”) It is obviously a feeble attempt to evade the overwhelming judgment of history that it was tried, in spades, threatening a second sovereign default crisis, and came up short.

5.  Most of all, you can tell a bad idea when you can tell the economics is cooked up after the fact to serve a political agenda.  A politician wants to spend a lot of money. “Hey economist, give me some talking points.”  “Sure,” says the economist, “we’ll defend it as fiscal stimulus.” That’s the only view that makes sense to me of the above inconsistencies, and it explains why this old idea is still bandied around in policy circles.

I am here to save good economic ideas, not to argue an alternative political agenda. Maybe it is a good idea to borrow, hire people, (in US, mostly state and local government workers), start a “green” industrial policy, give lump-sum or temporary tax rebates, and so on. I don’t think so, but we can have a good argument.  Just don’t justify it by “stimulus,” the proposition that each dollar so borrowed and spent makes us all $1.50 better off!  Doing so debases economics’ genuine ability to analyze policy and give us a credible menu of cause-and-effect statements! 

Keynes famously said, “Practical men… are usually the slaves of some defunct economist.” He was right (for once). Now he is the defunct economist. But we need not be his slaves!

References

Barro, Robert J. 1974,. "Are Government Bonds Net Wealth?" Journal of Political Economy 82 (6): 1095–1117.

Barro, Robert J. , 1981, “Output Effects of Government Purchases,” Journal of Political
Economy, 89: 1115.

Baxter, Marianne and Robert G. King, 1993,  “Fiscal policy in general equilibrium,” The American Economic Review, 83: 315-334.

Christiano, Lawrence, Martin Eichenbaum, and Sergio Rebelo, 2009, “When is the Government Spending Multiplier Large?” Manuscript, Northwestern University

Friedman, Milton, 1957, A Theory of the Consumption Function Princeton: Princeton University Press

Lucas, Robert E. Jr. 1975, “Econometric Policy Evaluation: A Critique,” in K. Brunner and A. Meltzer, eds., The Phillips Curve and Labor Markets, North-Holland.

Lucas, Robert E. Jr, and Thomas J. Sargent, 1979 "After Keynesian Macroeconometrics"  in After the Phillips Curve, Federal Reserve Bank of Boston, Conference Series No. 19: 49-72; reprinted in
the Federal Reserve Bank of Minneapolis Quarterly Review 3 (1979): 1-6

Kydland, Finn and Prescott, Edward C. (1982). “Time to Build and Aggregate Fluctuations” Econometrica  50 (6): 1345–1370.

Romer, Christina and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan”, Janua

Footnotes

1 John H. Cochrane is a professor of Finance at the University of Chicago Booth School of Business http://faculty.chicagobooth.edu/john.cochrane/research/Papers/

2 Yes, I’m aware that old Keynesian models do give a multiplier to tax financed spending. Also, some new Keynesian models such as Christiano, Eichenbaum and Rebelo (2009) predict huge government spending multipliers whether financed by taxes or by borrowing. However, tax-financed spending is usually thought to have a weaker (if any) effect, which is why the current policy debate is only about borrowing to spend.

3 Advocates will go nuts here, and complain that A might be putting money in the bank, and “banks aren’t lending,” or stuffing the money in mattresses. As you can tell, this line of argument leads us into “something’s wrong” with the banking system, and confusion between fiscal and monetary policy.

4 I take the “plans” language from Greg Mankiw’s textbook “Macroeconomics.” 

5 Explaining “new-Keynesian” economics is too big a task for this essay. My paper “Determinacy and Identification with Taylor Rules” and its references are the best place I can recommend for this question. 

Nova/Atrium Lecture in Macro/Finance (Video)

(Also web page on the event) Lecture given at NOVA school of business and economics in Lisbon, Portugal, 2010. Thinking through fiscal and monetary policy, along the lines later written up in Inflation and Debt and Understanding fiscal and monetary policy in the great recession.

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