Tuesday, August 5, 2014

Macro debates, the oped

This is a a Wall Street Journal Op-Ed, on supply vs, demand in understanding slow growth. WSJ asks that I don't re-post the oped for a month; a month has passed so here it is for those of you who don't subscribe to WSJ.

The underlying paper is The New Keynesian Liquidity Trap, for those wanting more substance to some of the claims about New Keynesian models.

They didn't want the graph, but I think it illustrates the point well.

The Op-Ed, [with a few cuts restored and one typo fixed]:

Output per capita fell almost 10 percentage points below trend in the 2008 recession. It has since grown at less than 1.5%, and lost more ground relative to trend. Cumulative losses are many trillions of dollars, and growing. And the latest GDP report disappoints again, declining in the first quarter.

Sclerotic growth trumps every other economic problem. Without strong growth, our children and grandchildren will not see the great rise in health and living standards that we enjoy relative to our parents and grandparents. Without growth, our government's already questionable ability to pay for health care, retirement and its debt evaporate. Without growth, the lot of the unfortunate will not improve. Without growth, U.S. military strength and our influence abroad must fade.

Prominent macroeconomists of all stripes bemoan our slow growth. Stanford's Robert Hall calls the years since 2007 "a macroeconomic disaster for the United States of a magnitude unprecedented since the Great Depression." Describing our current situation, Harvard's Larry Summers (an Obama adviser) or Princeton's Paul Krugman sound a lot like Mr. Hall, Stanford's Ed Lazear and John Taylor (both of whom served in the George W. Bush administration) or Arizona State's Ed Prescott.

Where macroeconomists differ, sharply, is on the causes of the post-recession slump and which policies might cure it. Broadly speaking, is the slump a lack of "demand," which monetary or fiscal stimulus can address, or one of structural sand-in-the gears that stimulus won't fix?

The "demand" side initially cited New Keynesian macroeconomic models. In this view, the economy requires a sharply negative real (after inflation) rate of interest. But inflation is only 2%, and the Federal Reserve cannot lower interest rates below zero. Thus the current negative 2% real rate is too high, inducing people to save too much and spend too little.

New Keynesian models have also produced attractively magical policy predictions. Government purchases, even if financed by taxes, and even if completely wasted, raise GDP. Larry Summers and Berkeley's Brad DeLong write of a multiplier so large that spending generates enough taxes to pay for itself. Paul Krugman writes that even the "broken windows fallacy ceases to be a fallacy," because replacing windows "can stimulate spending and raise employment."

[ The full Krugman quote, which got cut for space, is delightful, and accurate about how the models work: “many of the usual rules of economics cease to hold,” so the world is “topsy-turvy.” “Thrift leads to lower investment; wage cuts reduce employment,…. the broken windows fallacy ceases to be a fallacy,” because replacing windows “can stimulate spending and raise employment.”]

If you look hard at New-Keynesian models, however, this diagnosis and these policy predictions are fragile. There are many ways to generate the models' predictions for GDP, employment and inflation from their underlying assumptions about how people behave. Some predict outsize multipliers and revive the broken-window fallacy. Others generate normal policy predictions—small multipliers and costly broken windows. None produces our steady low-inflation slump as a "demand" failure. [Documentation in The New Keynesian Liquidity Trap.]

These problems are recognized, and now academics such as Brown University's Gauti Eggertsson and Neil Mehrotra are busy tweaking the models to address them. Good. But models that someone might get to work in the future are not ready to drive trillions of dollars of public expenditure.

The reaction in policy circles to these problems is instead a full-on retreat, not just from the admirable rigor of New Keynesian modeling, but from the attempt to make economics scientific at all.

Messrs. DeLong and Summers and Johns Hopkins's Laurence Ball capture this feeling well, writing in a recent paper that "the appropriate new thinking is largely old thinking: traditional Keynesian ideas of the 1930s to 1960s." That is, from before the 1960s when Keynesian thinking was quantified, fed into computers and checked against data; and before the 1970s, when that check failed, and other economists built new and more coherent models. [, models that put time, people, and economics in to macroeconomics.]  Paul Krugman likewise rails against "generations of economists" who are "viewing the world through a haze of equations."

Well, maybe they're right. Social sciences can go off the rails for 50 years. I think Keynesian economics did just that. But if economics is as ephemeral as philosophy or literature, [if it returns to rejected ideas, as physics does not] then it cannot don the mantle of scientific expertise to demand trillions of public expenditure.

The climate policy establishment also wants to spend trillions of dollars, and cites scientific literature, imperfect and contentious as that literature may be. Imagine how much less persuasive they would be if they instead denied published climate science since 1975 and bemoaned climate models' "haze of equations"; if they told us to go back to the complex writings of a weather guru from the 1930s Dustbowl, as they interpret his writings. That's the current argument for fiscal stimulus.

In the alternative view, a lack of "demand" is no longer the problem. Financial observers now worry about "reach for yield" and "asset bubbles." House prices are up. Inflation is steady. The Federal Reserve evidently agrees, since it is talking about taper and exit, not more stimulus. Even super-Keynesians note that five years of slump have let physical and human capital decay, which "demand" will not quickly reverse. But we are stuck in low gear. Though unemployment rates are returning to normal, many people are not even looking for work.

Where, instead, are the problems? John Taylor, Stanford's Nick Bloom and Chicago Booth's Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago's Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth.

These views are a lot less sexy than a unicausal "demand," fixable by simple, magic-bullet policies. They require us to do the hard work of fixing the things we all agree need fixing: our tax code, our cronyist regulatory state, our welter of anticompetitive and anti-innovative protections, education, immigration, social program disincentives, and so on. They require "structural reform," not "stimulus," in policy lingo.

But congratulate all sides for emphasizing that slow growth is the burning problem—though Washington seems to have forgotten about it—and that slow growth represents a self-inflicted wound, not an inevitability to be suffered.


  1. Jose Romeu RobazziAugust 5, 2014 at 4:40 PM

    What about the austrian school explanantion? (yes, they would agree with all the structural stuff), but I am talking here about capital destruction that happened as a result of malinvestment induced by the low rates of the greenspan years. Capital destruction turns capital scarcer (therefore higher real rates than would normally prevail). Scarcer capital also decreases labor productivity (below "trend" growth), and finally, relatively abundant labor keep labor cheap (no growth in real wages). All this logic seems appealing to me...

    1. The only problem is that rates weren't low during Greenspan's time at the Fed. Austrians are serious crackpots, nothing more. Heed them at your own peril.

    2. Jose Romeu RobazziAugust 6, 2014 at 5:35 AM

      I worked at Chase Manhattan in 2000, in their leveraged loans desk in London. I know for a fact that banks were throwing money at any ridiculous telecom story. Unnecessary to say that the company that take 4 billion euro in one of the deals I worked for went down less than three years later ... 4 billion euro trashed in the system. Interest rates seemed to low then, to me. Why do you say there weren't too low ?

    3. Austrian economics is reality. End of story.

  2. James Madison said the same thing over 200 years ago: "What prudent merchant will hazard his fortunes in any new branch of commerce when he knows not that his plans may be rendered unlawful before they can be executed?"

    The issue isn't whether rates were nominally low or abnormally low under Greenspan, it's whether they were appropriate for the current conditions. I think Austrian theory does an excellent job of explaining what happened and why things aren't better now. The system hasn't been allowed to purge itself. The problems are still there and as Mises pointed out, the only way out of this type of situation is to go through the painful process of unwinding. Instead, we have even more malinvestment. When in the history of the world did a bunch of fabulously wealthy people run out and buy thousands of houses, sight-unseen, at full asking price so they could become landlords and securitize the leases?

    For once I agree with Krugman. Mathematical modeling, to this non-economist with his nose pressed up against the window, is overemphasized. Mathematical modelling is often a useful first approximation but in scientific endeavor models are tested in the real world and the results must be reproducible. Arguing over mathematical models that can't be tested is like debating whose imaginary friend is better.

  3. The only problem is that rates weren't low during Greenspan's time at the Fed.

    Compared to when? ZIR period? The Volcker years?

  4. Jose Romeu RobazziAugust 8, 2014 at 4:48 PM

    Mr. Cochrane, I took the time to go over your paper "The New Keynesian Liquidity Trap". I also went throuhg the paper from Eggertsson and Mehrotra. I am an electronic engineer, and learned how to solve differential equations a long a go, but it was very instructive to see in another field something that we, engineers, whose sole job is to adapt models to reality, do every day: take a theoretical model, solve it unconstrained, and after go ahead and use the contrained solution, the one that exists in the real world. Anybody who has taken the time to solve a system of differential equations should know that the "contrained" solutions (meaning, those with specific boundary conditions) can be very different from the theoretical, unconstrained solution, and even more important, the constrained solutions are the only ones that exit in the real world. It is a relief to see that at least some researchers in economics are indeed worried with real life solutions, not very particular, unconstrained and idealized views of the world. I also noticed that the New Keynesian model is particularly targetd to answer what happens after the shock (the financial crisis). But what if we try to use it to find out what are the causes of the financial crisis ? Do you have any work that try to explain the causes of the financial crisis ? Thank you

  5. Dear Grumpy Economist

    You discredit the use of Keynesian ideas in economic policy thinking by making the comparison that physics would not return to rejected ideas. This statement is not completely true. Physicists continue to use Newtonian mechanics even though it is now known not to be correct, particularly at very high speeds or small scales. They continue to use general relativity even though the theory breaks down at the smallest scales. Etc.

    The contrast with economists is that physicists are in the advantaged position of being able to say unambiguously when to use which theory (to arrive at results that are indistinguishable from experimental observations). Economists, on the other hand, seem generally to be less interested in such a pragmatic approach. Many wed themselves to one specific class of models and their associated world view that they then elevate to an ideology, leading to adversarial schools of economic thought (or stripes as you refer to them). Few attempts are made to overcome the unique obstacles in social sciences to determine which models describe the world better in which circumstances. Physicists are devoting a lot of effort to building a unified theory and world view, but in the mean time they also know which theories can help them along in which circumstances. While scientists can rightfully be described as always looking for the truth, in the end they have to make do with what is useful.

    I'm a physicist and an amateur economist, and the "physics envy" (as some economists have called the desire to to constantly make comparisons with physics) continues to baffle me. I remember once reading an economics paper where it was boldly claimed that economists have one very powerful tool that was not available to physicists: equilibrium. :)


    1. Dani Rodrik comments on exactly these issues here:


    2. Mr Anonymous,
      Mr. Cochrane actually solves a New Keynesian model in a rigorous and very thorough way, showing that when one applies real world boundary conditions the solution obtained is actually very diferent from the theoretical unconstrained solution. He shows that in the real world we have data that support the constrained solutions (that for exemplo do not result in very large keynesian multipliers that the unconstrained solution generates). As I understand it, the correct physics metaphore would be: Mr Cochrane is using Newtonian Mechanics to solve ordinary mechanic problems, and Relativity Theory to solve a nuclear bomb, whereas the bulk of new keynesian studies try to use Relativity Theory to solve ordinary mechanics problems ...

    3. I'm afraid we're talking past each other. Changing boundary conditions do not make it a different model. Different boundary conditions lead to different solutions for the same model.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.