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The New York Times


A Dark Age of macroeconomics (wonkish)

Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity.

There has been a tendency, on the part of other economists, to try to provide cover — to claim that Fama and Cochrane said something more sophisticated than they did. But if you read the original essays, there’s no ambiguity — it’s pure Say’s Law, pure “Treasury view”, in each case. Here’s Fama:

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 here’s Cochrane:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.1 This is just accounting, and does not need a complex argument about “crowding out.”

Second, investment is “spending” every bit as much as consumption. Fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.

There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line.

It’s like the fact that the capital account and the current account of the balance of payment have to sum to zero: that’s true, but it does not mean that an increase in capital inflows magically translates into a trade deficit, without anything else changing (what John Williamson used to call the doctrine of immaculate transfer). A capital inflow produces a trade deficit by causing the exchange rate to appreciate, the price level to rise, or some other change in the real economy that affects trade flows.

Similarly, after a change in desired savings or investment something happens to make the accounting identity hold. And if interest rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often presented to freshmen. Here’s the diagram:

INSERT DESCRIPTIONA case of mistaken identity

In this picture savings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works. But you do have to accept that it shows the fallacy of arguing that the savings-investment identity proves anything about the effectiveness of fiscal policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.


From 1 to 25 of 119 Comments

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  1. 1. January 27, 2009 9:48 am Link

    In my view, people know quite a bit about macroeconomics after taking a couple of undergraduate classes, but unlearn most of it in PhD macro courses, where IS-LM and such are never mentioned again.

    — Ragout
  2. 2. January 27, 2009 9:51 am Link

    It says something about the hubristic tendencies of economists, that the Chicago economists are as certain of their correctness now as Irving Fisher was prior to the Great Depression. Of course, Keynesians had their own day in the sun and were similarly arrogant during the 1960s. Why abandon a beautiful model just because it doesn’t fit the facts?

    — John Howard Brown
  3. 3. January 27, 2009 10:00 am Link

    While this doesn’t speak to your point precisely, I think the public perception of economics suffers from a couple of problems. The first is the layman perception of economics, which has been influenced greatly by talking heads and Republican politicians, to try and simplify it into a few talking points which are largely empirically untrue, but nonetheless quite stubborn. The other is that economics appears simple and elemental to layman, leading them to claim false expertise based on experience. Your comments section is a perfect example – how many comments have you gotten which start off with “well I may not have a Nobel Prize in Economics or all your fancy Ivy League degrees, but I know about economics…” The profusion of this sort of folksy stupidity must make you want to tear your hair out. Personally, I can’t tell you the number of times I’ve had to explain that microeconomics is not simply a supply and demand chart. And the concepts of marginal revenue/cost and elasticity are simply not worth teaching to people who’ve already formed a view, without the benefit of facts.

    I think another problem is that obviously the politics of the time seem to be having an impact on the scholarship and policy, which is unfortunate. As you know, much of what is asserted can be easily disputed via empirical results, but for some reason people rarely ask to see the numbers. It’s easier to consider things in terms of axioms, most of which turn out to be completely wrong.

    It’s unfortunate, but I’m hoping that the age of Obama can dispel this notion that we are entitled to both our own opinions and our own facts. If nothing else, a return to evidence-based thinking would be a lasting contribution to the democracy.

    — GP
  4. 4. January 27, 2009 10:11 am Link

    It appears that a substantial portion of the economics profession accepted Reagan’s dogma that government is not the solution, it is the problem. They were well paid for their adherence to orthodoxy.

    — Stan Kelley
  5. 5. January 27, 2009 10:14 am Link

    Since big decisions are riding on these arguments I’m frustrated by the indirect nature of the debate. I want Chicago champions and Keynesian champions to meet in a Steel Cage Match to hammer out all these points in one place for us to ponder.

    — Athenian
  6. 6. January 27, 2009 10:17 am Link

    Sometimes I can’t believe how simplistic economic reasoning appears to be. If your summary of Fama and Cochrane is accurate, they’re merely looking at a snapshot of the moment the government issues new debt for economic stimulus. They’re ignoring the fact that much of that debt will be purchased by individuals, institutions and governments outside of the U.S. economy. They’re also ignoring the fact that, after the stimulus, some participants within the U.S. economy will have more money at their disposal for saving or investment than they did before the stimulus. For example, an unemployed person may suddenly begin spending more and start saving money. And what about the multiplier effect? The idea that the issuance of government debt immediately diminishes private investment seems like an absurd construction to me. How can you guys all be in the same profession?

    — Paul Dorell
  7. 7. January 27, 2009 10:21 am Link

    My own impression (from my terminal MA at a prestigious Canadian university) is that academic economics as an intellectual endeavour is utterly lost. It got lost because it placed the fetish of mathematical modelling over the basics of sound thinking and analysis: defining your terms carefully, thinking about underlying institutional structure, being willing to entertain different views of how the world works (while being willing to compare and contrast these views in a consistent intellectual framework). Economics as it is currently constituted thinks that pushing symbols around on a chalkboard is “analysis”, and that the only ingredient for “rigour” is that no algebraic mistakes are made.

    And now we see the full flowering of this intellectual bankruptcy: professors at prestigious universities making elementary errors of economic reasoning, because economic reasoning is something they neither TEACH or have LEARNED.

    Burn the economics academy down. Burn it down and start over.

    — Darren McHugh
  8. 8. January 27, 2009 10:22 am Link

    What’s amazing to me is that the Republican free-market/anti-government philosophy has had such a poisonous effect on all levels of policy and thought on the subject. I’m not educated enough in the subject matter to express an opinion on the economic content presented in this article, but I do understand the message: “People who really should know better, don’t.” That’s truly scary.

    Keep up the good work, Mr. Krugman.

    — Jonathan S.
  9. 9. January 27, 2009 10:24 am Link

    You are not going to get a meaningful prediction in economics from an equation. Equations are fine for illustrating basic principles in textbooks, but outcomes in the real world are a matter of integration of the effect of many variables over a long period of time. Since economists can’t predict even the simplest things a few months in advance, mathematical predictions are basically worthless. Economists seem to be preoccupied with using meaningless mathematical models to justify their prejudices, while at the same time ignoring clear signs from fundamental indicators, such as stock and housing prices, that things are out of whack.

    — skeptonomist
  10. 10. January 27, 2009 10:25 am Link

    Moreover S=I holds only in a closed economy. If you consider the international dimension, things get more complicated. Remember the Feldstein Horioka puzzle?

    — Paolo Zanghieri
  11. 11. January 27, 2009 10:29 am Link

    Paul, I heard the same arguments last night on the News Hour . Where do the nay sayers think money comes from? Don’t they understand that the government can print money; so much (even all) of the pump-priming can come from newly issued notes, not someone’s mattress? Or is this not a fair view? Perhaps you can explain why the answer: “The government can print the money, stupid!” is the incorrect answer.

    But I fully agree with your point about the Dark Ages. I find it stunning that so many academicians are in the iron group of dogma. What’s next, the Chicago Inquisition?

    — David Lentini
  12. 12. January 27, 2009 10:35 am Link

    “We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.”

    Aside from the theoretical lapses, this is contradicted by the enormous increase in total GDP in WW II. Was this produced by tax cuts? What looking-glass do these people use to get into their fact-free wonderland?

    — skeptonomist
  13. 13. January 27, 2009 10:52 am Link

    One of my favorite non-fiction authors, John Ralston Saul, often remarks that the end of the Enlightenment, our time, reflects the end of the feudal age it replaced.

    Knowledge in the feudal age was not meant to improve understanding of the world. It was meant to support the status quo. Its purpose was to make sure that things didn’t change, that those with power remained in power.

    Whether such knowledge was in tune with the way the world worked or that knowledge improved the lot of society was not a consideration.

    A pity we’ve returned to that time.

    — Rob Graham
  14. 14. January 27, 2009 11:03 am Link

    Why do you think they’re committed to the view that savings automatically equals investment? They can accept that there’s some sort of delay. The point is just that due to the fact that savings eventually equals investment that the stimulus won’t be effective. What you have to argue is that there is some mechanism that functions in the delay between the equilibration of savings and investment that will make the opportunity costs of the stimulus worthwhile. But what is that argument supposed to be?

    — Selfreferencing
  15. 15. January 27, 2009 11:10 am Link

    This explanation doesn’t seem to prove that an increase in government spending leads to a higher GDP. There’s more than one degree of freedom. It shows that an increase in government spending leads either to a higher GDP, or lower investment. Similarly a reduction in taxes could lead to an increase in savings, or an increase in GDP. That still leaves us with the question of what kind of stimulus, if any, works. Prof. Krugman has argued in this blog that Keynesian stimulus hasn’t worked in the past because it isn’t fast or big enough. That would suggest that increasing government spending first drives out a certain amount of investment, then (hopefully, there isn’t much historical precedent) starts increasing GDP if the stimulus is sufficiently huge. I shudder to think just how much additional debt we need to go into to achieve the small, temporary gains promised by the stimulus package.

    Is Krugman arguing for what should happen in an ideal world, rather than what actually tends to happen in the real world?

    — Tom
  16. 16. January 27, 2009 11:11 am Link

    Once again, Krugman ignores how the government gets its money.

    First let us recall that for an average tax rate t, T=t*GDP and S=(1-t)*GDP. Lets say t is 0.35.

    Krugman wants us to increase G as a way to increase the GDP. Lets say we increase G, and therefore the GDP, by 100.

    Without changing the tax rate, T grows by 35 and S grows by 65. But now our government is 65 extra in debt. With interest we end up paying back about 75 or so, depending on how long it takes to pay back.

    So, while in the short term our GDP grew, in the long term we reduced our GDP by about 10 while we pay off debt.

    Remember, every dollar spent must be taxes now or taxed plus interest in the future. Because if this it is impossible for the government to raise the GDP in the long term. They can only raise it in the short term through deficit spending which will decrease in in the long run.

    — Scott
  17. 17. January 27, 2009 11:25 am Link

    Their arguments are a crass oversimplification, I think. Why does public spending crowd out provate spending? First, you have a time relationship that’s ignored: The “bill will not come due” right away for the public spending, so clearly private spending can happen during this interim. Second you have the place relationship that is ignored. Public and private spending are not going to occur in the same place. Gov’t by its very nature will spend money in the places that private industry won’t, or can’t. These people are clutching at straws to come up with a rational argument to support their prejudices, and they are failing.

    — Smitty
  18. 18. January 27, 2009 11:40 am Link

    Dear Mr. Krugman,

    An easier way to understand why Fama and Cochrane are wrong is to simply point out that the accounting identity is static. It only describes a moment in time. How do they explain that the numbers in the identity change when measured at different times. Where does the growth or shrinkage come from?

    — Vic Parker
  19. 19. January 27, 2009 11:41 am Link

    That we are in the dark ages is in part the fault of Keynesian economists themselves (ourselves). In contrast to the enormous amount of research done on monetary policy as a stabilization tool, we have done very little to modernize the way we think of fiscal policy. As John Cochrane pointed out in the Chicago forum that everyone’s been watching, you can search through graduate economics textbooks and lecture notes and never see a coherent case made for the efficacy of fiscal stabilization policy. So it’s little wonder that the knowledge we had in the 1960s (say) has been lost.

    — Maynard
  20. 20. January 27, 2009 11:50 am Link

    These are very complex arguments in which there are no simple answers. I do not believe that one can reply to these arguments as a piece.

    Fama suggests that the equation is that, as you rightly infer to his argument, the government spending not only crowds out private spending but does so in such a way that it actualy inhibits growth because the investments are less valuable in the long run. These investments have a terminus, if you will, but in private investment they not only continue but consequently have a much greater multiplier.

    Cochrane has a much simpler argument really. His whole argument is based on the idea that there is a financial equation having to do with borrowing, with interest rates, with government participation that is not coming out right. His argument seems to be that equation simply does not compute. The amount of money and the characteristics of the currnent bail out proposal are inefficient because the numbers simply do not balance. Hence, the argument about their being accounting rather than economic arguments. I think only Cochrane’s are such.

    But just as Say’s law does not apply in a modern situation where the “production” are actually the financial instruments themselves, these arguments are wrong because they are not accurate in the current situation.

    The problem is that when they are applied to the bail-out, they lump the entire bail-out program into one premise. And the bail-out is not one homogenous entity. It is actually several different policies.

    One could be termed a welfare program. Another could be termed a government infrastructure program, such as the often used example–the federal interstate highway program. Another aspect still in the plan is a program of upgrades on existing government programs that have been neglected. One could make a strong case that all these are not necessary efficient stimuli…they are not all meant to be.

    The argument against the stimulus program, as done by Fama and Cochrane is false because they argue only against the basic theory of government versus private spending, and government borrowing against the various potential results. The latter would be either failure of the program to stimulate or successful stimulation followed by severe (my interpretation) inflation.

    But the suggestion that the current situation matches the conditions required for the logic to work is wrong. In order for Fama and Cochrane’s analysis to be correct, they must first separate the issues. I am not sure that if you asked either one: should we have a more aggressive welfare segment (food stamps, expanded unemployment, etc) that they would disagree.

    When you lump all the various ideas and programs together, as they have done, you can make an argument. Not a good one. Not an accurate one. But in each case, one that, if properly addressed, does raise important issues.

    One important issue I would cite is whether economists, at the outset, should not more carefully target their arguments so that whatever part of a policy may have flaws, that aspect is truly and accurately analyzed. And those parts that are important, urgent, even essential to survival in some cases, will not be inhibited by politicians using false arguments to keep vital services from the people.

    — Joseph O’Shaughnessy
  21. 21. January 27, 2009 11:57 am Link

    I think that many of these deniers actually believe that a stimulus by government spending can influence behavior, but they’re worried that accepting that fact will commit them to a stimulus by government spending. Although their use of equations seems simplistic and mechanistic, so does picking an amount for the stimulus as you do. You make it sound as if we’re changing the oil. As well, I feel that infrastructure spending should be efficient and necessary. Just picking a number makes it sound like we’ll spend a lot of money foolishly.

    I agree that a stimulus can effect behavior as we wish. I believe it because my political economy is a lot like Shiller’s. I read that he advocates a massive stimulus. And here’s my problem. I’m with Shiller on the stimulus. In order to work well, it needs to be very large. However, I’m also with Buiter, in believing that this spending carries serious risk for us going forward. Consequently, I end up with a plan much like the administration’s.

    I also don’t consider social safety net spending a stimulus. It’s what we should do in order to help our citizens get through this crisis. By calling it a stimulus, I’m not sure if these government spending critics are saying that we shouldn’t spend on the social safety net, or simply that they don’t think that infrastructure spending works as a stimulus. As I said, I do, when it’s very large.

    — Don the libertarian Democrat
  22. 22. January 27, 2009 11:59 am Link

    The “stuff coming out of Chicago” would have to improve quite a bit to meet the standards of the Dark Ages. We’re talking more Old Stone Age, here.

    — Peter Principle
  23. 23. January 27, 2009 12:00 pm Link

    From the point of view of someone who does not understand economics but realizes that economists have tremendous influence in this world, the enormous range of policy positions in the field make it very difficult to see economists as anything other than highly skilled advocates. Asking and economist what economics tells us about an important problem is just the same as asking a lawyer what law tells you about something. The lawyer’s job is to make the law say what someone wants the law to say.

    Granted that, I certainly prefer Krugman’s point of view, or DeLong’s, to that of th right wing fanatics at Chicago or George Mason.

    — John Emerson
  24. 24. January 27, 2009 12:03 pm Link

    Another way to look at it is the M*V=Y*P. (M is Money, V is the velocity or Turnover rate of the Money, Y is the output level of the economy {real GDP}, and P is the nominal Price level)

    During a banana, errr I mean Liquidity trap, M keeps going up from central bank injections, but V goes down as institutions keep hoarding cash. GDP or Y*P more or less stays the same as more and more money does injected into the economy is trapped in a liquidity pool, not being invested because the expectations for the return on that investment are too low.

    When the government spends money, say on construction of a bridge it instantly creates new jobs, with new income. Those new income with be spent, at least a portion of the incomes…so on and so forth.

    The government did not print the money it borrowed it, from a pool of money that was not being used because invesment expectations were so low (we are in a depression) This has a direct effect on V. Velocity increases while M money stays about the same. Since we are below full emplyment Y output goes up without much counter effect on P prices.

    — Gregg Janke
  25. 25. January 27, 2009 12:09 pm Link

    To be fair to the barbarians, the chart doesn’t prove the point professor Krugman is making. Yes, an increase in G will lead to an increase in NOMINAL GDP. But, if the economy is at or near full employment, this will occur through an increase in the price level, not an increase in real production. If there are major structural distortions or imbalances in the economy, this may happen even if the economy is not close to full employment.

    I realize this situation doesn’t apply now (or at least I hope it doesn’t) but it means that the “barbarians” aren’t quite as clueless as Krugman makes them out to be.

    — Peter Principle
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