Sunday, March 25, 2012

Cochrane blasts austerity AND stimulus...???

Another salvo in the Macro Wars. In a newish blog post, John Cochrane declares that austerity is hurting Europe:

Austerity isn't working in Europe...In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms... 
Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path. 
Why is austerity causing such economic difficulty? What else should we do?
He then declares, in keeping with much of his past writing, that stimulus would also be a bad idea:

Lack of “stimulus” is the problem, say the Keynesians...They claim that falling output in Europe is a direct consequence of declining government spending...They -- and we -- just need to spend more. A lot more. 
Where will the money come from?...The U.S. can still borrow at remarkably low rates...But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes... 
Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves... 
For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output...[But] Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts.
These two points of view just don't seem consistent to me. Here's a few reasons why:

1. How can austerity and stimulus both be harmful for the economy? Cochrane clearly states that austerity is not just ineffectual, but is actively harming Europe. This is important. Because he then claims that increasing government spending (stimulus) would actively harm rich economies (by raising default risk, causing rising interest rates and crowding out). He could have argued that the level of government spending simply doesn't affect growth one way or another. But he didn't. He claimed that either slashing or boosting government spending would cause a significant deterioration from where we are right now. It doesn't take a genius to see the logical implication of this position: Cochrane must believe that the level of government spending is exactly optimal right now.

So policymakers in every rich country (including Barack Obama) have gotten the level of government spending exactly right! That's nothing short of amazing. Who says government is inefficient? ;-)

2. If austerity increases deficits, why wouldn't stimulus reduce deficits? Cochrane laughs at the notion, currently being advanced by Brad DeLong and Larry Summers, that increased government spending could pay for itself. But just a few sentences earlier, he claims that austerity is failing to close budget gaps! Again, let's apply simple logic. Draw a graph with spending on the x-axis and deficits on the y-axis - basically, a Laffer Curve for spending. If austerity and stimulus would both increase deficits, we must be at a local minimum on that graph - in other words, our current level of spending must be exactly the level that minimizes fiscal deficits. Again, a huge win for government policy!

(Now, note that Cochrane has left himself a bit of wiggle room. Instead of saying austerity is increasing deficits, he says it simply isn't "swiftly closing budget gaps." But his talk of a "downward spiral" clearly invokes the notion that a substantial amount of austerity would have the opposite of the intended effect on the fiscal balance.)

3. How does the "downward spiral" work? This isn't related to the previous two points, but I just wanted to throw it in because it annoyed me. Cochrane writes: "As incomes decline [under austerity], tax revenue drops, and it is harder to cut spending. A downward spiral looms." Wait a second. This doesn't seem like a spiral. If austerity reduces incomes, which reduces tax revenues, which prompts policymakers to enact more austerity, then that could clearly cause a downward spiral. But if falling incomes make it "harder to cut spending" - i.e., harder to enact further austerity - then the spiral should arrest itself. Right? I just don't understand how Cochrane thinks this is supposed to work.

But anyway...

Over the past couple of years, stimulus opponents have been relentlessly pounded by the evidence. Countries that have cut spending have performed worse. This makes it hard to argue that government spending does not affect GDP during a recession. And it makes it very, VERY hard to argue that austerity works. Basically, if you are still saying that cutting spending would boost GDP in the current recession, most observers think you are disconnected from reality.

So how do the opponents of fiscal stimulus respond? All through the recession, they've been saying that boosting spending doesn't boost GDP. But if cutting spending hurts GDP, how is the anti-stimulus position tenable? Well, stimulus opponents could argue that government spending is simply irrelevant - that the correlation on the spending/GDP graph does not equal causation, and that the countries who enacted more austerity simply happened to be the ones that were hit by worse shocks to begin with. But like I said, that's proving a difficult case to make.

The only other out for stimulus opponents is to claim that we are at the perfect level of government spending right now - the level that maximizes GDP and minimizes deficits at the same time. If this is true, then austerity and stimulus would both be bad. But I have to say, this case doesn't seem credible either. How is it that every rich country just happens to be at exactly the right level of spending?

Cochrane's post goes on to extol the virtues of long-term structural reforms. I have no problem with that (though the reforms I'd suggest might be very different from his). But isn't it a bit beside the point? You can't have your anti-stimulus cake and eat it too! Opponents of government spending have been forced to bow before the overwhelming weight of evidence that cutting spending has been bad for GDP. But they still refuse to accept the logical implication of that evidence, that boosting spending would have boosted GDP. I just don't get it.


  1. Anonymous12:33 PM

    I think he's taking a bit of a cheap shot at DeLong and Summers. First, their paper is particular to certain situations (eg, really low interest rates), and that it incorporates into the analysis the loss in future growth that comes from not fixing a depressed economy. These two things don't make it comparable to the arguments of the 80's regarding tax cuts, nor are they really arguing that stimulus pays always pays for itself, but rather, it's preferable, in certain situations, when compared to just letting the economy languish.

    I think what Cochrane is really wants is less spending and less taxes. He doesn't like the spending side of stimulus and he doesn't like the tax side of European austerity measures. I don't think he makes this explicit because he can't do so without exposing contradictions in his analysis and revealing that ultimately, his preferred policy is based more on a GOP small government ideology that it is on actual economic reasoning with regard to growth and deficits.

  2. I also found this post very interesting, and left Cochrane a number of questions:

    John, I have a few key questions from this post, which I'll ask below. These are questions, or counters, at least some of which I'm sure you've heard, or thought of. A big question is, will you directly respond to them, or ignore them (as they're not mentioned and countered in this post).

    I know if you're trying to persuade, sometimes the best strategy is to ignore key counters, or holes, if you think the vast majority of your intended audience will never think of them anyway, so why make them known. But if you want to persuade economists and well educated laypeople, opinion leaders, who will think of these things, and/or may hear of these things, then it's best to directly address them, assuming you do have good valid counters. I hope that you'll do that, so here goes:

    "U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't."

    Krugman said MAYBE they could pay for themselves in government revenues. But also:

    (1) You'd need $5 of output if you wanted payback in just 1 year, and if you didn't count increases in state and local tax revenues, which you should. Presumably the effects would last longer than 1 year, especially if the stimulus were done in 2008. But, more importantly:

    (2), This is crucial, so I really hope you'll respond to it: Not all stimulus is, or need be, ditch digging, or consumption. What about the payoffs in future years from high social NPV investments like basic science and medicine (yes, improved medicine may not be reflected in GDP, but it should be; that's why I said SOCIAL NPV), education, alternative energy, smart infrastructure,... A stimulus bill could include tons of this; there's no shortage of such positive social NPV projects that we pass up year after year. And there was a substantial amount of this in Obama's stimulus bill, albeit not nearly enough.

    (3) Tax cuts have incentives on their side – Evidence please. You and most economists know well the income and substitution effects, the backward bending labor supple curve, and the fact that if people always work more hours when you increase their take-home pay per hour, why did the number of hours worked in the first half of the 20th century plummet at the exact same time that take-home pay per hour skyrocketed. MIT economist Jonathan Gruber, an expert in this area, wrote, in his 2007 textbook, "Public Finance and Public Policy", 2nd edition, "Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation." (page 734). We need your evidence of these substantial incentives from tax cuts, John. Please don't just act like it's self-evident.

  3. "The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe?..."

    Krugman and other esteemed Keynesian, center, and left economists I'm sure will agree that many of these things are very bad and should be changed. But here's the big question for you John: I'm sure these things were just about as bad 5 years ago, but the economy was vastly better. I'm sure these things were just about as bad in the mid-90s, but the economy was vastly better. So they don't seem to be the reason for the recent plummet, because they haven't changed. This was an argument also given in Japan. When the Japanese economy went south, people hauled out all of these structural problems, and a lot of them were real and serious, but they existed when the economy was booming too. So, while they may have made growth and wealth a lot less than they could have been, they don't appear to have been a reason for the slump. Why not fix these structural drags AND fix, or deal with, whatever actually caused the sudden recent plummet and years long severe recession?

    "Greek wages have in fact declined about 10 to 12 percent, according to the IMF -- so much for the impossibility of nominal wage declines."

    Yeah, but it took Great Depression-like suffering, a startling percentage of families homeless. Was it worth the suffering? Was there a far easier way?

  4. "Forget about “stimulating.” Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession. Most "spending" is in fact transfer payments, which even Keynesian economics recognizes are not very simulative, not the mythical (and curiously carbon-intensive) roads and bridges, and most of that goes to people who are relatively well off..."

    What percentage of roads or bridges are to nowhere, honestly? Krugman and most Keynesian economists are against inefficient agriculture subsidies. Electric cars? Are you going to argue against the externalities from not insuring against catastrophic global warming risk? (or funding some of the worst and most harmful authoritarian regimes in the world).

    And, if most "spending" is in-fact transfer payments (aside from the fact that millions of hardworking middle-class families with children face ruin, no medical care, or homelessness, without social insurance in a very risky world – try to imagine if that was your family, if you didn't have a high paying job for life), then why don't you come out for far more public investment? This is a big question. Long term growth is almost all about scientific advance, and the high end infrastructure and education so crucial to scientific advancement. Why aren't you calling for universal pre-school, like Heckman? For big increases in smart infrastructure? In basic science. Universal free bachelor's degree (or valid technical training). Studies show most students today working at least 20 hours per week while going to college full-time, about a quarter work 40+. How much would that have hurt your learning if you had to do that? Here's one of my favorite Paul Romer quotes:

    As just one example, recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result. The institutions of complete property rights and perfect competition that work so well in a world consisting solely of rival goods no longer deliver the optimal allocation of resources in a world containing ideas.


    Why aren't you coming out more for public investment, instead of just against public transfers?

  5. Austerity was all about hurting the poor and the middle class.

    For Cochrane, structural reform is just a new euphimism for hurting the poor and the middle class.

    Old whine, new bottle.

  6. Daniel3:35 PM

    Doing nothing is sometimes the best option.

  7. "So policymakers in every rich country (including Barack Obama) have gotten the level of government spending exactly right!"

    Eh. Maybe not, but who are we to second-guess them? It seems to me, given that one can make arguments either way (as Cochrane has), the presumption should be that they've gotten it right, unless you can make a convincing case to the contrary. Personally I find the pro-stimulus case more convincing (at least on the margin), but I don't think it's contradictory (or knifedgeous, if I may coin a term) to believe that neither side has a strong enough case to warrant changing the status quo.

  8. That's a great blog post, and it tells an awful lot about how far economists are from understanding macroeconomics (Krugman may be the closest, but I'm not convinced he's spot on either).

  9. What strikes me with economists those days is how they seem not to care about money. For freshwater economists, money is neutral, and thus inexistent in models. For neo-keynesians such as Krugman, it's all about budget policy.
    Evidence from Europe suggests differently: the Euro is simply killing southern economies there. Nothing to do with budget, nothing to do with social programmes or trade bareers (pretty much the same all across Europe, and nothing new). In a national economy, you need a national currency (and a flexible exchange rate) and in dire straits, you may play loose with it.
    That's what the US did. Could have played looser maybe, but it does not look as bad as Europe altogether.
    If economists pay so little attention to money, it is because they hardly understand the stuff. They don't know why wages and prices are (downward) sticky and they can't say if inflation is good or bad (and at which level). In fact, they might not even know what money is. Take an example, government debt: is it money? In theory no, but when it appears that government will never afford repaying, and that the FED will eventually have to roll the press, then what is the difference between treasury bonds and greenbacks?

  10. How can stimulus and austerity both be harmful for the economy?

    It seems to me that austerity is clearly going to be short-term harmful in terms of measured GDP, while stimulus will be long-term harmful to the extent that it is not spent on productivity-enhancing positive NPV projects. In other words, spending for spending sake might boost short-term GDP, but it merely adds debt without creating the cash flows to service said debt.

    Its a ridiculous comparison to grade the short-term GDP effects of austerity versus that of stimulus. Of course spending more now will flatter measured GDP. To expect otherwise is ludicrous. The question is which one has the optimal medium- and long-term benefits. That is what the debate should be about...

  11. no, i would argue that Krugman's graphs are an equal indictment of the central bank.

    In NK framework, fiscal stimulus is only effective "when not offset by monetary policy."

    The flip side is that if fiscal stimulus were enacted, the central bank would lean against it.

    Now, to argue that fiscal stimulus works at the zero lower bound, you have to argue that either the central bank CANNOT offset it (because the monetary policy transmission mechanism is broken) or it WONT offset it (because there are a bunch of inflationistas, or political pressure, or idiocy).

    Now, taking these in order: there is overwhelming evidence that 1)"unconventional" monetary policy has been effective (Krugman himself admits we have just not tried enough) and 2)the main reason we have not done more is fear by inflation hawks of incipent inflation (translation: more QE will only fuel inflation not real growth).

    The flip side of this argument is that any demand-side stimulus would be offset by the hawks (for example, in the form of forecasting interest rate hikes sooner).

    Now observe that in going through Krugmans recent graphs, he took off the countries which had independent monetary policy like the UK. because fiscal austerity can be offset by monetary policy

    So, the "austerity causes growth to decline" argument is an indictment of Trichet's ECB.

    Once one appreciates that even in an NK framework, fiscal policy can be offset, ask: does "unconventional" policy work at the ZLB, and why dont we have more?

    I can only speak for myself: QE does work, more demand-side fiscal policy WOULD be offset by the hawks, hence we would only get bigger govt.

    In Europe (i lived there for a while) I am sympathetic to the we-need smaller-govt argument.

    As for Cochrane, he does not get it on so many levels. If he were REALLY smart and understood macro, he would realize that even in the NK framework, fiscal policy is offset (DeLong and Krugman are smart and appreciate this BTW). But he's not arguing the nuances of the Phillips curve (the degree toi which Fed stimulus would increase inflation vs real output). He's just arguing against doing anything for no good reason.

  12. I would be interested in hearing about the long-term (or in some cases, potential medium-term) effects of borrowing "too much." For example, in Greece's case, all that borrowing was boosting GDP, but ultimately led to an unsustainable situation where the act of borrowing made borrowing drastically more expensive, which (presumably) brought the country to a point where spending was doing more harm than good.

    If you are going to promote spending as a way to boost the economy, don't you have to also discuss when a country should stop spending? You should even be able to do this without talking out of both sides of your mouth.

    In other words, when we look at the economic gains achieved by borrowing, are we measuring them against the long-term effects of the borrowing that paid for that spending? My first reaction to your take on Cochrane is that if he's saying that the European countries are at the point where spending is pushing up borrowing costs to unsustainable levels, then he could very well be right that those economies will contract either way. Say it ain't so?

  13. Re my above post - I might have interchanged "borrowing" and "spending" a little too casually there, but I hope that doesn't detract from my main point.

  14. Ansel...Not sure what you're asking. Are you asking whether deficits are "sticky," in the sense that it's politically easy to raise deficits but politically hard to lower them?

  15. Hmm I guess if the answer isn't readily apparent, it must be a decent question ;)

    Assume that a country (let's call it Helena?) gets to the point where the interest payments on its debt has caused it to reach a point where it has effectively "over-borrowed", such that further borrowing is cost-prohibitive. (Borrowing costs are hyperbolic, yes?)

    In other words, if Helena's government spends money, the borrowing costs will hurt the economy more than the benefit from that spending. (No clue on how to characterize this harm technically, but can we suppose it will either directly or indirectly exert downward pressure on GDP?). I imagine if Helena's government cuts spending, GDP would similarly go down.

    I'm wondering if you believe that this tension between increasing spending and cutting is more like a handcar. E.g., once you get to the point where borrowing costs make stimulus a negative, one simply switches over to austerity? At some point, the handcar rolls forward, increasing GDP?

    Intuitively I don't believe this is the case. At some point you can't spend or starve your way out of a recession. But my larger question is this: isn't it extremely important for advocates of stimulus to factor the downward pressure on GDP caused by the increase in borrowing costs against the positive affects of the stimulus? To end with another analogy, if we are drinking libido juice, but losing hair and getting zits in the process, is the doctor looking out for our long-term romantic interests, or just continuing to write the same old script, to our eventual detriment?

    1. You're talking about this, right?

      Also, I had a crush on a girl named Helena when I was 18. She was kind of a dufus and not really that hot, but I liked the fact that she was loud, obnoxious, and overconfident. She didn't like me back, though...I should have drunk the libido juice!