December 23, 2014
I see that John Cochrane is once again attacking Keynesian economics, giving an “autopsy for Keynesians” in the Wall Street Journal. His central line is that Keynesian economics has been repeatedly proven wrong in the recovery. He sees the U.K.’s turn to austerity as a brilliant success; and the continued U.S. growth, in spite of deficit reduction, as further proof of the failures of Keynesian economics. He tells us that even Greece and Italy are sticking with the euro, rejecting the course of “devaluation and inflation.”
I understand that Cochrane’s polemic is directed at Paul Krugman, but as a card carrying Keynesian, I will take up the defense. First, it requires some serious re-writing of history to pronounce the Keynesians wrong at every turn in this recession and recovery. Going back to the days of Great Moderation, some of us Keynesian types noticed the economy was being driven by a housing bubble long before the beginning of the Great Recession.
I’m not sure where bubbles fit in Cochrane’s world, but in this economy they are run-ups in asset prices that are not consistent with the fundamentals of the market. In most cases they are not of great consequence for the economy as a whole, only for the markets directly affected. However when the market is a massive market, like the U.S. housing market, and the bubble grows to the neighborhood of $8 trillion (@ $10 trillion in today’s economy), it is a big deal. The housing bubble raised residential construction to a record share of GDP. The associated wealth effect led to a huge consumption boom with the saving rate pushed to a record low.
When the bubble burst, there was no component of GDP that would magically replace these sources of demand. The outcome was a severe recession. The real world followed pretty well on this Keynesian’s line of thinking.
Cochrane somehow thinks the Keynesians blundered in believing that the stimulus would set everything right:
“Our first big stimulus fell flat, leaving Keynesians to argue that the recession would have been worse otherwise.”
Well, some of us were arguing at the time that the stimulus was far too small to get the economy back on its feet, so we were hardly surprised when our prognostications proved correct. (Krugman made the same case in a far more visible forum.)
Cochrane then adds:
“With the 2013 sequester, Keynesians warned that reduced spending and the end of 99-week unemployment benefits would drive the economy back to recession. Instead, unemployment came down faster than expected, and growth returned, albeit modestly.”
For my part, I never saw a recession, just weaker growth. The GDP data seem to agree with me. Growth in the first two quarters of 2013 was just 2.3 percent. If we just look at final demand (excluding the buildup of inventories), growth averaged 1.8 percent in the first half of 2013. While the unemployment rate did fall by 1.2 percentage points from December of 2012 to December of 2013, this was largely because of people leaving the labor force. The employment to population ratio did not change over this period. Should us Keynesian types feel embarrassed?
At this point there is considerable research on the impact of stimulus and most of supports the Keynesian story. (Here are a couple from the I.M.F. and a good meta-analysis from my friend Sebastian Gechert. It’s not clear what real world evidence Cochrane thinks we should take as refuting the benefits of Keynesian stimulus.
Cochrane can be given partial credit for a mistaken prediction of some Keynesians:
“Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.”
Since all of us card carrying Keynesians are supposed to believe in sticky wages, it is not clear why any ever took seriously the idea of a deflationary spiral. After all, even Japan never saw its deflation rate exceed -1.0 percent for any substantial period of time. Some of us did try to point out that the obsession with deflation was misplaced, as the rest of the Keynesian clan eventually came to recognize.
Cochrane’s view of the U.K. as a success story that vindicates austerity also seems to fly in the face of the data. At the most basic level, the bottom line numbers are not especially inspiring. More than four years into the reign of austerity, per capita GDP in the U.K. is still 3.9 percent below its 2007 level. That’s considerably worse than the 1.9 percent growth in Keynesian (since 2013) Japan and even the 1.2 percent drop in semi-austerity France.
The modest turn-around the U.K. has achieved has been largely on the back of a new housing bubble, with inflation-adjusted house prices again approaching bubble peaks. This run-up is at least in part due to deliberate policy as the Conservative government gave a first-time homebuyers tax credit to boost the market.
Many of Cochrane’s other assertions just fly in the face of reality or deliberately distort what Keynesians say about the world. For example he has a tirade about the evils of debt:
“Keynesians tell us not to worry about huge debts, or to default or inflate them away (but please, call it ‘restructuring’ or ‘repairing balance sheets’). Even the Obama administration has ignored that advice, promising long-run solutions to the debt problem from day one. Europeans have centuries of memories of what happens to governments that don’t pay debts, or who need to borrow for a new emergency but have stiffed their creditors once too often. More debt? Nein danke!”
We have seen a huge run-up in debt since the downturn and yet long-term interest rates are for the most part at record lows. Japan, the most profligate spender of them all, now has to pay a usurious 0.34 percentage point interest rate on its long-term debt. Are we advocates of deficit spending supposed to see our argument refuted by this evidence?
He then complains that we see even wasteful spending as boosting the economy. Yep, that’s true in a downturn, but we would all prefer useful spending. He challenges Keynesians:
“Stimulus advocates: Can you bring yourselves to say that the Keystone XL pipeline, LNG export terminals, nuclear power plants and dams are infrastructure?”
Umm, yes. I don’t know any Keynesians who would dispute that this spending would provide a boost to the economy. The question is how large and at what cost. Sending in troops to raze Wall Street would also provide a boost to the economy. Is that worth the cost? (Okay, that was a bad example.)
At the end of the day, Cochrane can make a political argument. His team has won in convincing governments to go the route of austerity. Is this good? Well, the U.S. is still down close to 6 million jobs from its trend level. Greece is looking at double-digit unemployment for at least the rest of the decade. The story for other euro peripheral countries is not much better.
Why have political leaders opted to put their populations through hell? My answer is that the people who have the money it takes to finance elections, and also who control much of the media, are not bothered by the current situation. After all, the stock market has rebounded, their banks have been saved. They’re doing just fine, even if the average French, Italian, or American worker is still faring badly.
Does that explanation work? I’m open to other stories, but it is the political analysis where Cochrane may have a case against the Keynesians. His attack on the economics doesn’t stand up to the light of day.
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