I recently reread John Cochrane’s now infamous 2009 attack on fiscal stimulus for about the 4th time, and it’s not getting any better. Oddly, he ends up arguing that we need more money and T-securities, which is precisely Brad DeLong’s argument. But he seems confused about the Keynesian model, arguing that the Keynesians favor more consumption, not more investment.
I have some sympathy of Cochrane, as I also find Keynesianism very confusing. You often hear Keynesians warn about too much saving. Since it’s basically a closed economy model where S=I, that would seem to imply they fear too much investment. Yet they don’t really worry about too much saving, rather they worry about too little saving triggered by an attempt by the public to save more at any given interest rate, which sets in motion a series of events that lead to less saving. Or at least I think that’s what they assume (in accelerator models), but perhaps I’m just as wrong as Cochrane.
In my view the basic problem with the Keynesian model is not that it’s “wrong” (how could something be completely wrong and yet accepted by so many brilliant people?) but rather that it’s right, when it’s right, for peculiar and unreliable reasons. Consider the effect of an increase in the propensity to save under the following three monetary regimes:
1. Gold standard
2. Interest rate targeting
3. Inflation targeting
In the first two cases the attempt to save more will depress NGDP, and if wages and prices are sticky, will cause a recession. But not in the third. It’s interesting that the Keynesian model was developed during the first policy regime, achieved its greatest popularity under the second, and started to fade under the third. Cochrane’s right that by the 1980s and 1990s the new Keynesians no longer talked much about the paradox of thrift, or fiscal stimulus.
Why did it work under the gold standard? That’s easy. An attempt to save more (or less investment caused by weaker animal spirits) will depress market interest rates. This increases the demand for gold by reducing the opportunity cost of holding gold, thus increasing the value of gold. Since gold is the medium of account, an increase in the value of gold depresses prices and NGDP. (Recall that the supply of gold is nearly fixed in the short run.) If wages and prices are sticky you get a recession. During a recession people are poorer and may well end up saving less.
Why did it work under interest rate pegging? That’s easy. An attempt to save more (or less investment caused by weaker animal spirits) will depress market interest rates. To prevent interest rates from falling the central bank must reduce the money supply. That tight money policy will depress prices and NGDP. If wages and prices are sticky you get a recession. During a recession people are poorer and may well end up saving less.
Why doesn’t it work under inflation targeting? That’s easy. The central bank will adjust the money supply to keep prices on target, which means offsetting any factor that depresses AD.
When viewed from this perspective the Keynesian model seems very peculiar. If the problem is the central bank reducing the money supply, then it would seem more natural to directly focus on central bank policy as the cause of changing NGDP. If the problem is more demand for money, then why obsess so much over saving? As Nick Rowe likes to point out, the problem isn’t too much saving, it’s too much money hoarding. Attempts by drug dealers to hold more Federal Reserve Notes are just as contractionary as a higher propensity to save. At that’s still true if the drug dealers don’t try to save any more, but merely convert bonds to cash.
The Keynesian model gives us the right answer in two of the three cases. In contrast, the monetary perspective is always right, because NGDP is basically a monetary phenomenon. Even worse, I suspect that many less sophisticated Keynesians start to take their model literally. The sophisticated ones like Krugman and DeLong understand that attempts to increase saving trigger too much demand for base money (or too little supply.) But others think that if the public attempts to save more it directly reduces output, because “people aren’t buying things.” This is of course a basic fallacy, as saving equals investment in closed economy models. More saving means they are buying more investment goods. The problem, if there is a problem, is that attempts to save more may trigger more demand for the medium of account. But if the central bank targets inflation, then we don’t need to worry about this increased propensity to save depressing AD. In the same way, currency hoarding by drug dealers is contractionary under a gold standard or interest rate targeting, but not under inflation targeting.
Update: Commenter Tommy pointed out I erred in the previous sentence. Drug dealer hoarding is contractionary under a gold standard but not necessarily under interest rate pegging.
I think Cochrane’s basic mistake was in attacking the simplistic, naive, common-sense version of the Keynesian model, and not the actual Keynesian model. He thinks Keynesians believe that more saving is a bad thing, whereas they actually worry about a higher propensity to save causing lower interest rates and more money demand, or the central bank preventing a fall in interest rates by depressing the money supply.
If we want a general theory of NGDP, we need to model money. There is no other way. Instead, the dominant model is a roundabout way of looking at one particular cause of fluctuations in the money market, and hence in NGDP, which is completely conditional on the type of monetary regime. Even worse, from a common sense perspective this model seems to argue that changes in propensity to spend have a direct impact on real purchases and real output, not merely an indirect impact through changes in the market for money.
I’d recommend that Cochrane focus more on NGDP determination, not the determination of P and Y. It would make it easier to see where the Keynesians are coming from. They are trying to explain NGDP, and then assume that changes in NGDP affect RGDP via sticky wages and prices. When viewed this way, Cochrane would need to either criticize the sticky wage/price assumption, or criticize the assumption that fiscal stimulus can boost either M or V. Instead he meanders all over the place, and criticizes the Keynesian model as it’s interpreted by its most naive proponents.
I should add that I find Keynesianism to be mind-numbingly illogical, so it’s quite possible I got Cochrane wrong, or DeLong/Krugman wrong, or the Keynesian model wrong. If I did, there’s only one person I trust to set me straight, and he lives in Canada. (Actually two, but both live in Canada.)