Cochrane needs to review Hume, Fisher, and Friedman

John Cochrane has lots of sensible things to say about the euro-crisis, but his analysis is marred by a serious error:

A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a liter bottle, that wouldn’t threaten the

metric system.

Bailouts are the real threat to the euro. The European Central Bank has been buying Greek, Italian, Portuguese and Spanish debt. It has been lending money to banks that, in turn, buy the debt. There is strong pressure for the ECB to buy or guarantee more. When the debt finally defaults, either the rest of Europe will have to raise trillions of euros in fresh taxes to replenish the central bank, or the euro will inflate away.

Leaving the euro would also be a disaster for Greece, Italy and the others. Reverting to national currencies in a debt crisis means expropriating savings, commerce-destroying capital controls, spiraling inflation and growth-killing isolation. And getting out won’t help these countries avoid default, because their debt promises euros, not drachmas or lira.

Perils of Devaluation

Defenders think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth.

Hume, Fisher, and Friedman would have approved of the measuring stick analogy.  But they also understood that money is non-neutral in the short run.

In Zimbabwe the government destroyed the supply-side of the economy and then printed money to paper over the problem.  Of course their RGDP fell.  I could offer the following examples in reply:

1.  The big Argentine devaluation of 2002 turned a depression into 8% a year RGDP growth.

2.  The big US devaluation of 1933 turned a depression into 8% a year RGDP growth.

Cochrane could argue that there must have been “real” factors at work, but unfortunately in both Argentina and America all the real factors were government policies he (rightly) loathes.  Both countries grew rapidly in response to currency devaluation despite counterproductive statist policies.  And those two examples are at least as relevant (or irrelevant) as Zimbabwe.  Greece has both real and nominal problems, and thus is totally unlike Zimbabwe.

We know that when countries are severely depressed due to a fall in NGDP, a sharp currency devaluation most certainly will boost competitiveness.  That doesn’t mean that Greece doesn’t have all sorts of other problems, but Greek wages would not immediately double if they exchanged two drachmas for each euro.

I’m increasingly frustrated with the tendency of modern Chicago economists to treat Friedman as a hero, and then gloss over the fact that his greatest achievement was showing that recessions and depressions are caused by nominal shocks.

On all the microeconomic issues Cochrane is right, but on the euro he couldn’t be more wrong:

The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.

Fisher said the dollar was like a measuring stick with a length that was always changing.  He opposed fixed exchange rates (i.e. the gold standard) because he wanted the central bank to keep the “length” stable.  Greece can’t do that if it’s tied to Germany.  Friedman understood this problem as well, which is why he predicted the euro would end badly.  He was right.

Cochrane should have called for the ECB to make sure nominal growth doesn’t plunge next year.  If they want to make the euro work (and it seems they do) then the least the ECB can do is provide enough NGDP growth so that the structural problems in countries like Greece are not compounded by disequilibrium in the labor market.  [The original version omitted “not” before compounded.]

And I sure wish Chicago would go back to teaching its students the lessons of Hume, Fisher, and Friedman.

HT:  Tyler Cowen

Update: Ramesh Ponnuru has an excellent critique of a piece in The American Conservative that is critical of NGDP targeting.



28 Responses to “Cochrane needs to review Hume, Fisher, and Friedman”

  1. Gravatar of c8to c8to
    22. December 2011 at 15:12

    when i was seventeen (i drank some very good beer), no, i thought the euro was a good idea. and i thought exactly that, let’s have a world currency and let prices fluctuate.

    obviously people like to hide their wage fluctuations through inflation and exchange rate changes rather than a nominal pay cut. so now i don’t believe in the tooth fairy, eskimoes or currency unions.

  2. Gravatar of c8to c8to
    22. December 2011 at 15:37

    “If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth.”

    The poison is in the dose: a stable growth rate (in money supply or better NGDP) is far different than an accelerating rate.

    Note: looks like an exponential graph, but the y axis is already in powers of ten — nice!

  3. Gravatar of Daniel Richard Grayson Daniel Richard Grayson
    22. December 2011 at 15:38

    Perhaps ” are compound by disequilibrium in the labor market ” should be ” are not compounded by disequilibrium in the labor market “.

  4. Gravatar of Shane Shane
    22. December 2011 at 16:05

    The US experience shows that Cochrane is right about bailouts being the problem, but for the wrong reasons. To bail out the banks, the Fed had to find a way to create trillions in reserves without risking inflation. So it sterilized those injections with IOR, in effect ending monetary policy in October 2008 and switching to fiscal policy. Something similar will likely happen in Europe it seems.

    It’s like the first scene in _Blazing Saddles_ when Clevon Little drives his handcart into the quicksand and the bosses come and pull out the valuable handcart, leaving the humans stuck in the muck. The banks were what mattered to the Fed, so that’s what they pulled out of the sinkhole, leaving the rest of us stuck.

    The diabolical irony is that in order for the banks to be the cause of the recession they first had to………………

    convince everyone they were the cause of the recession. It was FDR in reverse: the malefactors of great wealth were hated by the public and they welcomed that hatred, because as long as they were held responsible for the crisis, any effective response would be perceived to necessitate bailing them out.

  5. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    22. December 2011 at 16:10

    What’s with this graph showing real GDP above nominal from 01-05:

  6. Gravatar of dwb dwb
    22. December 2011 at 16:10

    there are REAL reasons for the disparities in wages (different regulations, lack of labor mobility, etc etc etc).

    the ECB has a far harder problem right now than targeting NGDP. Effectively they have 17 NGDP targets, with rigid barriers to convergence, and no fiscal stabilizers.

    The ECB incentive here is very interesting to me. The ECB now presumably has a truckload of soverign debt as collateral for loans to banks. If banks bought their country’s debt at the encouragement of their central bank and politicos and borrwed at the ECB do do so, doesn’t that create a huge incentive for the ECB and Euro central banks to make sure the soverign debt is repaid to avoid bank failure? Did the banks get an implicit guarantee? The ECB is going to look phenomenally stupid for doling out loans to banks that later failed and even stupider for taking sov debt as collateral. Regardless of a haircut, it will be argued that banks with the biggest sov exposure were the most likely to fail and the ECB lent the most to precisely those banks. isn’t moral hazard and adverse selection fun?

    there are multiple self-fulfilling equilibria possible here. If everything comes out fine and dandy, wo-hoo. But, the ECB lending facility has potentially leveraged up the entire system with a greater sensitivity to a sov debt implosion and sudden loss of confidence, and potentially made it more likely that they will end up with a massive pile of sov debt and bad bank loans on their balance sheet. So I would have to say, seems to me that this loan program creates an enormous incentive for the ECB to inflate the Eurozone to protect its reputation and balance sheet.

  7. Gravatar of marcus nunes marcus nunes
    22. December 2011 at 16:40

    Cochrane, Izabela Kamiska, David Smith, among many others (many times Krugman´s included), don´t do economic analysis. They write down their “belief system”.
    That explains much of what is wrong with economics and why the economy is so “screwed up”!

  8. Gravatar of Benjamin Cole Benjamin Cole
    22. December 2011 at 16:44

    Cochrane’s rant is just more hysterical whimpering about inflation.

    The Euros should inflate, obviously.

    The problems of Greece, Italy et al, would be a lot easier of they had their own printing presses, and could inflate their way out their messes (with fiscal austerity too).

    I just wonder if ever the Cochranes of the world will be able to segregate out fiscal policy from monetary policy, and dead old shibboleths from what needs to be done here and now.

    Cochrane should visit Japan–where industrial output is down 20 percent in since 1995–if he thinks tight money is the answer to everything. Japan is becoming a backwater nation, suffocated under the boot of the Bank of Japan.

  9. Gravatar of von Pepe von Pepe
    22. December 2011 at 17:20

    How long is the short run?

  10. Gravatar of Lorenzo from Oz Lorenzo from Oz
    22. December 2011 at 17:53

    Von Pepe: normally, until you can change the level/pattern of capital. So, the short run is where capital is constant. It is an analytical time period, not a chronological one.

  11. Gravatar of Vadim Vadim
    22. December 2011 at 18:02

    I wish everyone arguing for the ‘lets turn on the printing press and inflate our way out of this mess’ solution would at least acknowledge the huge wealth effects such a policy would have.

    The way I see it, the debt crisis is simply a reflection that borrowers aren’t producing enough goods and services to repay their lenders. In money terms this means that someone has to eat losses. Why should the losses be widely distributed among all savers/lenders through inflation? Why shouldn’t the borrowers have to reduce their consumption (ie austerity)? Better yet, let’s have the insolvent banks/gov’ts fail and let the losses fall where they rightfully should.

  12. Gravatar of ssumner ssumner
    22. December 2011 at 18:44

    c8to, Well put.

    Thanks Daniel, I corrected it.

    Shane, Very interesting interpretation.

    Patrick, It’s below nominal from 2005.

    dwb, That would be good, wouldn’t it? (Unless it went too far.)

    Marcus, Well they certainly have a different belief system from me.

    Ben, Yes, Japan is another good example.

    von Pepe. It’s not a specific number, the long run effect gradually takes occurs over months and years. I think the economy has adjusted to some extent to 2008, but we’ve had negative demand shocks even in the past 6 months.

  13. Gravatar of Pennist Pennist
    22. December 2011 at 19:16

    If only there was a model against which we could understand the fundamental differences between your view and Cochrane’s.

  14. Gravatar of dwb dwb
    23. December 2011 at 06:26

    me, i do not think the ends justify the means (but maybe thats why im poor at politics) I think if the end goal is higher inflation they should come out and do it, not through back-door QE that has a risk of making the systemic risk worse and potentially destroying credibility. But then… the whole situation is upside down. If they do QE, it would be buying corporates, not sovs. huh? They are ok buying bank bonds, lending to banks, buying corporate debt, before sovs? sovs, historically, are one or two orders of magnitude less likely to default. (AA sov is really not comparable to AA corporate). ECB and the political elite are ok bailing out a bank or a corporate before the govt? really? the voters stand for this? bizarro world to me…

  15. Gravatar of ssumner ssumner
    23. December 2011 at 06:48

    Pennist, I think Cochrane just needs to be more consistent about what model he’s using. I suspect he agrees that nominal shocks do matter.

    dwb, I agree.

  16. Gravatar of ssumner ssumner
    23. December 2011 at 06:53

    Vadim, I’m certainly not advocating inflating our way out of this mess.

  17. Gravatar of W le B W le B
    23. December 2011 at 09:14

    “If they (the ECB) want to make the euro work (and it seems they do) then the least the ECB can do is provide enough NGDP growth so that the structural problems in countries like Greece are not compounded by disequilibrium in the labor market.”

    And if they don’t provide enough NGDP growth we must conclude that they don’t want the Euro to work – however illogical that postion may seem.

    Would that make it the first Central Bank ever to oversee the elimination of its own currency/existence.

  18. Gravatar of Greg Ransom Greg Ransom
    23. December 2011 at 10:56

    A diet of one-sided examples is not intellectually or morally healthy …

    You are cherry picking examples to support you claims, while examples proving the opposite can be found, re deflation.

  19. Gravatar of John John
    23. December 2011 at 12:23

    The idea of money as a measuring stick is crazy. Money’s value is in constant fluctuation and the only way to get any sense of it is to measure against all the goods and services in the economy. I wouldn’t feel comfortable giving an exact length with a measuring stick that was always expanding and contracting, but that’s what money does. The supply and demand for money is always changing. No wonder the Chicago school people are so god awful when it comes to money.

  20. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    23. December 2011 at 12:38

    ‘Patrick, It’s below nominal from 2005.’

    Which is where it would be expected to be. Did we have negative inflation from 01-05?

  21. Gravatar of ssumner ssumner
    23. December 2011 at 12:41

    W le B, More likely they are ill-informed.

    Greg, Read my post again, more carefully.

    John, Cochrane is certainly not representative of the traditional Chicago School, as I indicated.

  22. Gravatar of ssumner ssumner
    23. December 2011 at 12:42

    Patrick, No we had positive inflation, which is why the nominal grew faster than the real. I’m not following your criticism.

  23. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    23. December 2011 at 13:33

    Well, I think I solved the mystery after a little detective work (I watched three Thin Man movies last night on TCM).

    A graph of real v nominal GDP would always show nominal above real by definition, as you derive real GDP by subtracting an inflation measure from nominal GDP. With a positive inflation rate the American Conservative graph has to be wrong.

    So, I went here;

    and found an Excel spreadsheet comparing ‘GDP in Current billions of dollars’ with ‘GDP in billions of chained 2005 dollars’. The spreadsheet is misleadingly titled, ‘Current-dollar and “Real” Gross Domestic Product’.

    The author of the piece didn’t understand that he was looking at two different methods of looking at the same thing, (Real GDP).

  24. Gravatar of dwb dwb
    23. December 2011 at 16:34

    very surreal when Krugman quotes Friedman against Cochrane. Some days I feel like I’m living in an M.C. Ecsher painting.

  25. Gravatar of Prakash Prakash
    23. December 2011 at 18:10

    Money as a measuring stick. If we are coming back to first principles, here is a question – it is a genuine confusion in my mind and I’ll be glad to know the market monetarist answer.

    In the austrian view, it is very clear as to what money is – it is the most marketable good. It is the gold standard, the thing against which everything is measured.

    In the market monetarist view, approximately where does the marketability of money lie if the policy of maintaining a small constant NGDP growth is regularly followed.

    Is it somewhere in the middle of all goods and services?
    When a random good in the economy is picked, the average person is indifferent to the good or to holding the money.

    Or should money be somewhere below the median, so that people prefer buying some goods or services or creating investments compared to holding money? If the latter, then how much below the median – 40 percentile ? 30 percentile ?

    Or am I looking at this in a wrong angle?

  26. Gravatar of W le B W le B
    24. December 2011 at 03:12

    “More likely they (the ECB)are ill-informed.”
    Which means that the future of Europe, with all its tensions and potential for inter-community strife, and indirectly of so many other economies, is in the hands of the unelected, the unaccountable, the ill-informed and the incompetent.

    Thank you so much for your tireless campaigning blog.

  27. Gravatar of ssumner ssumner
    25. December 2011 at 08:56

    Patrick, You are wrong, a graph of real and nominal would not always show nominal higher, even if you always had inflation. It would show the nominal always growing faster. That’s different.

    dwb, Yes, confusing to me as well.

    Prakash, I think you are looking at this the wrong way. It doesn’t matter whether you target NGDP or some other aggregate, the demand for money is based on its utility in transactions and its anonymity. That’s all.

    W le B. Thanks.

  28. Gravatar of Assorted Links « azmytheconomics Assorted Links « azmytheconomics
    29. December 2011 at 06:16

    […] 1. John Cochrane on the Euro Crisis Sumner comments. […]

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