Via Casey Mulligan and Karl Smith, here is John Cochrane's response to Paul Krugman. It's a very good response. But there is one part where John Cochrane is definitely wrong. It's small, but important. And it's all about Say's Law, and the crucial difference between a monetary exchange and a barter economy.
"Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income."
It's the last sentence that matters; I quoted the rest just to provide context. John Cochrane is saying (unless I have totally misunderstood him) that Keynesian economics is logically inconsistent in requiring that people make plans that violate their budget constraints. If correct, this criticism would apply equally to monetarists as well as Keynesians.
This criticism would be correct in a barter economy; it is not correct in a monetary exchange economy. But Keynesian economics makes no sense in a barter economy, and nor does monetarism (unsurprisingly).
Forget investment and taxes (and forget exports and imports, government expenditure, borrowing and lending, land, used furniture, and everything else, while we are at it). Let's just leave consumption on newly-produced goods, and income. Can people plan to spend more than their (planned/expected) income?
In a barter economy: no. In a barter economy, an offer to buy is an offer to sell. "Wanna swap 5 of your bananas for 10 of my apples?". I plan to earn 10 apple's worth of income and spend it on 5 bananas, but we cannot distinguish the act of earning income from the act of spending it. And anybody who planned to buy goods of a greater or lesser exchange value than those he planned to sell has made some sort of arithmetic mistake.
But in a monetary exchange economy, offers to buy goods with the medium of exchange, and offers to sell goods for the medium of exchange, are distinct acts. I can plan to buy goods of greater exchange value than the goods I plan to sell, if I plan on reducing my stock of money. And if everyone plans to do the same, and if they realise those planned expenditures, they will be surprised to find their incomes rising by the same amount. There is no logical inconsistency in people planning to spend more with the same income in a monetary exchange economy.
General gluts are always and everywhere a monetary (medium of exchange) phenomenon. The very distinction between Aggregate Demand and Aggregate Supply is a monetary (medium of exchange) phenomenon.
Whats wrong with macroeconomics? The same thing that's wrong with Finance, apparently. We need to integrate Finance into monetary theory. We need to integrate monetary theory into Finance.
Hoisted from comments: Jason says "Doesn't sound like a small deal to me. If a guy cannot even distinguish between a monetary economy and a barter economy, then what business does he have in doing macroeconomics?". Yes, it's important. But we need to encourage Finance people to do macro, and macro people to do Finance, and part of the price of doing that is we will make mistakes.
[Addendum: my guess is that the Keynesian blogosphere will mostly ignore this mistake in John Cochrane's response, and instead jump all over him for an alleged mistake in what he says about Ricardian Equivalence, in ignoring the distinction between tax cuts and government spending increases. Actually, what he says about Ricardian Equivalence is not necessarily wrong; it just depends on what you assume about the substitutability between government and private spending (which he forgot to mention).]
Worthwhile Canadian Initiative 
Good on Cochrane.
Wouldn’t Keynesian economics make sense in a barter economy with storage technology? A common unit of measure is not necessary.
In fact, the greater potential for asymmetrical information and the ability of a politically powerful entity to obfuscate values suggests that Keynesian style stimulus may work even better than in a pure barter economy.
Typo….. grrr. Corrected below:
…suggests that Keynesian style stimulus may work even better in a pure barter economy (as opposed to an economy with money).
Thanks westslope! Short answer: no. The role of money as a medium of exchange is crucial. Storage of goods cannot create the same sort of general glut. Long answer in one of my old posts here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/why-an-excess-demand-for-money-matters-so-much.html
I liked the post, but I, not surprisingly, I guess, misinterpreted it. When he says this:
“Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the “ifs” and figuring out the likely “therefores.” This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false.”
I thought that he was differentiating, in my terminology, between Econ & Pol Econ. The models are not perfect representations of reality, but useful aids in making decisions in Pol Econ. What he claims Krugman is doing is acting as if certain economists actually believe the model is reality, not a useful tool. Krugman is not giving the rest of the story. The models have proven themselves useful in the past, and are still useful. But then you have to look at the world and consider other models as well.
Instead, he’s saying that Krugman is the one wedded to a particular model as if it was reality. And he then uses this model to argue Pol Econ, which is inherently imperfect, is perfect in this case, where his model is concerned. Cochrane is making the more modest claim for what econ can do, not advancing a doctrinaire view of any kind.
Here’s my problem: I agree with Cochrane, but then that could be because I have him, in this case, basically agreeing with my point of view. When Krugman agrees with me, I’ll defend his ideas as well.
The only real beef I have with Cochrane is about his predecessors. In Pol Econ, it is quite possible that older views can provide more firepower than current ones.
Money is a (pretty bad) asset that is held because it helps economize on various stuff without much macro importance, so what’s all the hubbub? Or did someone come up with a closed, microfounded, no-free-parameters model of the macro economy in which money drives more than 30% of aggregate fluctuations?
You have countless generations of macroeconomists looking at how they can prove that monetary policy causes output and my thought is that if you keep looking and it just doesn’t seem to be there, maybe it really isn’t there.
You are right of course, however reading him I believe he believes it impossible for government spending to increase real incomes. He does throw some caveats against it, perhaps not under all circumstances, but this seems his chief argument.
His failure to distinguish between commercial and investment banks, and between insurance and guarantees and those without such but too big to fail anyway undermines his understanding of the crisis. Then he fails to address the most important idea, that finance will have to be incorporated into these models. While Keynesian models have been and are central to the modeling undertaken, the Neoclassicals have been influential at the decision making and regulatory level. They were at the heart of Greenspan’s regulatory avoidance, and that bubbles don’t exist. And far from arguing against data, Paul is arguing the data has been neglected in favor of prejudgments and that it had nothing to offer after the failure of conventional monetary policy. The failure to work out those before being needed is probably the worst indictment of economics.
“Wanna swap 5 of your bananas for 10 of my apples?”. I plan to earn 10 apple’s worth of income and spend it on 5 bananas, but we cannot distinguish the act of earning income from the act of spending it. And anybody who planned to buy goods of a greater or lesser exchange value than those he planned to sell has made some sort of arithmetic mistake.”
Can’t you borrow 1 banana (of output) in a barter economy? It amounts to the same thing as spending more than your income in a monetary economy.
Don: I have a different interpretation of the usefulness of Ricardian Equivalence (that perhaps is consistent with what Cochrane is saying). Ricardian Equivalence lays out a set of assumptions under which bond-financed tax cuts have no effect on AD. That forces those of us who think that bond-financed tax cuts do increase AD to spell out our own assumptions, justify them, and better understand why we think that bond-financed tax cuts do increase AD.
Angry at the Margin: I think you missed my point. This is not about whether fluctuations in the money supply are or are not a major cause of fluctuations in AD. It’s about whether Keynesian (or monetarist) statements about planned spending being different from income are logically inconsistent, and that depends on whether we have a barter economy or an economy in which people use a medium of exchange.
By the way, there is a very good reason why it’s hard to prove that money causes output: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/01/why-theres-so-little-good-evidence-that-fiscal-or-monetary-policy-works.html
anon@11.31: I ruled out borrowing and lending to keep it simple, but lets bring it back in.
Suppose we have a barter economy, initially at full employment, where planned consumption equals income. Then suddenly everyone decides they want to consume 1 less banana, and lend 1 banana to someone else. Yes, planned consumption spending is less than income. But can this cause a recession? No. Everyone tries to lend 1 banana (i.e. swap 1 banana today for a promise to repay (1+r) bananas next year, where r is the rate of interest), but since nobody wants to borrow, they fail to lend. Unable to lend the 1 banana, they consume it instead. End of story. No recession.
For the most part I’ll leave Krugman and Cochrane to their pissing contest. Seems to me that Krugman was just poking the bear. It’s the macro equivalent of Peter Woit’s ‘Not Even Wrong’. So I think that Cochrane is overreacting a bit.
The one statement by Cochrane that I really take exception to is this:
” .. dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.”
Then why bother with macro at all? Coming from a physical sciences background, I view a theory that provides no verifiable predictions as religion, not science. I certainly hope economics can aspires to more than throwing up it’s hands and saying “oh well, we aren’t smart enough to make predictions”.
“their incomes rising by the same amount.”
Isn’t “everyone’s income rose the same amount” equivalent to “nothing changed”? That just means prices went up.
Doesn’t sound like a small deal to me. If a guy cannot even distinguish between a monetary economy and a barter economy, then what business does he have in doing macroeconomics?
Patrick: But Cochrane was talking about the efficient market hypothesis, not macro in general at that point. And, weirdly, the inability to make a verifiable prediction is itself a verifiable prediction. Think about predicting the position of a particle that theory says should follow Brownian motion. (And it is consistent with EMH that you can make predictions, conditional on the future information available to the market.)
pointbite: I meant “real income” (and real consumption). In a sticky price world, it isn’t the same as saying “nothing (real) changed”. (Assuming everyone is the same is just a simplifying assumption in this case, so I can switch easily from talking about the individual to talking about the aggregate.)
Jason: I hoisted you from the comments, and replied in the post.
“Suppose we have a barter economy, initially at full employment, where planned consumption equals income. Then suddenly everyone decides they want to consume 1 less banana, and lend 1 banana to someone else. Yes, planned consumption spending is less than income. But can this cause a recession? No. Everyone tries to lend 1 banana (i.e. swap 1 banana today for a promise to repay (1+r) bananas next year, where r is the rate of interest), but since nobody wants to borrow, they fail to lend. Unable to lend the 1 banana, they consume it instead. End of story. No recession.”
This is wrong.
If I want to borrow a banana in a barter economy, that means I want to consume one banana more than my income is capable of buying in exchange. The result it creates additional demand for banana production, the same as in a monetary economy. The economy expands.
The opposite of that is that I want to consume one less banana than my income is capable of buying in exchange. That banana is left in the producer’s inventory. The idea that the producer is the one who ends up consuming it is irrelevant. The relevant fact is that the producer adjusts to the reduced demand by cutting banana production in the next period. That causes a recession.
There’s no difference in these dynamics as between a barter economy and a monetary economy.
P.S.
In a barter economy, every good and service is its own medium of exchange. Borrowing money to purchase a good or service in a monetary economy is exactly the same as borrowing the purchased good or service in a barter economy and consuming it.
Patrick:
All disciplines experience this same difficulty accurately forecasting events. You should watch biologists flounder around with pre-season forecasts for fish such as salmon, for example. That said some simple (ordinal) models do well at roughly a year out. 3-day weather forecasts are surprisingly accurate. Beyond 5-days may not be much better than a roll of the dice.
Incidentally, economics is the lead discipline for managing risk precisely because we recognize so much raw, brutal uncertainty.
anon: By the way, are you the same “anon” in all 3 comments? Would you like to adopt an alias please, so I can keep track of who said what? (Especially since you seem to know economics, and your comments are valued.)
I disagree. I went over this ground in some previous posts (can’t remember them all now, unfortunately!)
Suppose everyone produces bananas, but you can’t consume your own bananas (just to motivate trade, and rule out my answer of consuming your own bananas if you can’t lend them). Everyone otherwise identical. Assume bananas are perishable (to rule out storage/investment).
Start in full employment. Barter economy. Assume for simplicity a perfectly inelastic supply of labour/bananas. 10 bananas per person. Suddenly everyone wants to save and lend 1 banana, and consume only 9. Hold the interest rate fixed (otherwise r just falls until the excess supply of loans disappears, of course).
There is an excess supply of loans, so people are unable to lend. Faced with this constraint on realising their first-best plans for consumption and lending, they revise their plans. Their second-best plans are to produce and consume 10 bananas and lend none. Cutting production and consumption to 9 bananas is definitely third-best (given my assumption of a perfectly inelastic labour supply curve.
This is an example of Patinkin/Clower/Barro and Grossman/Leijonhufvud/Bennassy etc.’s distinction between notional and constrained demand functions. Notional demand is for 9 bananas. Constrained demand (what you get when you max U(.) subject to budget constraint AND subject to constraints on the quantities you can actually trade if you are on the short side of a market that is not clearing, is for 10 bananas.
You want to swap 10 bananas for 9 bananas plus the promise to repay (1+r) bananas next year. But nobody is willing to do the swap. The best swap you can find is 10 bananas for 10 bananas. So you do that second swap.
No recession, in barter.
In a monetary economy, you try to swap 10 bananas for money, then buy 9 bananas, and lend 1 banana worth of money. You can’t find anyone to borrow the money, so you hold it instead of lending it. But then you find you can only sell 9 bananas. You can’t consume your own 10th banana, and you can’t swap it. So it rots. So you stop producing it. And then the Keynesian multiplier kicks in.
“There is no logical inconsistency in people planning to spend more with the same income in a monetary exchange economy.”
Quite possibly the dumbest statement I have read this week. No wonder economics is such a mess.
If you gave any thought to the growing volume of unmatched exchanges implied in your statement, you would have a ready description of asset price inflation and bubbles.
“General gluts are always and everywhere a monetary (medium of exchange) phenomenon. The very distinction between Aggregate Demand and Aggregate Supply is a monetary (medium of exchange) phenomenon.”
I take the above comment back: THIS is the dumbest statement I have read this week!!! Your other statement pales in the comparison.
My god, I can’t believe they let you people speak to policy makers!
1
Nick:
Anon is correct. If we have an economy with bananas and banana bonds, and the banana interest rate is wrong, then there can be a surplus of bananas and a shortage of bonds.
With bananas being currently produced and bonds not being currently produced, then there is a general glut of the currently produced good.
In a monetary economy, if we rule out monetary disequilibrium by assumption, and there is a shortage of bonds, then people have nothing to do but buy bananas. (one good models look a bit silly in this situation.)
But in a barter economy, there is a surplus of bananas and a shortage of bonds. And that is where we are left.
Now, when people respond by growing less bananas, the reason is that they don’t want to sell bananas because there is nothing for them to buy. In this scenario there is nothing like the problem of recession, which I would see as wanting bananas to eat, but they cannot grow them. (People want to buy consumer goods, but they cannot find employment because no one can buy the consumer goods they produce.)
Interest rates are wrong, and so gains from trade between leisure and banana bonds (and so, between present and future bananas) cannot be made. More leisure, less banana production, and so, a real business cycle recession.
Monetary disequilibrium theorists dismiss the shortage of bonds story because bond prices are flexible–it is only when the disequilibrium spills over to money that it causes problems. And, it is true that if we imagine price floors on interest rates, or something, money not spent on bonds is spent on something else or held. Assuming no monetary disequilibrium means it is not held. And so, it is spent on goods. But in a barter economy, that doesn’t happen.
Of course, your points about notional vs. effective demand apply. And choosing to work less because there is nothing for you to buy may result in less production, but it is nothing like the scenario were there is excess capacity because of an inability to sell–the phenomenon we want to explain.
Suppose there are price ceilings throughout the economy, shortages, and people choose to work less (or maybe spend more time in home production.) The volume of market activity shrinks. Price ceilings cause a recession. Well, maybe.
Anon:
In a barter economy with many goods, the obvious responses to your statements would be that first, the banana bonds only create a matching demand for bananas if someone is willing to buy them. The demand for banana bonds is the supply of bananas.
Second, if the banana producers exchange bananas for the bonds, they are no longer exchanging them for apples or bread, or whatever. And so, those demands fall. (If we think of bananas only, that isn’t an issue.)
If banana bond issuers no longer want to borrow as much, and the banana producers can’t exchange bananas for banana bonds, they try to exchange them for other things–bread, apples, and the like. The demand for those other goods rise. There is no drop in aggregate demand.
If the banana producers don’t want apples or bread (and just banana bonds,) and so choose to grow less bananas becaue there is nothing they want to buy, then both aggregate supply and demand fall together. This is what should happen. The “problem” we are interested in would be when demand falls and not supply, resulting in surpluses and demand constrained production.
However, if the interest rate on banana bonds doesn’t adjust, and they would like to work more, grow bananas now, and exchange them for banana bonds at the current interest rate, then there is an excess supply of bananas.
Imagine retired professors still teaching a bit. They save part of their retirement salaries, but the added teaching allows them to save more. They are investing this moeny in the bull stock market. After a few years, their plan is to travel the world. Or perhaps they are making provision for their grandchildren’s education. Suddenly, there are no investment projects of reasonable risk. They invest less, save less, and work less. Aggregate income and output fall. So? They work less because their is nothing they want to buy. It isn’t the same thing as not being able to buy because one cannot sell. And when that happens generally, in a way that suggests that there is a general overproduction of scarce goods, then, there is a problem. And that hypothetical (and I think, very real) situation, is what we are interested in.
Think of Robinson Crusoe. He works 10 hours a day. He accumulates a store of coconuts, catches fish, builds a wood pile for the signal fire, builds a hut. Then he decides he can take it easy a bit. Work only 7 hours a day. A recession? Well, you can call it that if you want. But if something like that happens in a social order, it certainly isn’t a problem. No, we are intersted in these odd situations where people want to work, porduce, sell, buy, and consume, but they are hampered because they cannot sell.
I believe that this occurs when there is an imbalance between the quantity of money and the demand to hold it.
Starting with your monetary economy example, the simple bottom line is that you produce 10 bananas and can only sell 9. There is a recession because you reduce your production to 9 in the next period.
You must use the same example in the barter comparison. You produce 10 bananas and can only sell 9. There is no demand for additional bananas. This means no additional demand through buying outright. And there’s certainly no additional demand through borrowing. There’s no reason to assume one reduces one’s purchases just to make room for borrowing in this simple case. So, there is a recession because you reduce your production to 9 in the next period.
In general, you are confusing accounting periods in the causality and dynamic of the recession. In both cases, the recession is set in actual motion by what happens in the next accounting period; not the current one. Your second best plan in the barter case is one of forced consumption in the current period, which is not what the economy wants. Hence the recession starts in the next period.
No difference in the outcome.
“With bananas being currently produced and bonds not being currently produced, then there is a general glut of the currently produced good.”
(from Bill Woolsey)
Similar to my:
“And there’s certainly no additional demand through borrowing. There’s no reason to assume one reduces one’s purchases just to make room for borrowing in this simple case.”
i.e. there is a shortage of banana bonds issued
westslope:
“economics is the lead discipline for managing risk”
God, I think not.
The most important idea in managing risk is that of the scenario.
The most mangled brand of analysis to be found in economics is that of the counterfactual, which is essentially an ex post scenario.
Ummm. Charley Toyou: before calling people dumb, you might want to try to understand the distinction between: is it logically inconsistent for people to plan to spend more than their income? ; is it a good idea for people to plan to spend more than their income?
When you have your reading comprehension problem fixed, then we can begin work on your economics (and perhaps your civility).
Bill:
If there is a tabu against consuming your own bananas (to motivate trade) then there are effectively n different goods (with n agents). It would be almost the same (but a little more complex) if we made the standard New Keyneian assumption of n different varieties of bananas, and a taste for variety.
“But in a barter economy, there is a surplus of bananas and a shortage of bonds. And that is where we are left. Now, when people respond by growing less bananas, the reason is that they don’t want to sell bananas because there is nothing for them to buy.”
There is indeed a notional excess supply of bananas, and a notional excess demand for bonds. But why would people respond by growing less bananas?
In a barter economy there will be a market in which bananas are traded for banana bonds, and a second market in which (my) bananas are traded for (your) bananas. I can’t sell my 10th banana in the first market, but I can sell it in the second market. And I will do so, given my assumption of a vertical labour supply curve, it costs me next to nothing to produce that 10th banana, and even though I would prefer to trade it for a bond, trading it for a banana to consume is better than not producing it and enjoying more leisure.
But in a monetary exchange economy, that second market doesn’t exist. I want to do a matched trade (“OK, here’s the deal, if I buy your bananas for money, will you buy my bananas for money?”), but these matched trades aren’t allowed.
Now, if I relax my assumption of a perfectly-inelastic labour supply curve, it is true that an inability to buy bonds will cause me to reduce production a bit (like in your professor working for his pension example). But there has to be some sort of envelope theorem (wish my maths was better) that says the drop in production will be smaller than in a monetary exchange economy. (In a Keynesian unemployment equilibrium I can get nothing in return for producing an extra banana; in a barter economy I can consume an extra banana in return for producing an extra banana, which is not as good as getting an extra banana bond, but is a lot better than nothing.)
With the tabu understood, let there be 3 goods: bananas; banana bonds (promises to pay (1+r) bananas next year; and money.
In a monetary exchange economy, there is a market in which I can trade bananas for money, and a market in which I can trade banana bonds for money. There is no market in which I can directly trade my bananas for your bananas. And the absence of that third market matters.
fourthtimeanon: I think my reply to Bill also responds to most of your comment (you and Bill must have been posting at the same time).
There is indeed a timing issue for the working out of the Keynesian multiplier (it is easiest to imagine a Keynesian counterpart to the Walrasian auctioneer, but doing a tatonnement on quantities, not on prices). But let’s see if we get the first disagreement sorted out first.
Suppose apples are the second real good. Suppose you are unable to sell the final banana in a monetary economy. Why would you be able to get paid in apples for producing the same final banana in an equivalent output barter economy? Why is there a difference in the clearing outcome and the market clearing real price? Unless there’s a difference, a recession follows in the barter economy as well as the monetary economy.
I think you are quire right: Cochrane is committing the fallacy of Says’ Law.
Unfortunately, Cochrane would never admit it. When Brad DeLong and Paul Krugman slammed his rant on Fiscal Policy at the beginning of the year, his all-purpose denial of error consisted of insisting that they should read further, to where he contradicted himself later in the same essay. Here, he complains, “most of all, Paul isn’t doing his job. He’s supposed to read, explain, and criticize things economists write, and preferably real professional writing, not interviews, opeds and blog posts.”
Cochrane might have a point. I thought Krugman’s essay was dreadful. (And I share many of Krugman’s political commitments and ideological predilections.) But, it leaves one wondering what the relation of High Theory among the priesthood on the Olympian Plains of Moon Economica is supposed to have to policy and political discourse among “the lay people” down here on planet earth. (As a lapsed Catholic, I appreciated the metaphor.) Cochrane seems to think Academic Economics has labored over the last couple of generations to confirm Cochrane in every ideological prejudice he holds dear, while Krugman faults Academic Economics for doing so, instead of learning about the economy. Viewed in that way, the two of them are in perfect agreement. Dani Rodrik would so proud, to find convergence in the profession.
Cochrane’s bedrock theoretical premise is expressed in the conditional: “if money is not going to be printed, it has to come from somewhere.” I have no idea where he thinks money comes from, other than printing. But, hey, he’s a professor of financial economics, so I’m sure he has some ideas on the subject. (Maybe, you should offer him some bananas? Is that too snarky?)
Sarcasm aside, I don’t feel any confidence that Cochrane will recognize that he’s made an error, or that he is under any obligation to make coherent sense, when speaking to we “lay people”.
Back to the apples:
Nick, you need to break your “apple income” down into at least corporate income and wage income.
What does the model look like if productivity and/or cheap labor shift the supply curve for apples to the right, the fed adds bank reserves to shift the supply curve of loanable funds so that interest rates come down, the workers have a price inflationary attitude of 2% per year for apples and overestimate their permanent wage income (expectations are too high) so that they borrow using bank loans denominated in currency (NOT APPLES) based on that overly optimistic permanent wage income leading to the demand curve for apples being shifted to the right?
In the end, does the “apple corporation” get operating margin growth, quantity growth, and price inflation?
Do the workers get negative real wage growth and more bank loans denominated in currency, and the “apple corporation” gets positive real corporate income and possibly excess savings?
Does that scenario lead to more wealth/income inequality?
“What’s wrong with macroeconomics?”
IMO, it fails to properly track debt (loans based in currency), that the fed has a “monopoly” over the fungible money supply, and that the fed (along with the spoiled and the rich) can exploit an oversupplied labor market and productivity for their own personal gain.
“Can people plan to spend more than their (planned/expected) income?”
Is it better to ask can the lower and middle class in the high wage countries spend more than their wage income and have faulty expectations about future wage income?
Nick: Income in a barter economy has nothing to do with the act of exchange, and everything to do with production. So I think you’re confused.
Then you move on to AD and AS. Here Cochrane’s critique applies (despite the presence of money). The quantity of real goods and real production cannot be altered by the creation of money. Society as a whole cannot plan to spend more than its income.
So in Cochrane’s remark are people ‘collective’ or individual instances.
The only reason you cannot sell your banana is because your price is sticky. Therefore your assumption of a vertical supply curve is inconsistent.
So when you write: “Suddenly everyone wants to save and lend 1 banana, and consume only 9.” You are embedding a pricing assumption. i.e., you need to think about why everyone is suddenly insisting on saving one banana and will do so at any (opportunity) cost. Really what you are saying is that the banana had zero marginal utility, to which we can conclude that people were indifferent between that extra banana and leisure. Therefore your stated ordering of preferences is inconsistent.
Once again, I see no difference.
You are saying that in a monetary economy a consumer can offer his current period income plus an additional stock of pre-existing money (or newly borrowed money) for goods and services. Your key phrase is expenditures “if realized”. If realized, this means that the offer of new money income plus an existing stock of owned or borrowed money results in additional real output, causing realized income to exceed assumed or planned income, across the board.
There is no difference with a barter economy.
The equivalent barter situation is that the consumer offers his current period real income plus an additional stock of pre-existing real assets (or newly borrowed assets) for goods and services. If realized, this means that the offer of new goods and services plus an existing stock of owned or borrowed real assets results in additional real output, causing realized income to exceed assumed or planned income, across the board.
Krugman’s expose of economic thinking is imperfect, but contains much more truth than not. He’s no more ideologically bent than most economists. He just gets a lot more print and continuous attention for it. Apart from the issue here, Cochrane’s defence in general is insipid. I have no doubt Krugman will destroy him again. In fact, he’s already started:
http://krugman.blogs.nytimes.com/2009/09/11/mathematics-and-economics/
fourthtimeanon:
I think both Cochrane and Krugman are being childish. They really need to get over themselves.
Cochrane basically tries to personally discredit Krugman by calling him a communist. It’ laughable. But what did Krugman expect? He did lob a ‘not even wrong’ bomb in a popular magazine. That is bound to create reactions ranging from annoyance to blind rage.
Cochrane’s response is vitriolic and a total overreaction. Krugman said nothing controversial or deep. EMH and rational expectation are pretty clearly spherical cows. But the way to deal with it is to make the cow more cow shaped. Neither men is making much of a contribution in that direction by exchanging silly, long winded attacks.
fourthtimeanon,
At any one time, you can find individual economists doing high theory, low (applied) theory, measurement theory, empirical hypothesis testing, laboratory hypothesis testing, comparative analysis, applied measurement, welfare (normative) economics, prescriptive (normative) policy, forecasting, philosophy, etc. Or even some indecipherable mix of the above.
Yes, some of the above constitutes and ex post counter-factual approach. The Popperian paradigm is still popular, if not the outright dominant approach to advancing knowledge. But then the same observation applies to many other if not all other disciplines.
Yes, childishness by both. Krugman because of his public ideological profile is on the receiving end of numerous broadsides, so it’s not that surprising he vents personal at times. Cochrane is hopeless with more mathematics; he’s enslaved by it. Krugman is interesting for his similarity to Taleb regarding the use of mathematics. He has imagination beyond that, and also knows how to write.
IMO, two(2) great posts.
http://globaleconomicanalysis.blogspot.com/2009/09/greenspanism-root-cause-of-this.html
Inside it:
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/6179033/Lehman-is-a-footnote-in-the-great-East-West-globalisation-crisis.html
It starts “You can see why markets and governments both like to blame Lehman Brothers for the “Great Contraction”. Such wishful thinking shields investors from the nasty reality that deeper forces are at work: it absolves officialdom from its own destructive role in fixing the price of credit too low for 20 years, luring us into debt.”
http://www.calculatedriskblog.com/2009/09/moment-with-minsky.html
“And since the failure of many economists to see the coming crisis is being widely discussed, here is a quote from Minsky on macroeconomics:
‘There is nothing wrong with macroeconomics that another depression [won’t] cure.'”
Sorry for the delay in responding.
I just realised something weird:
John Cochrane is saying that people (presumably in aggregate) cannot plan to spend more or less than their planned (expected?) income. I interpret this as the same as Say’s Law (there cannot be an overall excess supply or demand of newly-produced goods.
1. I am saying that JC is right in a barter economy, but wrong in a monetary exchange economy.
2. Bill and fourthtimeanon are saying that JC is wrong in both a barter and a monetary exchange economy. (Right?)
So relative to Bill and fourth, I am actually defending JC! I am saying there are at least some cases where he’s right (just not in the real world, which is a monetary exchange economy).
And Jon is saying that JC is right, in both barter and monetary exchange economies? (Jon: I like to distinguish between the AS curve that describes how much people want to sell, and the “price-setting curve” which describes how prices are fixed (or not). So if prices are assumed fixed in the short run, the AS curve is still vertical, but there’s a horizontal line describing how prices are fixed, but I don’t want to all that horizontal line a SRAS curve.)
forthtimeanon: Let’s add apples to the model. (That’s a good idea, because it’s a lot simpler than having varieties of banana). Half the people produce only apples and consume only bananas; the other half do the exact opposite. All bananas identical; all apples identical. Assume symmetry. In the initial equilibrium, everybody produces and consumes 10 fruits. Price apple = price banana. Now assume everybody want to save 1 bit of fruit. Hold prices (and interest rates) fixed.
Notional excess demand for bonds of 1 fruit per person. Notional excess supply of 1 fruit per person. What happens next?
In a monetary exchange economy: people are frustrated/constrained in the bond market, so they plan to save instead in the form of money. Sales of fruit drop below 10. Unsold fruit rots. Recession. Excess supply of fruit.
In a barter economy. Rather than letting their fruit rot, apple producers swap their apples for bananas, and banana producers swap their bananas for apples. Demand for fruit, conditional on the constraint in the bond market, equals the supply of fruit. No recession. This cannot happen in a monetary economy, because there is no market where apples are traded directly for bananas.
Look: I’m obviously not explaining this clearly enough, if good economists like you guys aren’t understanding what I’m saying. And it’s an absolutely crucial point; I think it must be at the root of the disagreement between PK and JC.
I’m going to do another post.
One more time now:
Monetary Economy
Banana producer produces and sells 10 bananas
Banana producer buys 9 apples
Banana producer saves income from 1 banana
Apple producer produces 10 apples and sells 9
Apple producer buys 10 bananas
Apple producer dissaves income from 1 apple; i.e. has borrowed from the bank to consume 1 banana
There is no other market for the final apple; the final apple rots
End result is that apple producer is in debt; banana producer has money
(These are offsetting banking system debit and credit entries)
Apple producer cuts back apple production to 9; cuts back banana consumption to 9
Etc., recession starts
Barter Economy
Banana producer produces and sells 10 bananas
Banana producer buys 10 apples
Banana producer consumes 9 apples and lends (i.e. saves) 1 apple
Apple producer produces and sells 10 apples
Apple producer buys 10 bananas
Apple producer consumes 10 bananas
Apple producer makes a market in apples, and borrows 1 apple from banana producer
Apple producer now has a short position in apples; i.e. has dissaved in apple terms
End result is that apple producer is in debt for 1 apple; banana producer has the loan
But there is no market for the apple producer’s borrowed apple; the final apple rots
Then apple producer cuts back production to 9 apples; cuts back banana consumption to 9
Etc., recession starts
Comments:
a) The bilateral exchange facility of the barter economy is irrelevant to the economics
b) The difference between bonds and money is irrelevant to the economics
Clarification above:
“Apple producer now has a short position in apples; i.e. has dissaved in apple terms”
Technically, he’s net short after the apple rots
“Apple producer makes a market in apples, and borrows 1 apple from banana producer”
Why does the apple producer borrow 1 apple? I thought everyone wanted to save 1 fruit?
If everyone want to lend 1 apple or banana, they will be unable to, because nobody will borrow.
Nick,
I think if you really want to get to grips with this question you need to spell out what actually happens in your barter economy when some of the goods are unfit for human consumption. Since you are planning a new post I won’t go on about this. Instead I’ll pass the microphone to Frank Hahn:
“In a barter world a man would not offer his labour in exchange for say some of the sulphuric acid he helps to produce, except on the speculative basis that he could exchange it again. One would expect ‘market failure’ to be far worse here than in an economy with a medium of exchange (see Ostroy and Starr, 1974). In the fable world of labour and corn this problem would not arise but there would also be no need for a medium of exchange.”
The Ostroy and Starr paper which Hahn refers to is here (PDF file), but I haven’t read it and I’m not sure that I would understand it even if I did.
There’s no banking system in a barter economy, so I’m assuming the producers assume the intermediation role – i.e. are the market makers for borrowing and lending in the commodity they produce. Just because there’s no money doesn’t mean there’s no intermediation function.
The other way saving can take place is to exchange commodities but simply not consume. That technically is saving, but the market value of the saved income/asset quickly declines to zero. It’s hard to see why anyone would be motivated to do that as a channel for saving, so I introduce the market maker concept, where the market maker agrees to assume the risk, as is the case in monetary system markets.
Whether the desired saving is sequential or simultaneous doesn’t matter to the recession dynamic. Illustrating sequential, propagating desired saving is simpler.
Kevin: you (and Frank Hahn) are absolutely right. Abolishing money would not solve the problem; it would just make it worse.
Barter is not illegal in a monetary exchange economy; it’s just that the transactions costs are too high for 99% of the cases where the unemployed might want to barter their labour, directly or indirectly, for the goods they want to consume.
The right way for me to do this analysis would be to build in those transactions costs explicitly. But that’s too hard. Instead I have taken a shortcut. I am comparing a hypothetical zero transactions costs barter economy to a hypothetical monetary economy where monetary trades have zero transactions costs and barter exchanges have infinite transactions costs.
It’s not that monetary exchange makes things worse. It’s that the transactions costs that cause people to use money make things worse.
fourthtimeanon: OK. I think I follow you there. I am following the implicit assumption that in disequilibrium the “short side rules” (quantity traded is the minimum of quantity demanded and quantity supplied), so when there’s excess demand for bonds, people cannot buy bonds (they cannot lend fruit). When you introduce market makers, I think you are moving away from that assumption.
But if the market makers find they are stuck with borrowed fruit they cannot re-lend, I think they will stop borrowing it. So the ultimate lenders will be unable to lend, and will be forced to trade for current consumption instead.
Nick: My intuition is that all of these problems devolve into some sort of price-stickiness issue. This is equally true in a barter economy as in a monetary economy. The distinguishing issue is that given money and CBing; its often the CB who is ultimately ‘price-sticky’.
Krugman recently wrote:
Krugman presents this an embodiment of an AD problem. I see something very different: who set the interest-rate at 0%? Calling it a demand problem (or a supply problem) gets it wrong. Its a price-stickiness problem. 0% is the wrong price and by fiat it has been pegged as such. The result: the market does not clear.
Hi Nick,
I think you guys have lost track of something in your discussion. Say’s law does not come from nowhere and in the pure barter economy you can get a recession.
In a word without any money demand Say’s law comes from non-satiation, marginal utility declines but never hits zero. Thus, in your apples-bananas exchange economy a recession would go like this:
Start out with apple guy producing 10 apples and using them to buy 10 bananas from the banana producer. Now, suppose that something changes that increases the effort that the banana producer needs to expend to pick the 10th banana, perhaps poor weather reduces the amount of low hanging fruit (a productivity shock).
The banana guy says to himself “forget it, I’ll live with buying 9 apples if I have to and spend more time with my wife”. (The first time this happens he will still get 10 apples but he correctly anticipates that in the future he will have to live with only 9, rational expectations.)
So, the first time this happens they go to market and the apple guy still sells all 10 apples for, now, 9 bananas (otherwise the apple would rot, prices adjust to clear the market).
But now that his output has fallen in value the apple guy no longer wishes to expend the effort to produce the 10th apple, he too only picks the low hanging fruit and spends more leisure time (because he likes leisure as well as bananas).
Result, a recession, GFP (gross fruit product) has fallen, employment has fallen. However, the unemployment is a voluntary response to a productivity shock lowering the marginal product of labour relative to the marginal product of leisure.
The barter economy still has a business cycle but it’s a real business cycle.
correction: second paragraph should begin “In a world without any money demand …”
Another question(s):
In a barter economy, is there a central bank trying to achieve price inflation?
Adam P said: “Now, suppose that something changes that increases the effort that the banana producer needs to expend to pick the 10th banana, perhaps poor weather reduces the amount of low hanging fruit (a productivity shock).”
How about a positive productivity shock and/or cheap labor shock?
If I’m remembering correctly, Nick agreed with me that cheap labor and/or productivity growth produce price deflation. So, how does the central bank increase the “fungible” money supply to produce price inflation in apples?
Once again, the apples story needs to be broken into at least the apple corporation and the apples workers. It would probably be a good idea to add an entity that owns the land the apple corporation uses too.
Jon said: “Krugman presents this an embodiment of an AD problem. I see something very different: who set the interest-rate at 0%? Calling it a demand problem (or a supply problem) gets it wrong. Its a price-stickiness problem. 0% is the wrong price and by fiat it has been pegged as such. The result: the market does not clear.”
I see it as too much AD is coming from debt (loans denominated in currency & future demand). It seems to me that 0% interest rates (or near it) are the wrong price(s) because of too many bank reserves and/or excess savings of the rich.
Are there other markets besides the 0% interest rates that aren’t “clearing” correctly?
Do they even exist?
For Nick, I left this post at:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/09/longterm-unemployment-in-canada-and-the-us.html
“For Stephen & Nick, so you are saying we need more jobs? Is that correct?”
Could you answer that one? Thanks!