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 
Adam P
I like the story, but that’s not really a recession in the usual sense. People are actively preferring/choosing leisure over labour.
Nick,
I didn’t want to get in the way of the discussion, but your response was along the lines of what I was saying. Excellent post and comments.
Take care,
Don
Jon,
Not so recent. The baby sitting co-op is a famous Krugman parable going back more than 10 years. And no doubt very relevant to this discussion.
Both houses, unfortunately, have the pox.
“I like the story, but that’s not really a recession in the usual sense. ”
First of all, that is a recession in the RBC sense, that’s the only recession in the RBC sense. That’s the story Krugman was attacking in his piecce, PK wasn’t going after monetarists.
Secondly though, I was prompted to offer it by Nick’s assetion that there was no recession in the barter economy and that people end up forced to consume the economy’s output. That is true in an endowment world without any production, but if their is any effort expended to pick the fruit then it can break down.
One dimension not mentioned yet for the barter situation is that of aggregate versus individual saving. Aggregate saving cannot occur without the production and exchange of capital goods, since aggregate saving must equal aggregate investment. Individual saving can occur in two ways – exchange for and holding of capital goods, or exchange for and lending of either capital goods or consumer goods.
The banana/apple economy is one in which aggregate saving is not possible, but individuals may still attempt to save. The banana producer cannot save effectively in terms of apples received in exchange for bananas without lending them; otherwise they will rot and his saving will be reduced to zero. And if there is no demand to borrow apples, he will reduce his banana production in response since the last apple he receives in exchange is useless for either consumption or saving. The recession follows.
“that’s the only recession in the RBC sense”
Looks like you described a supply shock rather than a demand shock.
http://delong.typepad.com/sdj/2009/09/in-which-nick-rowe-says-john-cochrane-commits-small-but-important-errors.html
http://economistsview.typepad.com/economistsview/2009/09/whats-wrong-with-macroeconomics.html
Nick: Ok, I’ll bite. Yes, the RE comments disturbed me. As you pointed out in a very nice long-ago post, RE implies that an increase in G can have no stimulative effects only in the (what seems to me anyway) very special case where G is a perfect substitute for C. What bothers me is that the freshwater people who (implicitly) make this assumption to dismiss the possibility that fiscal stimulus will be effective are often the very same people who regard G as pure and absolute waste always and everywhere in other contexts. If we go to the horse’s mouth, Barro, he did research showing that military spending increases interest rates. Well if G affects interest rates in a fully employed economy it will certainly be stimulative in an economy with unemployed resources.
Also, how about public investment, a big component of the US stimulus? Are we supposed to assume that private investment will be cut back by as much as public investment is expanded? (Here, permanent income is unaffected, or perhaps increased, so C will either stay the same or grow). But then why shouldn’t this argument apply within the category of private investment itself, so that a surge in private investment can’t increase demand in an economy with Y below potential , or r in a fully employed economy, because it will lead to an offsetting drop in (other) private investment?
I’m not sure I’m making sense. (-; This is something I know never happens to Cochrane or Krugman!
“Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income.”
How about Paul’s Keynesian economics requires that workers make plans to consume more, invest more, and pay more taxes with the same wage income?
GO,PAUL!
“And hence the most surprising thing in the debate over fiscal stimulus: the raw ignorance that has characterized so many of the freshwater comments. Above all, we’ve seen the phenomenon of well-known economists “rediscovering” Say’s Law and the Treasury view (the view that government cannot affect the overall level of demand), not because they’ve transcended the Keynesian refutation of these views, but because they were unaware that there had ever been such a debate.
It’s a sad story. And the even sadder thing is that it’s very unlikely that anything will change: freshwater macro will get even more insular, and its devotees will wonder why nobody in the real world of policy and action pays any attention to what they say.”
NO MERCY! TO THE MAT!
http://krugman.blogs.nytimes.com/2009/09/14/freshwater-rage/
http://delong.typepad.com/sdj/2009/09/more-musings-on-the-total-intellectual-train-wreck-that-is-todays-chicago-school.html
Jon: yes, you could think of it as a problem due to sticky prices. If prices were perfectly flexible, then we would always have market clearing, and then the problem of whether there could be excess supply of all newly-produced goods would be moot. But this does assume, implicitly, that the AD curve slopes down, and always intersects LRAS at some point, and I wanted to stay out of that question for this post (it was the topic of my “Pre-Darwinian Macro” post).
Adam P.: Good to see you back here!
The equality between marginal disutility of labour and marginal utility of the marginal product of labour (Keynes’ Second Classical Postulate GT p.5) defines full employment (more strictly, unless you incorporate monopoly power, it defines optimal employment). I agree that changes in e.g. productivity or preferences can cause output to fluctuate, but not in the sense of necessarily violating Say’s Law, because there doesn’t need to be an excess supply of output during one of these RBC recessions.
Mine is a Keynesian treatment, because like in the GT, I am looking at cases where the Second and Third Classical postulates fail together (the third is Say’s Law).
Too much Fed: There is no money in a barter economy, and so no central bank. Corporations don’t make any difference in this story: they earn income from sales, pay some out in wages, interest, dividends, rents, spend some on investment, save some in bonds, save some in money, jsy like people. Red herring. “For Stephen & Nick, so you are saying we need more jobs? Is that correct? Could you answer that one? Thanks!” Very crudely, yes.
fourth: yes, the baby-sitting coop is very much apposite in this context.
“And if there is no demand to borrow apples, he will reduce his banana production in response since the last apple he receives in exchange is useless for either consumption or saving. The recession follows.” Why won’t he consume that last apple? He would prefer to save it, but consuming it is presumably better than letting it rot (unless he really is satiated today at 9 apples)?
kevin: you are making perfect sense to me! But I think the paradox cuts both ways. The simplest assumption that justifies right-wing assertions that fiscal stimulus won’t work is that government spending is a perfect substitute for private, and is therefore equally useful; the simplest assumption that justifies left-wing assertions that fiscal policy works is that government spending is useless!! (Actually, more complicated assumptions could make either position logically coherent, I think). On investment, I see your point.
If we think of government as just one of many players, the key question is the cross-partial derivatives between one player’s spending and the present and future marginal utilities/profitabilities of other players’ spendings. For example, we can imagine government spending that raises the future benefits of future private spending, and so has a negative multiplier because it encourages current saving! (I think I got my head round this in one of my old posts on RE, but can’t remember it now.)
Plus, we treat G, but not I, as an exogenous policy variable.
Nick,
With regard to your response to Brad pointing out that this is a huge and extremely consequential mistake, “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.”
I don’t agree at all that that means we have to greatly downplay the seriousness of a mistake. When someone makes a mistake that leads to extremely costly mis-conclusions and mis-prescriptions, it’s very important that you let them and the public know that this is not a small error of little consequence. You have to let them know for the public safety. You can do it nicely, certainly, if that’s best, but misinforming them on the extent of the consequences and seriousness of a major error of understanding is just too harmful to competence and the world economy.
If I could add, you just mislead the public with this kind of thing in a very serious way, making them think maybe these guys are only a little off and we should keep listening to them very seriously when they make these far right conclusions and prescriptions.
“Misinforming”? “Mislead”?
Harsh words. Excessively harsh, even.
“Why won’t he consume that last apple? He would prefer to save it, but consuming it is presumably better than letting it rot (unless he really is satiated today at 9 apples)?”
That question seems to be central to your argument, and may be the important one. Yes, I think satiation is the answer. After all, saving is defined primarily by forgoing consumption.
Suppose my preference in a monetary economy was to allocate my income to 9 apples of consumption and the equivalent of 1 apple in monetary saving. The equivalent allocation in a barter economy is 9 apples of consumption and lending 1 apple. I must attempt to lend 1 apple because that is the only channel for saving if my only choice in barter exchange is to receive apples (which are non-capital items) in exchange for my banana output.
In either the monetary economy or the barter economy, my desire to save may set off a recessionary dynamic in the usual way – i.e. if too many others have the same idea.
But if my desire to save in a barter economy is further frustrated by a lack of a market for saving (i.e. a lack of a lending market), then the next logical step is to cut back my income deliberately to the level that would have corresponded to my desire to save. I won’t be saving, but I also won’t be generating useless income by getting paid with a 10th apple that I can’t use. So a recession follows in that way as well.
“Too much Fed: There is no money in a barter economy, and so no central bank. Corporations don’t make any difference in this story: they earn income from sales, pay some out in wages, interest, dividends, rents, spend some on investment, save some in bonds, save some in money, jsy like people. Red herring.”
In a barter economy, I think it would depend on whether entities found some “good” that would hold its value.
In a barter economy, I would think that imbalances could occur with excess profits for corporations, but they may not last as long as when debt (loans denominated in currency) is involved.
“‘For Stephen & Nick, so you are saying we need more jobs? Is that correct? Could you answer that one? Thanks!’ Very crudely, yes.”
OK. That is yes twice (Stephen & Nick).
I think there is a fallacy there. Do we need more jobs OR FEWER WORKERS???
Nick you remark: “But this does assume, implicitly, that the AD curve slopes down, and always intersects LRAS at some point”
I don’t find this line of reasoning practically meaningful. If AD/AS don’t intersect where are the gains from trade? Implicitly they do not exist. Its a rather consistent state of affairs. I would challenge you that whatever that non-intersecting situation is, it is outside the domain of present debate.
As I mentioned about your banana story, your assumptions are logically incoherent. Therefore you go through a long proof and demonstrate 1+1=3. No. This cannot be the way.
Nick: re: “the paradox cuts both ways” – yes, and I didn’t see this. This is what I like about your blog: I always learn something.
Barter economies vs Money economies.
Both are time/space economies, and as such, past and future production are part exchange, as much as present production is.
So, potential production is a transactional object, and implicitly or explicitly part of negotiations for income and expenditures.
Expectations are based on potential production and consumption.
All monetary processes are on barter economies too.
It took me a while to calm down and figure out how to respond to this.
Cochrane says that the US should not do anything about current high unemployment rates? And you agree with him?
I didn’t mean to be harsh to Nick. He seems like a great guy, but I think it’s important to point out that you shouldn’t say a very consequential error is small to try to put things more nicely, not in a case where those making the error can misinform so many, and do so much harm. It is possible to tell them, and the public, that the error isn’t small, it’s very consequential, and still be nice and understanding in how you word that.