Consumption smoothing and the balanced budget multiplier

Only for economists

                In some of the debate following this post, and then this, there often seems to be a big distinction drawn between models based on consumption smoothing, and the old fashioned balanced budget Keynesian multiplier. Even Paul Krugman felt it necessary to say that he ‘never said a word about the balanced budget multiplier’. Now of course the models are different. However I want to suggest that in the context of fiscal expansion in a recession caused by demand deficiency, the balanced budget multiplier story can be retold in a manner consistent with consumption smoothing.

                The most basic model of consumption smoothing involves two periods. Let period 1 be a demand deficient recession, and so output is determined in a Keynesian manner by aggregate demand. Period 2, which is much longer, is Classical, and nothing changes in period 2. (If having a two period model of unequal lengths is a worry, think of period 2 as being divided into a large number of sub-periods of equal length to period 1, but where every sub-period is Classical.) We keep monetary policy neutral by assuming the real interest rate is constant. Optimising consumers will then spend a fixed proportion of their permanent income in period 1: that is consumption smoothing. Let’s call this proportion c, which could be quite small. There is no investment, and the economy is closed.

                The government now increases government spending by G in period 1 only, and taxes rise by the same amount in period 1. The ‘direct’ or ‘first round’ effect is that consumption in period 1 falls by less than G, because the impact of higher taxes on consumption is smoothed via permanent income. That is as far as I needed to go in my ‘Mistakes’ post to make the point I wanted to make. However it is obviously not the end of the story, because higher output implies higher income. What happens to output eventually (call the answer Y)? Well consumption rises/falls by Y-G times the fixed proportion c, so we solve Y=G+c(Y-G), which of course implies Y=G, a multiplier of one. This is not only the same result as given by the Keynesian balanced budget multiplier, but the mechanics are identical. Consumption does not change at all: higher period 1 income offsets the higher taxes. We do not need to worry about any knock on effects in period 2, because permanent income ends up unchanged. So the simple Keynesian balanced budget multiplier need not be considered some ancient fossil that we are forced to teach undergraduate students, but a simple expression of what consumption smoothing implies in a particular context.

                We could get to the same result using consumption smoothing alone, by noting that consumption in period two is tied down by (classical) Y and permanent G. Second period consumption and the Euler equation then fixes period 1 consumption, as real interest rates are unchanged by assumption. So any change in government spending in period 1 leads to an equal increase in output.

Woodford, in section 2 of the paper noted by Krugman and myself, does something with similarities to this, but with more elegance. My period 2 becomes the steady state, a steady state in which (given the usual assumptions) the real interest rate equals the rate of time preference. With real interest rates fixed at this value in all periods, consumption is equal in all periods, so any temporary change in government spending leads to an equal temporary change in output. We get a multiplier of one. With this benchmark, it is then intuitive to see how the multiplier will fall if real interest rates are not constant but rise. Equally, if we are at a zero lower bound, the multiplier will be greater than one because higher output generates inflation, which reduces real rates.

Now I am not trying to say here that the simple, most basic Keynesian multiplier apparatus is in any sense ‘as good as’ consumption smoothing. In fact, if I was writing an introductory macro textbook, I would start with the two period consumption model and consumption smoothing, and mention the current income Keynesian consumption function only in passing. (My reasons for doing this are explained here.) All I want to suggest is one way of reinterpreting the balanced budget multiplier that is consistent with consumption smoothing. I think it is also nice that all this stuff ends up with the same result, a multiplier of one. If someone wants to argue that the multiplier is zero they need some additional argument, and as I suggested here, I have yet to see one that seems appropriate to the current situation.

UK Deja Vu?

Jonathan Portes has a nice chart comparing this recession to previous downturns in the UK. The most eye catching implication is the similarity between this recession and the 1930s. Although it appeared as if we were recovering more quickly, thanks to the rapid reduction in interest rates and fiscal stimulus immediately following the recession, additional austerity brought in by the new coalition government has coincided with a much slower recovery. Whether this is causal we cannot be sure, but in my view it would be very surprising if the additional austerity was not at least partly to blame.

I want to focus on a different comparison, between now and the recession of the early 1980s. These recessions were both severe, but their immediate causes were quite different. The recession that started in 1980 was the consequence of a very tight monetary policy designed to reduce inflation. RPI inflation averaged 18% in 1980, but came down to 5% by 1983. GDP fell by over 2% in 1980, and very slightly in 1981, but an unusual feature of the recession was that it was concentrated in the traded sector: manufacturing output fell by 15% over those two years. One possible explanation is ‘Dornbusch overshooting’: using monetary policy to reduce inflation in an open economy leads to a temporary loss in competitiveness that hits the traded sector.

The similarity with today lies in fiscal policy. In the 1981 budget, income tax allowances were not raised, despite rapid inflation. To put the same point using a bit of jargon, in 1981 the ‘automatic stabilisers’ provided by fiscal policy were switched off. Despite high and rising levels of unemployment, fiscal policy was tightened, as it was in 2010.

At the time I was working as a relatively junior economist in the UK Treasury, in charge of using the Treasury’s macroeconomic model to assess the economic impact of the budget. This sounds very important, but in practice it was not, because those in charge of policy did not believe the analysis that the model produced. Traditionally after every budget, the chief economic advisor, who was then Sir Terry Burns, presided over a discussion of all Treasury economists about the issues raised. Sir Terry began by presenting his analysis of why fiscal policy had to be tightened: the large budget deficit was in danger of making it difficult to hit (broad) money supply targets. When he finished, there was silence in the room. Given my role at the time, I felt I could not let this pass. I delivered a little speech suggesting the budget was totally inappropriate. It is what happened next that was noteworthy. It was like opening the floodgates: suddenly everyone wanted to speak, and with few exceptions the verdicts were equally damning. Sir Terry looked increasingly uncomfortable.

This pattern was mirrored in public through the publication of a famous letter to the Times signed by 364 academics. We are more used to such things today, but in 1981 this was a very unusual event, and to get so many distinguished academics (mostly economists) to express such a strongly critical view of government policy was a big deal. The 364 included Amartya Sen and the current governor of the Bank of England, Mervyn King. To look at the exact text of the letter is a bit of a distraction, as it included many statements which look decidedly odd today, and which I am sure many of the signatories at the time did not fully agree with. They signed it because they thought the policy was wrong.

I think it is therefore reasonable to use this letter as a proxy for the 1981 budget itself. In 2006 a number of journalists and commentators marked the 25^th anniversary of the letter. Here I want to quote from the end of a piece written by Stephanie Flanders, because I think she is a reliable guide to what the verdict at that time was on the 364.

And the letter itself? Well, unfairly or not, the letter became something of a joke on the economics profession, as Lord Howe [Chancellor at the time] confirmed. "I've actually produced a definition of economists as a result: that an economist is a man who knows 364 ways of making love, but doesn't know any women."

Was it right, given hindsight, to switch off the automatic stabilisers in 1981? In very simplistic terms you can argue both ways. Growth did pick up after 1981. Inflation came down rapidly, perhaps more rapidly than was intended. Unemployment stayed very high for the rest of the decade, clearly suggesting that the deflationary shock in 1980/1 was so sharp that it generated hysteresis, raising the natural rate for some time. This is the point emphasised by Steve Nickell, who probably has done more work on the UK unemployment/inflation trade-off over this period than anyone else. However in one crucial respect 1981 was not like 2010, in that monetary policy was still operating freely. If switching off the automatic stabilisers in 1981 had allowed an easing of monetary policy, and given how uneven the impact of monetary policy had been, then perhaps it made sense. However the conventional view today is that monetary policy should do all the work if it can, and that fiscal policy should just allow the automatic stabilisers to operate.

                So it seems to me that the question of whether the 1981 budget, or the 364 economists’ protest, was right or wrong remains an interesting question. However the point I want to make here is that the view on the political right is quite clear. This piece by Phillip Booth in the Daily Telegraph from 2006, based on editing a collection of essays on the issue published by the Institute of Economic Affairs, is headlined ‘How 364 economists got it totally wrong’.

                So my speculative question is this. Was this verdict on the 1981 budget influential (explicitly or implicitly) when the Conservative party in opposition decided that more austerity was needed? (I have focused elsewhere on the role of Greek default in changing the policy consensus worldwide, but the Conservative Party opposed Gordon Brown’s countercyclical policy from the start of the recession.) Did the verdict on the 364 embolden the view that it was OK, and possibly even desirable, to go against conventional (in the UK at least) academic opinion? If this verdict on history was important in influencing policy in 2010, was it appreciated that being at the zero lower bound today made the two periods crucially different? 

Savings Equals Investment?

This post is for first year undergraduate students (and the occasional blogger) who appear confused.

Q: If consumers spend less and save more, does this mean investment must increase?

A: Absolutely not. Someone increasing their saving does not automatically imply that some firm will decide to buy more capital goods.

Q: But surely savings equals investment by identity in the national accounts.

A: Indeed. Total output = total income = total expenditure = Y. In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition. But here investment includes what is called ‘stockbuilding’ or ‘inventory accumulation’, which includes goods that firms wanted to sell but could not. To make this clear, lets split measured investment (I) into these two components: I=DK (buying new capital goods) +DS (stockbuilding). So if people consume less (C falls), but investment in new capital (DK) stays the same, measured investment rises because firms accumulate inventories of the goods that consumers did not buy (DS rises).

Q: But this situation cannot continue, as firms may be losing money.

A: Exactly. They will cut back on their output, incomes will fall, consumption may fall further, and savings will also fall, cutting back on the initial increase that we started with.

Q: When will this process stop?

A: When firms stop accumulating inventories i.e. when DS=0. Then, and only then, will S=DK.

Q: But how can this be? We have assumed that DK stayed the same, and we started with an increase in S?

A: You have not been paying attention. Each time firms reduce their output to match lower demand, incomes and savings fall. Eventually the initial rise in savings is reversed, because overall income has fallen.

Q: Got it. But textbooks make a big thing about aggregate savings equalling investment. If it is just an accounting identity, why is it important?

A: What the textbooks really mean is that we eventually end up with a position in which S=DK. And that is important, for the reasons we have just discussed. It is called the paradox of thrift. A desire by consumers to increase savings ends up just reducing output, and savings do not increase at all. (Of course they are still saving more of their income: S/Y has gone up, but because Y has fallen, not because S has increased.)

Q: But I thought with all this ‘just in time’ production stuff, firms did not hold many inventories any more.

A: Well we could short circuit the story by forgetting about inventories and having firms accurately forecast what demand will be, and therefore what their output should be. In practice what we call involuntary inventory accumulation can still be important when looking at quarterly movements in national output.

Q: But is it realistic to assume investment – I mean DK – stays the same if savings are initially higher? If there are more savings around, it becomes cheaper to borrow, which will encourage investment, right?

A:  It might, but it might not. In particular, if output is falling, firms may be reluctant to add to their capital stock.

Q: But won’t interest rates keep falling until they do? After all, the asset market has to clear.

A: Savers have an alternative, which is to just keep their savings as money.

Q: But they will put the money in a bank, and the bank will lend it.

A: Maybe, but the bank may just decide to hold on to the cash.

Q: It seems to be really important what people do with their additional savings.

A: Perhaps. But I think the key point is that, most of the time, the person doing the saving is different from, and has different motives to, the person doing any investing. A highly complex financial system links the two. And in that system, there will be lots of opportunities for the additional savings to be parked as money.

Q: Money seems very important here. It is why the extra saving does not have to find its way into more investment.

A: I think that’s right.

Q: If people hold the extra savings as money, will that not increase money demand. What happens if the central bank keeps the money supply fixed?

A: People hold money not just as a way of saving, but also to buy and sell things. And if less is being consumed, there is less need for money on this account. It is difficult to predict what will happen to the total demand for money, which is why central banks nowadays focus on determining short term interest rates rather than the money supply.

Q: That’s not what it says in my textbook. It says the central bank fixes the money supply.

A: Yes I know. I’m afraid it’s a bit out of date. Don’t ask me why.

Q: So if the central bank determines the interest rate, why don’t they ensure the interest rate is low enough to encourage firms to buy more capital goods?

A: That is what they would like to do. There are two problems. First, it may take some time for the monetary authorities to work out what is happening, and what the right interest rate is. (I could talk about real and nominal rates here, but let’s leave that for another day.) Second, nominal interest rates cannot go below zero, and maybe we would need negative interest rates to persuade firms to raise investment enough.

Q: My textbook also says that the classical model assumes interest rates adjust so S=I, by which I assume they mean S=DK. Does that mean the classical model is wrong?

A: Only if you think it applies at all times, and that there is no other reason why output cannot fall. However if we assume that the monetary authorities eventually are able to chose the right interest rate, then the classical model is fine when thinking about economies over a long enough time horizon.

Q: This all seems like common sense. I feel a bit stupid not to have understood this before.

A: Don’t worry, you are not alone.

Downgrading France

One of the problems with the rating agencies’ assessments of the debt of major country governments is that they are too newsworthy. As a result, they appear to be much more important than they actually are. Jonathan Portes, before he started his own blog, had a healthily unbalanced assessment of their competence here.

                Having said this, Stephanie Flanders (and subsequently Paul Krugman) is absolutely right to focus on something interesting in S&P’s justification for removing AAA from France and downgrading other Eurozone economies. To quote from S&P:

We also believe that the [9^th Dec] agreement is predicated on only a partial recognition

of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU's core and the so-called "periphery". As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

It is good that the competitiveness issue that I discussed here is now considered as serious a problem as any fiscal profligacy. It is also good that the possibility that fiscal austerity could go too far is being raised. Until recently, the general view seemed to be: the more austerity the better.  

                However, there is a danger of inconsistency in all this. Let us focus on the competitiveness issue. To correct this problem, we need inflation in uncompetitive Eurozone countries to be below German inflation. To achieve this, we almost certainly need a period in which domestic demand in those countries is weak relative to Germany. That has already happened to a considerable extent. The key question, which I raised here, is whether what has been done already is enough, or whether the gap – in simplistic terms – between non-German and German unemployment needs to be greater still. If inflation forecasts are to be believed, competitiveness correction appears to be painfully slow, reflecting perhaps the difficulty in reducing inflation outside Germany when it is already very low.

                Of course it would be great if governments outside Germany could take measures that helped competitiveness without harming growth, but the group of such measures may be an empty set. It probably is the case that some measures may have more of an immediate impact on costs than others, and so if policy could focus more on the competitiveness problem that might help. But the real issue here is Germany.

                It is the outlook for Germany that makes everything so difficult. The OECD’s forecast is that German output will be below the level that will stabilise inflation over the next two years. This keeps German inflation low, making it that much harder for other countries to regain competitiveness. The Euro area desperately needs a much more rapid expansion in Germany, so that German inflation rises well above 2%. If the forecasts that this will not happen are correct, there is one policy instrument that is available that could turn this around, and that is fiscal expansion in Germany. (Yes, some more from the ECB would help too, but it is the relative position of Germany within the Eurozone that is key.) What S&P and others should be saying is: we need a large, quick but temporary increase in public spending in Germany to save the Euro.

Ideology and Demand Denial

Thanks to Chris Dillow and then others, my post Mistakes and Ideology in Macroeconomics was widely read and commented on. As Chris pointed out, it is possible to think in terms of mechanisms or complete models. My post was about one mechanism, consumption smoothing, which the texts I was looking at appeared to ignore. Many responses were along the lines of ‘what the authors of these texts had in mind is a model of this type, and in this type of model fiscal policy will be ineffective’. I’m happy to pursue this, not because I would be presumptuous enough to imagine I know what the authors ‘really meant’, but because I think it strengthens the idea that antagonism towards fiscal policy in the current situation has ideological roots rather than a sound basis in macroeconomic theory.

The most widely suggested model is one where there is never any demand problem: we are always at ‘full employment’. Then, of course, increasing one component of demand will have no direct effect on output, and higher taxes will have some negative impact on supply. Expansionary fiscal policy would be quite inappropriate in these circumstances.

If that is the argument, then I would insist on asking just how it is that the economy is always at full employment. The standard response, which is that prices are flexible, is not enough when we hit a zero lower bound for interest rates. As a suggested in another post, the ‘self correction mechanism’ by which demand shocks never impact on output requires a combination of price flexibility and monetary policy. (Actually, price flexibility is not even necessary – if the monetary authorities effectively targeted the output gap, for example.) This mechanism fails when we hit a zero lower bound.

Now an argument that said that the current recession was the result of a large negative supply shock rather than a demand shock, and we hit the zero lower bound because central banks misunderstood this fact, makes perfect sense in theory – it is just a little difficult to square with the facts, as many have pointed out. But this is a contingent argument. What the debate over fiscal policy has revealed is an underlying generic antagonism towards Keynesian analysis.

There is an asymmetry here. Keynesian economists do not deny that productivity or other supply side shocks can often be important. On the other side there appears to be, among many at least, a belief that Keynesian economics is never relevant. What this amounts to is what Krugman and others call demand denial. Yet the basis in economic theory for demand denial appears very unclear. Say’s Law, or maybe some kind of quantity theory with fixed velocity, would do it – but these were really bad ideas that the profession dismissed many decades ago.

Demand denial seems both surprising (an individual firm facing a fall in demand will reduce output), and hardly something to feel passionate about. So demand denial genuinely puzzles me. Keynes had a number of thoughts on this, as the following from the General Theory shows (‘it’ in the first sentence is a theory that involves demand denial).

That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

Now beautiful though this passage is, a good deal has changed since 1936. New Keynesian theory is a ‘consistent logical superstructure’, so there is no intellectual prestige involved in denying its relevance (except, perhaps, to fellow believers). Yet two sentences still ring true. The first is the idea that austerity is virtuous. Some of the popular discourse around fiscal policy has moral overtones, perhaps stemming from the idea that governments, like individuals, have to practice self control. Now while I think seeing economics as a morality play is generally unhelpful, in the case of fiscal policy there is a problem of deficit bias: governments over the last few decades have tended, on average, to spend too much or tax too little. (Some particular evidence, and a fairly comprehensive discussion of reasons for deficit bias, can be found here. For lots of data, go here, click on ‘subject: Real GDP Growth’ and select the historical debt database.) However deficit bias is a long term problem and a recession is not the time to start dealing with it. 

The final sentence from Keynes also still rings true.  One explanation for demand denial is that it has ideological roots. In the real world we have the problem of ensuring aggregate demand matches supply, and this requires state intervention – normally monetary policy.  For those who want to argue that state intervention in the economy is generally a bad thing, it is embarrassing to acknowledge that there is one area where it is essential. But I get no joy in seeing ideology mess with economics, and so I would be more than happy to be convinced that there was another explanation for demand denial.  

Correcting Eurozone Imbalances

I have been thinking about the extent to which real exchange rate misalignment within the Eurozone (essentially most countries have lost competitiveness with Germany) requires austerity outside Germany. I have argued that a much tighter fiscal policy (austerity) outside Germany would have been a good idea before 2007 to prevent these imbalances occurring in the first place. However that does not necessarily imply it is required now, for two reasons. First, misalignment is eventually self-correcting, as less competitive countries sell less goods etc. Second, perceived debt risk which is driving up long term interest rates provides an additional deflationary force in many of these uncompetitive countries.

                This question is essentially a forecasting issue, so I looked at the OECD Economic Outlook forecasts. The table below comes from there. It contains a bit of a puzzle. If you look at unemployment rates, you see just the kind of pattern you would expect if correction was underway (except perhaps for Italy). German unemployment is way below the Eurozone average,  and the German average level in the decade before the recession, whereas the opposite is true for Ireland and Spain. The OECD’s calculation of the output gap tells the same relative story: everyone is below the non-inflationary level of output, but Germany by not that much, and Ireland and Spain by much more.

                If we look at inflation, however, we get a much more depressing story. Take the GDP deflator (the price of domestically produced output) for example. Inflation in Ireland is less than 1% below Germany, and that is the most favourable comparison. The signs of real exchange rate correction are weak.  

                There are two possibilities here. One possibility is that these inflation forecasts are way too conservative. In particular, low unemployment in Germany will lead to more rapid inflation than is forecast here. The alternative story is that the inflation forecasts are broadly correct, and they illustrate both the difficulty in getting inflation down outside Germany when it is so close to zero, and the difficulty in getting inflation up in Germany when its economy remains depressed. In particular, if the output gap number is right, then it is hard to see German inflation rising much above 2%. 

	Unemployment (%)				Output Gap	Ave Forecast Inflation % 2011-13
	1998-2007	2011	2012	2013	2011-13	Compensation	GDP	Consumer prices
Eurozone	8.6	10.1	10.4	10.1	-3.2%	2.1	1.3	1.8
Germany	8.8	5.7	5.7	5.4	-1.2%	2.4	1.1	1.8
Ireland	4.8	14.2	14.0	13.4	-7.1%	1.7	0.4	0.9
Spain	10.6	22.5	23.0	22.4	-5.7%	1.9	0.8	1.8
Italy	8.7	8.1	8.4	8.7	-2.3%	2.1	1.4	1.8
France	8.8	9.4	9.9	9.8	-4.2%	2.6	1.3	1.5

Mistakes and Ideology in Macroeconomics

Imagine a Nobel Prize winner in physics, who in public debate makes elementary errors that would embarrass a good undergraduate. Now imagine other academic colleagues, from one of the best faculties in the world, making the same errors. It could not happen. However that is exactly what has happened in macro over the last few years.

                Where is my evidence for such an outlandish claim? Well here is Nobel prize winner Robert Lucas

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash.  It has no first-starter effect.  There's no reason to expect any stimulation.  And, in some sense, there's nothing to apply a multiplier to.  (Laughs.)  You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. 

And here  is John Cochrane, also a professor at Chicago, and someone who has made important academic contributions to macroeconomic thinking.

Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work.  Spending supported by taxes pretty obviously won’t work:  If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off.

Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

                But surely very clever people cannot make simple errors of this kind? Perhaps there is some way to re-interpret such statements so that they make sense. They would make sense, for example, if the extra government spending was permanent. The only trouble is that both statements were made about a temporary fiscal stimulus package. Brad DeLong tries very hard along these lines (see here for example), but just throws up inconsistencies.

                I prefer to just note that if any undergraduate or graduate student in the UK wrote this in an exam, they would lose marks. The more interesting question for me is why the errors were made. Of course everyone is human, including the best economists. (And if they were not among the very best economists, I would not be talking about these errors in a blog.) You get to be a brilliant economist or physicist by having great ideas, not by never making mistakes. But I think it is still the case that we cannot imagine members of a physics department making such errors. What is different about macro?

I want to suggest two answers. The first is familiarity with models. I cannot imagine anyone who teaches New Keynesian economics, or who talked to people who teach New Keynesian economics, making this mistake. This is because, in these models, we do have to worry about aggregate demand. We focus on consumption smoothing, and Ricardian Equivalence, and teach it from the start. I often tell my first year undergraduate students that if they write anything like ‘Ricardian Equivalence says fiscal stimulus will never work’, they are in danger of failing.

Lack of familiarity does not necessarily imply believing something is wrong. In a separate piece, Cochrane writes 

“New-Keynesian” thought is devoted to defending the importance of monetary policy, and incorporating specific frictions in the equilibrium tradition, not to rescuing the ancient view that fiscal stimulus is important and abandoning that tradition.  

This is broadly true for New Keynesian theory when monetary policy is unconstrained (see Kirsanova, T, Leith, C and Wren-Lewis, S (2009), Monetary and Fiscal Policy Interaction: The current consensus assignment in the light of recent developments, Economic Journal, Vol 119) but not when interest rates are stuck at a lower bound. Cochrane is not saying New-Keynesian theory is wrong, but implies incorrectly that it suggests fiscal stimulus will not work.

                Lack of familiarity with New Keynesian economics may be partly explained by the history of macroeconomic thought that I briefly noted in an earlier post. As New Keynesian theory is an ‘add-on’ to the basic Ramsey/RBC model, it is possible to teach macro without getting round to teaching New Keynesian theory. However, what many people find difficult to understand is how monetary policy (or at least monetary policy as seen by pretty much every central bank) could be regarded as an optional add-on in macroeconomics.

                The second difference between physics and macro that could lead to more mistakes in the latter is ideology. When you are arguing out of ideological conviction, there is a danger that rhetoric will trump rigour. In the next paragraph Cochrane writes

These ideas changed because Keynesian economics was a failure in practice, and not just in theory. Keynes left Britain 30 years of miserable growth. Richard Nixon said, “We are all Keynesians now,” just as Keynesian policy led to the inflation and economic dislocation of the 1970s--unexpected by Keynesians but dramatically foretold by Milton Friedman’s 1968 AEA address. Keynes disdained investment, where we now all realize that saving and investment are vital to long-run growth. Keynes did not think at all about the incentives effects of taxes. He favored planning, and wrote before Hayek reminded us how modern economies cannot function without price signals.   Fiscal stimulus advocates are hanging on to a last little timber from a sunken boat of ideas, ideas that everyone including they abandoned, and from hard experience.  If we forget all that, we could repeat the economics of postwar Britain, of spend-and-inflate Latin America, and of bureaucratic, planned India.

Let’s not worry about where the idea that Keynes disdained investment comes from, or any of the other questionable statements here. This is just polemic: Keynes=fiscal expansion=planning=macroeconomic failure.  It is guilt by association. What on earth does fiscal expansion have to do with planning? Well, they are both undertaken by the state.

I have argued elsewhere that the problem too many macroeconomists have with fiscal stimulus lies not in opposing schools of thought, or the validity of particular theories, or the size of particular parameters, but instead with the fact that it represents intervention by the state designed to improve the working of the market economy. They have an ideological problem with countercyclical fiscal policy. But the central bank is part of the state, and it intervenes to improve how the economy works, so this ideological view would also mean that you played down the role of monetary policy in macroeconomics. So ideology may also help explain a lack of familiarity with the models central banks use to think about monetary policy. In short, an ideological view that distorts economic thinking can lead to mistakes.