You may remember John Cochrane from the PBS documentary we watched. Cochrane also has a blog where he frequently rails against stimulus. One of his posts, Fiscal Stimulus, RIP summarizes his arguments against the idea of a fiscal multiplier.
Reading through Cochrane's post helped me understand why classicists believe the things they do. The crux of Cochrane's argument rests on the theory of Ricardian Equivalence:
"But here’s the catch: to borrow today, the government must raise taxes tomorrow to repay that debt. If we borrow $1 from A, but tell him his taxes will be $1 higher (with interest) tomorrow, he reduces spending exactly as if we had taxed him today! If we tell both A and B that C (“the rich”) will pay the taxes, C will spend $1 less today."Deficit spending today leads to fear of taxes tomorrow that reduces spending today, muting any stimulative effect. Obviously, Ricardian Equivalence makes some bold assumptions about the ability of consumers to anticipate and save for future taxes, but Cochrane insists that Keynesian advocates should have to explain why they think the assumptions are wrong and adjust their theory accordingly.
"Well, maybe some other Barro assumption is wrong. Yes, there are many. (“Liquidity constraints” are a common complaint, keeping people from acting based on their estimation of the future.) But if you take any of them seriously, the case for stimulus becomes similarly circumscribed. Each specifies a channel, a “friction,” something fundamentally wrong with the economy that matters some times more or less than others, that restricts what kinds of stimulus will work, and that can be independently checked. And in many cases, these “frictions” that falsify Barro’s theorem suggest much better direct remedies, rather than exploitation by fiscal stimulus."Cochrane also makes a very good point when he mentions that because economists can't do controlled experiments, it's risky to rely on "empirical evidence" over theory.
"I am also dubious about empirical work in the absence of theory. If you don’t know how stimulus can work, can you productively look for it? Is this like empirical work on the existence of UFOs? Seriously, the violations of Barro’s theorem that might make stimulus work at one time or place are surely different than those which make it work in another time or place. Surely empirical evaluation must tie to measurement of which of Barro’s assumptions one feels does not hold."Cochrane insists that without theory to guide us, empirical evidence will be quite useless, something that runs counter to Quiggin's argument in "Zombie Economics".
What do you think of Cochrane's arguments? Do they change how you think of the Classical vs. Keynesian debate?
Update: I fixed my links!
I enjoyed Cochrane's blog. In my mind, he makes some good arguments. Most notably: First, "cause and effect are hard to tease out in economics, because so much else is going on"; thus, we cannot assume there is one answer--stimulus--to fix an economy. Second, "there is a deeper problem with stimulus. Even if nobody notices future taxes, A was going to do something with the money. Suppose, for example, A was a small business owner, and he was going to buy a forklift. The government borrows the money instead, and gives it to B who buys a car. Now the composition of spending has changed towards more 'consumption.'" Third, that there is good reason to question the multiplier argument.
ReplyDeleteThe blog is very interesting and his perspective cannot be ignored at all. There is not a just a single factor which brings about changes in the economy. One of those factor is time. In analyzing an theories time should be carefully considered. Cochrane points out Keynesian theory was build considering a limited amount of time. I agree this is a flaw but I don't know any other single theory which fully explains the economics. Therefore, the article didn't really change my view of Keynesian economics, however it introduced me to some new flaws within the model and analyze it from different perspective.
ReplyDeleteWhen it comes to stimulus, the change in the economy depends on how the consumers react to the stimulus. Every single assumption can lead to a different result, the crucial point is to know which assumption fits well at the given time and situation. When it satisfies the assumption made in the Keynesian model, the stimulus would work exactly in the same way how the model predicts. However, as I said earlier there can be numerous assumption before predicting how stimulus work, so the success of Keynesian model is based on the chance that it will match the assumtions.