Critique of Krugman: Cochrane shines again

Cochrane starts off with the analogy of what the significance of Krugman's statements would be if he were in the hard sciences.

Imagine this weren't economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong.  Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses.  If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents don't move after all.

Cochrane argues effectively against Krugman's string of logic that markets are inefficient, which leads to booms and busts, which justifies government intervention.

[The efficient markets hypothesis] is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.

...It's the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what "fundamental" value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked.

More deeply, the economist's job is not to "explain" market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? "A wave of positive sentiment." Markets went down? "Irrational pessimism." ( "The risk premium must have increased" is just as empty.) Our ancestors could do that.  Really, is that an improvement on "Zeus had a fight with Apollo?" Good serious behavioral economists know this, and they are circumspect in their explanatory claims so far.

Cochrane then rebuts Krugman's recommendation that government institutions are the answer to these "so called" market inefficiencies.

...Krugman at bottom is arguing that the government should massively intervene in financial markets, and take charge of the allocation of capital.  He can't quite come out and say this, but he does say "Keynes considered it a very bad idea to let such markets...dictate important business decisions," and "finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a `casino.'" Well, if markets can't be trusted to allocate capital, we don't have to connect too many dots to imagine who Paul has in mind.
 
To reach this conclusion, you need evidence, experience, or any realistic hope that the alternative will be better. Remember, the SEC couldn't even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market.  Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment?  As David Wessel's excellent  In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts.

In his New York Times piece, Krugman criticizes modern macroeconomics for "mistaking beauty for truth." In other words, Krugman is arguing that modern macroeconomics has embraced elegant theory at the expense of practical explanatory power. Chari, Kehoe, and McGrattan have effectively argued against this premise, and Cochrane takes the same vein.

...[Krugman is] not clear on what the "beauty" is that we all fell in love with, and why one should shun it, for good reason.  The first siren of beauty is simple logical consistency. Paul's Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again.  It presumes that people don't think about the future in making decisions today. Logical consistency and plausible foundations are indeed "beautiful" but to me they are also basic preconditions for "truth."

With regard to questions about how big are the effects of government spending on output (fiscal multipliers) and the Ricardian equivalence theorem that says they are zero, Cochrane gives the following measuring stick.

...Is this theorem true? It's a logical connection from a set of "if" to a set of "therefore." Not even Paul can object to the connection.

Therefore, we have to examine the "ifs." And those ifs are, as usual, obviously not true. For example, the theorem presumes lump-sum taxes, not proportional income taxes. Alas, when you take this into account we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can affect the overall level.

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.  Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today's consumption and so on. And when you find "market failures" that might justify a multiplier, optimal-policy analysis suggests fixing the market failures, not their exploitation by fiscal  multiplier.  Most "New Keynesian" analyses that add frictions don't produce big multipliers.

This is how real thinking about stimulus actually proceeds. Nobody ever "asserted that an increase in government spending cannot, under any circumstances, increase employment." This is unsupportable by any serious review of professional writings, and Krugman knows it. (My own are perfectly clear on lots of possibilities for an answer that is not zero.) But thinking through this sort of thing and explaining it is much harder than just tarring your enemies with out-of-context quotes, ethical innuendo, or silly cartoons.

The climax of Cochrane's response to Krugman's justification for government spending is in the final paragraphs of the section in which he proposes that the Krugman/Keynesian ideology implies that Bernie Madoff should be a hero and government spending is most effective when it is stolen.

In fact, I propose that Krugman himself doesn't really believe the Keynesian logic for that stimulus. I doubt he would follow that logic to its inevitable conclusions. Stimulus must have some other attraction to him.
 
If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it.  Each dollar so transferred, in Krugman's world, generates an additional dollar and a half of national income.  The analogy is even closer. Madoff didn't just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.
 
If you believe the Keynesian argument for stimulus, you don't care how the money is spent. All this puffery about "infrastructure," monitoring, wise investment, jobs "created" and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.
 
If you believe in Keynesian stimulus, you don't even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.

With regard to Krugman's criticism that macroeconomics failed because it has no coherent theory for the crash, Cochrane turns the same accusation back on Krugman.

Krugman's article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.

Krugman argued that macroeconomics must proceed in three directions. The first direction, that macroeconomic models must incorporate more market imperfections, ignores the direction that macroeconomics has taken since at least the late 1980s.

..."Hello, Paul, where have you been for the last 30 years?" Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott's 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk,  and comparing the resulting models, quantitatively, to data.  The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same.

The second Krugman proposal is that Keynesian economics is the best suited for understanding recessions and depressions.

...One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book. As Paul bemoans, the "new Keynesians" who did just what he asks, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism. (Actually, though this is the consensus, my own work finds that new-Keynesian economics ended up with something much different and more radical than monetarism.) A science that moves forward almost never ends up back where it started. Einstein revises Newton, but does not send you back to Aristotle.  At best you can play the fun game of hunting for inspirational quotes, but that doesn't mean that you could have known the same thing by just reading Keynes once more.

Krugman's last proposal, that the future of macroeconomics should be less math intensive, is the most strange, given that Krugman's work on international trade, for which he won the Nobel Prize, involved very sophisticated mathematical structures.

Again, what is the alternative? Does Krugman really think we can make progress on his--and my--agenda for economic and financial research,understanding frictions, imperfect markets, complex human behavior, institutional rigidities by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read Moneyball) is there any real hope that this will work in economics?
 
No, the problem is that we don't have enough math. Math in economics serves to keep the logic straight, to make sure that the "then" really does follow the "if," which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.

Cochrane's next point emphasizes a characteristic of Paul Krugman's reasoning style that I titled on this blog, the Ad Hominem Index. With regard to Krugman's characterization and quotation of eminent economists (including Cochrane), Cochrane says the following:

...These are just gross distortions, unsupported by any documentation, let alone professional writing. And Krugman knows better. All economic models are simplified to exhibit one point; we all understand the real world is more complicated; and his job is supposed to be to explain that to lay readers. It would be no different than if someone were to look up Paul's early work which assumed away transport costs and claim "Paul Krugman believes ocean shipping is free, how stupid" in the Wall Street Journal.

... But most of all, Paul isn't doing his job.  He's supposed to read, explain, and criticize things economists write, and real professional writing, not interviews, opeds and blog posts. At a minimum, this style leads to the unavoidable conclusion that Krugman isn't reading real economics anymore.

I would add that one could take some pretty wild Krugman quotes out of context from his unpublished paper on the theory of interstellar trade.

Cochrane's final note is at the same time anticlimactic, civil, and damning. He puts forth his best explanation of why Paul Krugman has taken the approach described above. His answer is simply that Paul Krugman's actions are rational only if he has left economic principles and has embraced a quest to be "the Rush Limbaugh of the Left." So we all look forward to the radio talk show.

The only explanation that makes sense to me is that Krugman isn't trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them.  Krugman wants to be Rush Limbaugh of the Left.

...Most of all, this is the only reason I can come up with to understand why Krugman wants to write personal attacks on those who disagree with him. I like it when people disagree with me, and take time to read my work and criticize it. At worst I learn how to position it better. At best, I discover I was wrong and learn something. I send a polite thank you note.
 
Krugman wants people to swallow his arguments whole from his authority, without demanding logic, or evidence.  Those who disagree with him, alas, are pretty smart and have pretty good arguments if you bother to read them. So, he tries to discredit them with personal attacks.
 
This is the political sphere, not the intellectual one. Don't argue with them, swift-boat them. Find some embarrassing quote from an old interview. Well, good luck, Paul. Let's just not pretend this has anything to do with economics, or actual truth about how the world works or could be made a better place.

Once again, I find myself taking off my hat and thanking John Cochrane for his well reasoned, yet biting and entertaining, rebuttals to the inflammatory affronts to economics.