David R. Henderson  

The Most Important Macro Hour

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Ever since September, I've been wishing that Milton Friedman were still alive, not just because he was such a good, warm, friendly guy, but also because he would have brought a lot of clarity to the credit crisis, the bailout, and the proposed Obama fiscal policy. Well, today I watched three University of Chicago economists who, together, brought the kind of clarity Milton would have brought. Arnold has already blogged on this and mentioned the highlights but I want to add my recommendation and what I see as the high points.

I'm very impatient. I can speed read, but I can't watch or listen faster than anyone else. Yet the hour I spent watching the U. of C. event was the best macro hour I've spent since September.

The three economists, as Arnold mentioned, were John Huizinga, Kevin Murphy, and Robert Lucas. You will get a lot more out of watching it if you go to this web site, download Huizinga's and Murphy's overheads, and print them out.

Arnold covered Huizinga's highlights and so I have nothing to add other than that Huizinga laid it out beautifully and his overheads are worth showing to people. They show percentage job losses in various recessions to put this one in perspective. Huizinga, incidentally, was Yao Ming's agent.

The star presentation, though, was from baseball-cap-wearing Kevin Murphy. The clarity was superb. He laid out an equation that everyone could agree to so as to see if increases in government spending could have a good effect. The disagreements, he noted, would be on the various magnitudes and on one sign. Here's what Christie Romer must believe, here's what I believe, here's why Marty Feldstein is in trouble given his past work on deadweight loss from taxes, etc. Kevin made the point I made in my recent Forbes.com article about the destructiveness from cutting taxes without cutting marginal tax rates. Print out the equation and you can follow the numbers as you go along. Bottom line: if you share Kevin's view about the magnitudes, you will conclude that this Obama fiscal policy will be horrible. And you have to have a pretty extreme view of the magnitudes of the parameters to conclude that it will be on net good.

The final presentation was a sobering one from Bob Lucas, who made the Friedman-type points about the quantity equation and why the Fed must be the lender of last resort but we should avoid all the fiscal policy stuff.

The best contribution from the audience was from John Cochrane, who was a junior economist at the Council of Economic Advisers when I was a senior economist there. Cochrane pointed out that he had gone through the last 50 years of textbooks (on his web site, he says 40) and couldn't find any of them claiming that increases in government spending were a good way out of recessions. He pointed out that given that the problem is a lack of investment, having the government spend money that it borrows must crowd out some investment. But watch it yourself.

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CATEGORIES: Fiscal Policy

COMMENTS (6 to date)
geoff manne writes:

My take on this before the slides were available: here

Bob Murphy writes:

Cochrane pointed out that he had gone through the last 50 years of textbooks (on his web site, he says 40) and couldn't find any of them claiming that increases in government spending were a good way out of recessions.

David, can you please elaborate on this? (I haven't listened to it yet.) When I taught undergrads, I went over the standard Keynesian argument that Krugman gives, and it was in a textbook. (I then ripped the analysis, but it was in a textbook.)

So is the caveat for Cochrane: (a) he is talking about graduate texts, or (b) the textbooks say sure, deficit spending would work, but it makes more sense to do it with monetary policy?

RL writes:

It becomes increasingly evident, for those who have an ear for such things, that the government is more and more a loose cannon, acting without justification to benefit political favored actors over taxpayers, in short: a band of thugs. This is, of course, what it has always done and always been, but--similar to the detritus circling the bowl toward the end--things are moving faster now, and with increasing velocity.

Nick Danger writes:

Yeah, Friedman was extremely warm and friendly. Especially when he was espousing the elimination of public education. Friedman was the meanest curmudgeon to every slink around the face of the earth.

Brian Shriver writes:

Well, I have about as much faith in your models as I do in medieval medicine. Remember, to be a science you must attempt to be descriptive. It is not enough to drag around historically revered models and look for confirming evidence.

Savings - investment = Net exports? Oh really? Only if you conflate separate processes that are best viewed separately. Savings does not equal primary financial flows does not equal business investment.

Divide the economy into real and financial layers. In the real economy you have payments for goods and services, wages, taxes, etc, between four nodes: [H] [G] [F] and [W] (households, government, firms, and outside world. If you like you can label payment flows from [H], [G], [F], and [W] to [F] as C, G, I, and X, illustrating PY = C + I + G + NX. On this we all agree.

Now one unavoidable reality of such a diagram is that while any one node can run a surplus or deficit, aggregate surplus is zero. Moreover, domestic surplus equals world deficit (or vice versa, in fact).

So domestic savings equals net exports. Without investment. Investment is a payment flow from firms back to firms which at least on the aggregate level is self-financing. Which is why it is no surprise that in the real world investment is such a volatile a component of GDP and in fact has very little to do with savings.

Surpluses at individual nodes flow through the financial market as primary flows. Or not - when markets freeze up there are no flows. Moreover, financial flows can be used to support business investment (confirming evidence!!!) but can also be used to support deficit spending as well as speculation.

Maybe, just maybe, imbalances in the real economy led to unsustainably high primary flow volume which led to both overinvestment in housing and over-leveraging on Wall Street. The growing trade deficit was part of the problem - Bernanke's global savings glut. But don't forget household income polarization -- if the top 1% of households receive 24% of income, of course there's gonna be a helluva lot of money looking for a creditworthy borrower.

But if you assume savings = investment, you have just assumed away the whole problem.

Don't even get me started on your equilibrium assumption or your production function assumption. Capital is a constraint on output? On which planet? Obviously there's too much capital chasing too few opportunities. At the margin, capital is available instantly at very reasonable rates. And Demand is not a bottleneck? True only for plant managers in the former Soviet Union.

Shame on you for ignoring how the world works! Don't obfuscate your mediocre assumptions with a veneer of mathematical sophistication. And certainly now is not the time for smug victory laps!

Tear up those crappy models and attempt descriptive realism.

It's easy if you try!

Bill Woolsey writes:

I finally sat through the video.

Lucas was on the mark. The problem is severe and it is monetary disequilibrium. Deflation is not an answer. The money supply needs to increase enough to offset the decrease in velocity.

Thank heaven, Lucas doesn't believe the new classical continuous market clearing nonsense.

I found Huizinga's report on the facts of be useful. So far, this recession isn't unusually bad, but the Obama people are forcasting that it will last a long time. (We are Japan.) If the U.S. economy will still be producing below trend three years from now, then at least some of this fiscal stimulous won't be too late.

Murphy? He starts off saying he doesn't remember any macroeconomics. His equation has no room to even consider whether the public spending is financed by money or debt. No consideration of the deflation. I am happy that he puts such a high weight on the leisure of the unemployed. I suppose if unemployment insurance were ample enough, I might even agree. (No, I wouldn't.)

Cochrane? Fiscal policy can only work by making people worse off so they work harder? In his imagination, the deflation has already occurred. He believes that new classical, continuous market clearing nonsense.

_OF COURSE_ the fiscal stimulous is going to be financed with money in the short run. Of course, it will be financed with debt in the long run.

Think of it this way. New money is created and spent on public projects now. There is no nominal crowing out. Money is being created. It does increase the equilibrium price level, but the price level is above equilibrium now.

Once the panic, banking mess, whatever, has passed, the demand for money will fall again. The money will be withdrawn from circulation and more debt will be outstanding. The projects that would have been financed by the debt holders won't be financed.


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