John Cochrane Muses on Monetary Theory
By Arnold Kling
John Cochrane has posted an essay on his take on the economy, stimulus, and so on. I think he gets muddled in several places.He starts out with this.
Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out.”
The footnote is to Fama. But Fama is not right.
But then he starts to say some things that make more sense.
People are trying to shift their portfolios out of stocks and especially out of anything with a whiff of credit risk, and into cash or Treasuries. We see this desire in the dramatically high interest rates, and correspondingly low prices, for any debt – jumbo mortgages, corporate bonds, municipal bonds, securitized debt — that has even a small chance of default and no government guarantee, and the low interest rates and very high prices for government bonds and government-guaranteed debt. People are also trying (finally) to save more, but they want to do so in the form of safe, government debt or government guaranteed debt.
If we just had a credit crunch, we would expect to see stagflation – lower quantities sold, but upward pressure on prices. A credit crunch, like a broken refinery is a “supply shock.” Since we are seeing lower quantities sold and easing inflation, we must also be seeing a “demand shock,” and we need to understand its source.
I cannot evaluate the above statement without knowing the definition of a credit crunch. In my mind (see lecture no. 10), a credit crunch means that butcher cannot borrow to buy cake, the baker cannot borrow to buy candles, and the candlestick maker cannot borrow to buy meat, so you get deflation, not stagflation.
He goes on,
The bottom line, then, is that people want to hold more of both money and government debt – and don’t particularly care which. Trying to get it, we are trying to buy less of both consumption and investment goods. Again, this is a deflationary pressure.
At this point, I generate an internal warning light that blinks about stocks and flows. Consumption and investment are flows, meaning that they are purchases per unit of time. Money and debt are stocks, meaning that they are outstanding quantities. It’s not a good idea to add flows to stocks, or vice-versa. In the national income accounts, we say that (with no government or foreign sector) income equals consumption plus saving. We don’t say that income equals consumption plus saving plus money plus debt.
I’m ok with a Tobin story, in which a shift in portfolio preference lowers the market price of capital below the replacement cost of capital, causing investment to plummet. I’m ok with an Austrian story, in which a shift in demand from more roundabout production to less roundabout production causes the economy to undergo a major adjustment, which in the short run is contractionary. I am not ok with talking about shifting from consumption and investment into money. That is what I mean by muddled. Let’s be generous and assume that he is telling the Tobin story, but being careless.
Finally, he writes,
Fiscal stimulus can be great politics, at least in the short run. The beneficiaries of government largesse know who wrote them a check. The businesses and consumers who end up getting less credit, and the businesses that can’t sell them products, can only blame “the crisis,” and call up their congressmen to get their own stimulus.
This is important to keep in mind. Whatever the effect the policy has on total spending and employment, it will make people come to government to support whatever economic activity they want to undertake.