John Cochrane questions the accuracy of Keynesian economics by showing the failure of the Fed’s and CBO’s Keynesian models to accurately forecast the slow recovery. He ends a blog post by asking, “…the question of the day really should be why we have this slump — which, let us be honest, no serious forecaster expected.” I take exception. Here are excerpts from my book, Unintended Consequences:
On the structural nature of the recession:
“Investors and consumers have dialed back their appetite for investment and consumption to compensate for the now-recognized risk of damage from withdrawals.”
“If we leave the risk of damage from withdrawals hanging over the economy, it will slow rather than accelerate the already difficult structural transition of finding new ways to put short-term money to use.”
“Of course, the economy can increase employment by dialing down wages.”
On the effectiveness of fiscal stimulus:
“There is a big difference between increases in government expenditures when taxpayers expect lawmakers to offset increases with real cuts to baseline spending in the future, and increases when they don’t expect future offsets.”
“The post-1980 U.S. multiplier—the year when a period when exchange rates were floated—at 0.4 times government expenditures. That’s not very encouraging. This, however, includes a multiplier of 1.8 times for investment spending and slightly less than zero for increased government consumption. All of the multiplier effect comes from stimulating investment, not consumption.”
“Theoretically, the government could make investments in innovation that accelerate the economy’s transition from a misallocation of capital to subprime consumption to more sustainable endeavors, especially at a time when the private sector is reluctant to make risky investments of any kind. But lawmakers make lousy investors. The economy operates in an environment where success is highly uncertain and in large part randomly distributed. The private sector succeeds by funding many small investments—experiments that Darwinian survival-of-the-fittest ruthlessly rank-orders and prunes. The political investment process is entirely the opposite.”
On the effectiveness of monetary stimulus:
“Printing money doesn’t magically stimulate the economy. Only risk-taking does.”
“Increases or decreases in optimism tend to create self-reinforcing feedback loops that monetary policy can either allow or restrict. This self-reinforcing feedback loop is often mistaken as monetary policy itself growing the economy, but this is not the case. If the Fed relieves constraints to the expansion of credit—when there is no pent-up demand for increased risk-taking—credit will sit unused and the velocity of money will slow. This happens in recessions when investors and consumers grow risk-averse and hoard their output. In such circumstances, relieving credit constraints has little if any effect on the economy.”
“Increases in the money supply…sit idle during recessions when consumers and investors are reluctant to borrow money and lenders are reluctant to lend. Unless the money is spent, and production capacities tighten, prices are unlikely to rise. In that case, a little bit of price inflation may require a lot of monetary inflation. The cost of uncertainty from a large increase in the money supply may be enormous and long-lasting relative to a small amount of near-term price inflation. Again, the adverse reaction of consumers and investors to this uncertainty might be far greater than any benefit.”