John Cochrane, on Austerity, Stimulus, or Growth Now?

John Cochrane, The Grumpy Economist, on Austerity, Stimulus, or Growth Now?

Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The U.S. can still borrow at remarkably low rates, they point out. But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes. What should we do then?

The traditional Keynesian answer was: move on to monetary stimulus. Deliberately inflate and devalue. Break up the euro so the southern European countries can inflate and devalue even more.

Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves. In a March 17 column, Krugman wrote: “there’s a plausible case that spending more now actually improves the long-run fiscal picture.”

U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn’t.

Is there another explanation, and a more plausible way forward?

The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labor, product, and service markets” got nowhere?

Does it not matter that Greece has a high combination of individual, corporate, wealth and social taxes, higher still under “austerity?” True, Greeks famously don’t pay taxes, but businesses that must operate illegally to avoid taxes are much less efficient.

Money is fleeing Greece, Italy and Spain. Does talk of exiting the euro, followed quickly by devaluation, inflation (the IMF predicts 35 percent in Greece, should it leave), and capital controls, have nothing to do with lack of investment?


(via Instapaper)

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4 thoughts on “John Cochrane, on Austerity, Stimulus, or Growth Now?

  1. Greece is experiencing the results of extreme mismanagement. The benefits of deficit spending are greatly reduced, and may even be negative, if the money is simply wasted. Businesses growth can be strangled by needless regulation that makes it too difficult to do business.

    The situation in Greece does not indicate that the Keynesian approach will not work. It’s effectiveness, and the negative effects of reducing the money supply, have been amply defended. But again, excessive regulation, waste, corruption, and poor planning can nullify the benefits of the Keynesian approach.

  2. Agreed that Greece wasted the cheap euros they borrowed (low rates based on Germany’s credit rating and the implicit guarantee). The current ECB loans are covering current operating losses (no investing to waste).

    I don’t agree that fiscal stimulus is as effective as monetary policy. Deficit spending is much more costly than monetary though not useless as some claim. Former Obama CEA chair Christina Romer’s interview on Five Books is useful as are recommendations for further reading on the Great Depression.

  3. The effectiveness of monetary policy depends partly on the demand for money. If there is no demand for money, even reducing the interest rate to zero and increasing the money supply will have little or no effect (which Japan learned the hard way) in which case stimulus may be required. It all depends on the particular situation and sometimes it is difficult to tell what to do.

    In the case of Greece, it appears that the problems are so entrenched and of such long standing that there will probably be considerable suffering before recovery finally takes place. Ending corruption is never easy and never totally successful.

    Currently I am reading The House of Morgan by Chernow; it contains considerable information on what took place during the Great Depression. I’ve also read about FDR’s actions during the Depression, some of which (but not all) were misguided. One can learn much about history and economics by reading biographies.


  4. (…) even reducing the interest rate to zero and increasing the money supply will have little or no effect

    I think there is a lot more horsepower in the monetary arsenal than the Federal Funds Rate. Targeting say NGDP is much more powerful than short term interest rates. Because of lack of depth, for me it is risky to take confident positions on monetary policy – it seems to be a very tricky area, with manyfold multi-layer consequences. However, reading Scott Sumner for a couple of years has gradually increased my confidence about the reach of monetary policy.

    In particular Scott has persuaded me that the Fed (or ECB or…) can increase NGDP (nominal GDP) to any level they target – over the short term. Due to stickiness of prices (such as wages) this has the short term effect of increasing real GDP, and hence is highly effective as an anti-recession policy.

    Thanks for motivating me to finish up a little post on an Econtalk that I will commend to you on exactly this topic.

    Please see also the Bank of England’s excellent Quantitative Easing Explained.

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