KrugmanWatch – A Dark Age of macroeconomics (wonkish)

posted by Nima

February 22, 2009 · Posted in General Economics 

In A Dark Age of macroeconomics (wonkish) Krugman writes:

Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity.

Yes, every child understands that if the government spends money it has to come from somewhere. We shall see how well Krugman does in understanding this simple causality.

There has been a tendency, on the part of other economists, to try to provide cover — to claim that Fama and Cochrane said something more sophisticated than they did. But if you read the original essays, there’s no ambiguity — it’s pure Say’s Law, pure “Treasury view”, in each case. Here’s Fama:

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

And here’s Cochrane:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. 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.”

Yes, there is nothing new, strange, or arcane about these statements. They are simple common sense and don’t require any further elaboration.

Second, investment is “spending” every bit as much as consumption. Fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.

Now here Cochrane errs: The economy does care very much whether money is spent on a consumer good or on a factor of production. The entire structure of production depends on it. How many consumer goods and how many factors of production are needed on the market is indicated to entrepreneurs via interest rates and prices. It is of primordial importance to understand this causality.

There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.

Nobody asserts that savings are automatically converted into investment. Money might just as well be saved up by one individual without any investment on the part of this particular person. If he just saves up the money he effectively steps back from the market and leaves factors of production and/or consumer goods available for use by other entepreneurs and/or consumers. I already pointed this out in Welcome to Krugmanland.

What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship.

Wrong. What is Krugman talking about now? Nobody is interpreting an accounting identity as a behavioral relationship. All that the authors have done is explain behavioral relationships as such. Cochrane may have referred to the fact that this also makes sense accounting wise, but Krugman doesn’t understand this at all.

Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line.

It’s like the fact that the capital account and the current account of the balance of payment have to sum to zero: that’s true, but it does not mean that an increase in capital inflows magically translates into a trade deficit, without anything else changing (what John Williamson used to call the doctrine of immaculate transfer). A capital inflow produces a trade deficit by causing the exchange rate to appreciate, the price level to rise, or some other change in the real economy that affects trade flows.

Again wrong. A capital inflow represents an inflow of factors of production. When money is borrowed from abroad and used to purchase factors of production from that same country, imports increase and create a tendency toward a trade deficit without any effect on the exchange rate, especially when the government meddles with this process. More on this in The US Current Account Deficit. Krugman also conveniently mentions “some other change in the real economy” without any further elaboration. The reader himself shall decide if he believes that this kind of cursory writing is even in the slightest acceptable in an economic inquiry.

Similarly, after a change in desired savings or investment something happens to make the accounting identity hold. And if interest rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often presented to freshmen. Here’s the diagram:

INSERT DESCRIPTIONA case of mistaken identity

In this picture savings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.

This is all but laughable. No explanation at all is offered. We established above and at many other occasions that government spending needs to be funded by a restriction of private consumption/investment. Now Krugman “refutes” this by saying in effect: “Government expenses do NOT reduce private investment. Period.” But this doesn’t make his fallacy right. It merely shows that he has no way to argue his case on logical grounds.

Now, you don’t have to accept this model as a picture of how the world works.

OK. Thanks. Then why do you use it to argue your case. Mr. Krugman? The model is wrong. Everything derived from it is just as wrong.

But you do have to accept that it shows the fallacy of arguing that the savings-investment identity proves anything about the effectiveness of fiscal policy.

No. Wrong. We don’t have do accept a wrong thesis. There is no fallacy at all in believing that government spending has to be funded from somewhere. There is no fallacy to reject magic as the solution to our financial crisis. If anyone has to accept that his theory is a sheer fallacy, it would be Krugman himself. The fact that there is no such thing as effectiveness of fiscal policy has been shown long ago in The Trouble With Bureaucracy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

We do in fact live in the Dark Age of Macroeconomics. An age where Keynesian clowns such as Paul Krugman have launched a succcessful assault on logic and reason. An age where people like him are rewarded for their nonsense with Nobel Prices. An age where virtually every common sense causality suddely disappears in the sphere of economics.

Paul Krugman bears partial responsibility for this unfortunate development. It will take decades to repair the intellectual damage caused by people like him, not speaking of the damages done to people’s lives as a result of irresponsible policies of credit expansion and big government. Advertisement: Get your shortlink before someone else does at

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2 Responses to “KrugmanWatch – A Dark Age of macroeconomics (wonkish)”

  1. stupidhorriblenogoodlib on October 18th, 2012 11:57 pm

    krugman confuses me slightly as i continue to learn economics from him at an admittedly hobbyish level but this kind of BULL is exactly what he denounces thoroughly as popularized, obscurantist, anti-establishment saviorhood-in-a-bottle look-at-how-obvious-the-truth-is….. truthiness. at least i gave you a chance to convince me of something. i paid the simple price of time and understanding, or lack thereof. you could perhaps have argued the possibility of higher taxes, if i correctly understand that model i just today learned about. But hey, spurring gdp increases tax revenue, right????? (get it? its a joke about tax cuts leading to higher revenue? aw nevermind…. you’ll never hear from me again i promise…

  2. Nima on October 19th, 2012 12:16 am

    Sorry, I may have overlooked it, but did you actually detect any flaws in the facts I presented above? Because I sure as hell don’t want to put stuff out there that’s flawed and I always strive for truth and correction where I’m wrong.

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