Friday, January 23, 2009

You must be Brave or Foolish to go against UChicago econ

I've studied with all of the profs in this excellent U Chicago panel, particularly Kevin Murphy, who I believe is the smartest man at the school. And that's *really* saying something, as the place is silly with Nobel Prize winners.

And yet, and yet, I'm going to go against them. Foolish or brave? You be the judge.

First Huizinga: His major point is that this recession, so far, is not awful compared to previous recessions, so calls of a new Depression are overdone. I think it's difficult comparing this recession to past ones without also comparing how heroic Government actions have been to keep things from getting worse. I don't know if the 57, 74, or 81 recessions included bailing out the banking system, the shadow financial system, insurance companies, car companies, and more, but if things are not so bad right now it must, in part, be because a huge chunk of the private sector is now existing on the Fed's largess.

His identity

National Savings = I + Current Account

arguing that Government action will crowd out private investment is not being interpreted correctly.

You begin with

Y = C + I + G

And you claim that anything that is not spent is saved and you split saving up into public and private. This is how you get S = I

But, a more accurate use of the identity is to have private savings as the residual after private consumption, taxes, and investment

Y - C - I - T = G - T

Private savings = Federal deficit

This distinction between savings NOT being investment is critical, and is clearly the dynamic we see now, where banks are sitting on cash and not making loans (and private equity is similarly sitting on the sideline). A change in demand of cash is at the heart of the crises, and eliding it by using the wrong identity begs the critical question!

Next, Kevin Murphy.

I loved the model he used for evaluating fiscal stimulus:
• Let G = increase in government spending
• 1-α= value of a dollar of government spending (α measures the inefficiency of government)
• Let fequal the fraction of the output produced using “idle” resources
• Let λbe the relative value of “idle” resources
• Let d be the deadweight cost per dollar of revenue from the taxation required to pay for the spending

Love it!

But, the deadweight cost per dollar of revenue for taxation required to pay for the spending is *wrong*. Government does not need to tax in order to spend. The dollar is a fiat currency, not some "store of value" and as such the Government can spend more by changing entries in a spreadsheet, and not increase taxes. The result is a larger deficit, but a larger Federal deficit is exactly what we need to support aggregate demand as the private sector (net) deleverages.

Finally, Robert Lucas. Lucas at least includes price and velocity -- thank you for that! -- but again misses the key element:

MV = Py

Given that V is going to zero (as people demand more savings) you need to increase M by a large amount so y can stay where it given that P is fixed. In the long term, P will fall and we will return to the 10 cent hamburger, but in practice the US is simply not going to be allowed to enter a 1930s style protracted and deep deflation.

The obvious solution at this point would be to talk about how we can increase M rapidly, in a way that is equally rapid to reverse! The obvious candidate, and it would be obvious to Keynes if he was alive today, would be a payroll tax holiday. It would avoid all the fiscal problems that all three economists mention, while still handling the money supply in a way that gets us to a rebalanced economy without having to do things the hard way and increase the deficit through unemployment.

But, sadly, in U Chicago fashion we get stuck at "Government spending is bad" and don't take the next step on how to fiscally stimulate in a way that would actually work in the short term, and be better for the economy in the medium and long term also. There is a reason none of these three guys are on the NYTimes Op Ed page.


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