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My Response to John Cochrane (Who Was Responding to Krugman)

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Cochrane Threatens Austrians More Than Krugman Ever Did
By Robert P. Murphy

Although some Austrian economists (e.g. Mario Rizzo) expressed disappointment with Chicago University economist John Cochrane’s response to Paul Krugman’s infamous NYT Magazine piece, for the most part the people on “my side” have high-fived Cochrane for kicking sand in Krugman’s face.

This is a very short-sighted view. Just because someone gets in a fight with someone who we can’t stand–and I’ve criticized Krugman enough to have credibility on that score–doesn’t mean we should endorse any old arguments. There was quite a bit in Cochrane’s response that should alarm an Austrian economist, and in fact his views are arguably more dangerous to the Austrian alternative than Krugman. After all, all Krugman did was ignore us. But Cochrane ignored us and defended himself from Krugman in a way that “proves” Austrian economics is a collection of second-rate ideas. I don’t see how any Austrian economist can overlook all of that, just because he likes Cochrane’s conclusions that “Keynesian economics is awful” and “Paul Krugman is a jerk,” true those conclusions may be. In this brief essay I’ll quote from Cohrane and show how his ostensible attack on Krugman actually takes down Austrian economics as collateral damage.

Most of all, [Krugman’s article is] sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a stalwart that maybe continents don’t move after all, or that smoking isn’t that bad for you really.

I don’t need to dwell on why Austrians should dismiss this opening salvo from Cochrane. This is the incredibly naive Whig theory of history. Cochrane could just as easily blow up any Austrian who thinks Human Action contains better economic analysis than the latest edition of Mankiw.

(What’s really ironic is that later in the essay, Cochrane says, “Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas.” So I’m not sure what to make of his opening paragraph. It seems Cochrane finds it “sad” that today’s Keynesians would dare to use arguments that Cochrane had deployed against yesterday’s Keynesians. A bit like the US government saying other countries shouldn’t have nuclear weapons, because after all some evil regime might use them against civilians one day.)

After lamenting the sad day when someone would dare to criticize Nobel laureates (isn’t Krugman a Nobel laureate?), Cochrane then says:

And that’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and “spend like a drunken sailor” are pretty superficial compared to all the fascinating things economists are writing about it these days.

What is Cochrane talking about? Krugman has written boatloads on what could have prevented the current financial crisis. For example, Krugman has pointed to various types of (what he labels) “deregulation.” And as for the “drunken sailor” wisecrack, Krugman has put up formal models showing his views on aggregate demand and so forth.

Don’t get me wrong–I think Krugman is completely wrong (bordering on “insane” if that word is to have any meaning in reference to academics) in his views. But Cochrane’s rude dismissal of Krugman is just as much a lie as anything Krugman said about Cochrane. So again, for those Austrians who can’t stand what a dishonest thug Krugman is, you can’t very well think Cochrane did a great job taking him down. Unless it’s OK to lie for free markets (or in Cochrane’s case, significantly-less-socialized markets).

But the next paragraph is what really made me lose it:

It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.

How in the world can the proponents of the EMH continue to justify their belief in the EMH…by appeal to the EMH?!! I occasionally stop the radio channel seek on Christian stations, and it’s hilarious during the short spots when they say things like, “A lot of people wonder how we can trust the Bible. But they need to read First Corinthians 5 where Paul writes…” (I am a Christian, by the way.)

There were plenty of economists (especially the Austrians–see e.g. Mark Thornton back in 2004) who “called” the housing boom. I don’t know what exactly the EMH theorists make of this. Yes, you could argue that at any given time, you will have no shortage of economists (all of whom are ignorant of the EMH and the limits of their knowledge) shouting out all kinds of predictions, and then simple statistics show that some of them will be “proven right.”

But on the other hand, what more could opponents of the EMH do than to point to the recent housing bubble?! When Cochrane says the EMH is the “best tested proposition in the social sciences,” it is only because it is a tautology. Really, think about it: Do we need to go test the proposition that “if someone is making a bunch of money doing an activity, then other people will copy him and whittle away his returns, unless there is some reason that they don’t”? (I’m exaggerating slightly, but when you read the actual empirical defenses of the EMH against its typical objections, you realize that it is a way of viewing the world. It is not a conclusion derived from the facts; it is a way of organizing the facts.)

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient….Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.

I am a bit out of my league here, but I still suspect that Cochrane is once again defining away his opponents. Again I ask: What would the world look like if the EMH were false? Wouldn’t there be giant bubbles, during which many participants knew (or were quite sure) there was a bubble in progress–and invested and profited accordingly? (Of course that happened; don’t let Cochrane fool you into thinking otherwise with his “best tested proposition in the social sciences” bluff.)

As far as the equity premium puzzle, proponents of Mandelbrot’s “non-Gaussian” approach to financial markets say that it is the standard neoclassical use of a Gaussian distribution (calibrated with historical stock returns, yes including the Great Depression) that makes investors appear far too risk averse than we think they really are. What is happening is that the actual stock market is far more volatile than the calibrated models suggest. The housing bubble that just burst–as well as the 1987 crash–should have been “once-in-a-thousand-year events,” according to the standard models that Krugman is attacking. (Of course I am making up that number. But the basic point is right.) That’s one of the main themes in Nassim Taleb’s work, that the value-at-risk and other risk measures used by Wall Street quants gave a false sense of security. I’m not accusing Cochrane of being ignorant of this fact, but at best he is throwing out a non sequitur to evade the very real problem that Krugman pointed out.

Oh wait, it turns out Cochrane isn’t so sure about the usefulness of the EMH after all:

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles and opeds. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now. Crying “bubble” is no good unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row.

There you have it, folks. After telling us that Krugman is attacking the best tested proposition in the social sciences, Cochrane falls back on, “Yeah we don’t know anything, but neither do you. Until you can predict when a bubble will burst, stop complaining about my theory that predicts bubbles are impossible.” (Again I am slightly exaggerating to make the point–but not much.)

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefore.” Not even Paul can object to the connection.

Nope. Again I’m a bit out of my league here, but I am pretty sure that Cochrane is completely full of it on this point. Ricardian equivalence says that if the government finances a tax cut by running a higher deficit, while holding total government spending constant, that this won’t change aggregate consumption, GDP, private sector investment, or interest rates. Rational taxpayers realize they will face higher tax bills in the future, and so they put aside the tax refund to roll over at interest and pay the bills. Thus, what the government gives back with the left hand, it borrows out of the private sector with the right. (Interest rates don’t change because the extra saving by the private sector cancels out the extra borrowing by the government.)

Now there are all sorts of caveats in my argument above; it matters if it’s a lump-sum tax cut versus a reduction in marginal tax rates, it matters if the current generation of workers will die before the higher taxes hit, etc. That’s the tweaking of assumptions that Cochrane is referring to.

However, as Brad DeLong and Krugman have pointed out many times (in justified exasperation) on their blogs, Ricardian equivalence does not say that an increase in government deficit spending will be perfectly offset by the private sector. Think about it: The government decides to borrow and spend $100 billion more. Now for Ricardian “equivalence” to kick in, it means that the private sector must reduce its current consumption by $100 billion and increase savings by that amount, at the same interest rate. [UPDATE: I am assuming that the extra $100 billion in government spending is classified as “consumption” and not “investment.”] In other words, faced with a higher future tax bill, the present generation decides to deal with it by slashing current consumption by $100 billion, while maintaining all future levels of consumption at their pre-announcement levels. Well why the heck would they do that? It would make a lot more sense to assume that consumers originally try to cushion the blow by reducing consumption across all future time periods. Then interest rates have to rise in the present in order to force consumers to make present consumption (and private-sector investment) channel an extra $100 billion into the government’s coffers. So you can see, there is nothing “equivalent” going on here at all. Don’t misunderstand–Krugman and DeLong are totally wrong in my opinion for thinking it’s a good idea to boost “aggregate demand” (measured in nominal terms) by having the government borrow money and spend it. But Cochrane is totally wrong for invoking Ricardian equivalence to show that, to a first approximation, such a maneuver wouldn’t boost aggregate demand in the present. (This is what Krugman is complaining about in the 7th paragraph here.)

Uh oh, now the Austrian reader isn’t sure he can continue down this path with me. Suuuure, I didn’t actually endorse deficit spending, but I suspiciously agreed with Krugman and DeLong when they claimed to defang one of the most popular Chicago School critiques of it (namely, that private sector reactions perfectly offset it in a frictionless world). Well maybe I can win you back with this final quotation from Cochrane:

Third, and most surprising, is Krugman’s Luddite attack on mathematics; “economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” Models are “gussied up with fancy equations.”…

Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research — understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?

No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.

I rest my case. Paul Krugman is a jerk and offers horrible policy advice. But John Cochrane’s response is no friend-of-the-court brief in the Austrian critique of Keynesianism.

Robert P. Murphy holds a Ph.D. in economics from New York University. He is the author of The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery, 2009), and is the editor of the blog Free Advice.