Thursday, July 14, 2011

John Cochrane's Fiscal Model

One of my former professors, John Cochrane, was recently photographed in the course of dinner with Congressman Paul Ryan together with a nice bottle of wine and an even nicer hedge fund manager. Matt Yglesias suggests that this might have something to do with a paper Cochrane published last year on fiscal policy during the current recession. Cochrane is a truly gifted researcher in the area of asset pricing, teaches a great course and wrote a fantastic book in the same area. That's why it's such a surprise that his work in macroeconomic policy consistently underwhelm.

For example, as Brad DeLong notes, Cochrane has made the error of proposing an upward sloping IS curve, and made several other mistakes in the paper as presented at Berkeley.

Noahpinion reviews the Cochrane paper here, noting several important points:
The fact that Cochrane reduces the macroeconomy to two more-or-less uncontroversial equations causes me to invoke Noah's Third Law of Article Reading:
If your model is a subset of the intersection of most existing models, either you didn't get any new results, or you need to check your assumptions.
In other words, don't expect to get Exciting New Results using only the Same Old Stuff. Is John Cochrane really going to show that higher taxes cause inflation using nothing but an intertemporal budget constraint and hoary old MV=PY?

Simplifying your model past the point of full determinacy doesn’t remove the need to make additional assumptions about economic relationships; it just makes those assumptions implicit rather than explicit. If you say that only these two equations matter, you’re saying that other things, like imperfect competition and price stickiness, don’t.

...So Cochrane is being intellectually honest here. He’s admitting that he just left out all of the things that monetarists and Keynesians believe makes stimulus and quantitative easing effective. They “can easily be added,” but he doesn’t add them. So the conclusion that countercyclical policy doesn’t work is going to follow pretty naturally from the assumption that countercyclical policy doesn’t work.
Also, there's a peculiar idea in the paper that we're in the downward sloping part of the Laffer curve.
[Cochrane's estimate] implies that the Bush tax cuts raised our trend per-capita growth by 0.36%, or more than one-sixth. It also implies that the Johnson and Reagan tax cuts raised our trend growth far more than that, and that the Clinton tax increases significantly decreased our trend growth. Unsurprisingly (to me, anyway), a long-term plot of U.S. output doesn’t show any of these things.
It's a pretty thorough take-down. Go hence and read it all. Paul Krugman pans the paper as a game of "Chicago Calvinball". It does nothing to explain why the standard IS-LM models don't work as normal, other than that perhaps Dr. Cochrane has policy goals in mind that he'd like to see implemented.

More: Noah takes another whack at the Cochrane paper.

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