The macro wars

September 17th, 2009

Paul Krugman’s piece on “Why did economists get it so wrong” has attracted a vitriolic response from John Cochrane, reproduced here. Krugman’s piece was strongly worded, but the reply ups the ante, and I expect further escalation. Economics conferences in the next few years are going to be interesting events.

Given that, as Krugman himself notes, disagreements between economists were notably mild until the crisis erupted, what is going on here?

I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.

One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in the Economics Department of the University of Chicago) intensely dislike Krugman’s writing for the NYT.

But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.

Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.

Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.

In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.

Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]

So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.

Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.

fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.

fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.

  1. Alice
    September 20th, 2009 at 19:34 | #1

    But ABOM…at least Krugman is predicting the double dip..Cochrane (conducts major dummy spit …in which all his worst biases emerged…so much for objectivity.??.. the guy is one of Andy’s mob ..and I hope Andy doesnt take too much offence at me saying this…but you know the arguments ABOM.

    .” the world as we know it is bgeautiful and is always beautiful and we should just chant OMMMMM and let markets solve all the problems while all around us they implode” “Problems with banks or housing markets or bubbles???” “No everything is fine…the fundamentals are all sound ..the markets know best” know what I mean ABOM…

    The lunacy around us? Its there. The banks need hog tying. The trickle needs to be up, not down, the execs need to be serving time or at least threatened with it, the shareholders need control of their investments back, and the central banks shouldnt have so much power and money (my money).

    God what a mess we are in ABOM.

  2. Alice
    September 20th, 2009 at 19:47 | #2

    But ABOM – back to more important matters…your gold has been doing OK. My real estate has been doing pathetically till I rented the damn thing. NOTHING for 5 years except backwards…but ABOM, seriously, Im thinking Gosford..its gone backwards even faster than mine. Its starting to look cheap to me…especially when all those kids grow up whos parents couldnt afford Sydney and the extra 15 mill they plan to tip into immigration. Median price units down 15% over three years ago ABOM (and not old!). Starting to look attractive ABOM and not too expensive…

  3. Michael of Summer Hill
    September 20th, 2009 at 20:04 | #3

    Alice, whilst the price of gold looks attractive I would be very wary investing in gold especially if countries follow the IMF’s lead in selling 403 tonnes of gold.

  4. Alice
    September 20th, 2009 at 20:52 | #4

    ABOM – how things get distorted in economics. In 1973 according to Rothbard link he notes “the shackles of control were to be lifted from land, labour, capital and the like… Personal freedom and civil liberty were to be guaranteed against the depredations of the King and his minions”

    ABOM – do you not see how Rothbards vision has been distorted to control and humiliate labour (free and flexible labour, labour productivity, the stripping of rights from labour, workshoices etc). These have really served to oppress, not lift the shackles from labour. Tell me ABOM, is labour free to go where it wants in the great global opening of the borders? The only factor input that isnt free.

    No ABOM – whatever RothBards vision was, others have distorted it to oppress labour in the false name of free choice. Slavery is never very far away in a free market, no matter Rothbards genteel kindly vision for humanity. Its not Rothbard, its the bastardisation that followed Rothbard.

  5. Freelander
    September 20th, 2009 at 21:10 | #5


    We will never have a truely free world until property rights are free and freely transferable. Oh, for a world in which no property right lives in bondage.

    Labour will never be truely free until there are transferable property rights for labour.

    Ah? What’s another term for that? Slavery! Real freedom equals slavery.

    Like the communist vision, the libertarian vision’s utopia only looks good from a distance.

  6. ABOM
    September 20th, 2009 at 22:00 | #6

    Alice, I agree, Rothbard can be (and almost always is) distorted. But he holds the beacon so you can clearly see how screwed up we are now, and where we have gone wrong. Unless you see how a real free market (in money) works, you can never escape enslavement – you’ll keep running on the debt treadmill forever.

    On to more important matters. Yes, Gosford yields look OK – at today’s interest rates. But if the US dollar tanks and financial markets collapse again, the RBA will have to make a fateful choice – increase interest rates or let the $A die along with the US dollar. If you’re brave and think the RBA can always save us, proerty in some areas looks OK. If you think (as Steve Keen does) that we are at unprecedented levels of personal debt which cannot be worked off without a decade long Depression, then I’d save up in Swiss francs, Euros and $As and have 10% in real gold stored at home. Or buy a farm.

    I’m gutless and keep thinking “Will another sucker buy this property off me for more than I paid? And how much does he have to earn in order to pay for this?”

    At the end of the day it’s all about rental yield, so if you can improve the property and make it cash flow positive, OK. If you can’t – be careful. We’re in the most dangerous uncharted waters since the Great Depression (perhaps ever) and no one knows what comes next. We have aging demographics and a baby boomer generation that has just splurged on the biggest debt binge in world history to try to gear their way into a rich retirement. That’s just BLOWN UP in their faces.

    I have no idea what comes next, but I don’t think it’s another asset bubble in Australian housing.

  7. ABOM
    September 20th, 2009 at 22:25 | #7

    And don’t bet on Moshie’s investment advice. I haven’t seen anything from him worth remembering (if he can point to an accurate call he’s made over the last 2 years, let him point to it). IMF gold sales won’t touch the market, even for a second. They’ll go straight to Asian and Middel Eastern govts furious about US monetary policy turning their “precious” T-bonds into toilet paper.

    “This is it!” as Jim Sinclair often says.

    Gold is never a straight ride, but I’d bet on gold before low yielding negatively geared property. Steve Keen’s stuff on private debt levsls in Aust is truly frightening. If unemployment spikes, there will HAVE to be a wave of bankruptcies. Most Aussies seem to be one paycheck away from disaster.

    I believe now if the time to conserve what you have, not borrow to try to grab more. The question is – who will be out there willing to borrow in 5 years’ time to buy what you’re about to buy? If we’re in a demographic-driven depression, the answer is – not many.

  8. SG
    September 20th, 2009 at 23:38 | #8


    I cannot understand your reference to “individual liberties” by referencing Glass Steagall. Firstly, the removal was done under Clinton. Secondly, it was because the combined investment banking/retail banking model was extensively used by European and Japanese banks and there were expanding their US market share. Finally, if you are in favour of a free market model wouldn’t a more deregulated banking system be more in sync with your beliefs?

    I will read the 349-page PDF documents when I find the time to.

  9. SG
    September 20th, 2009 at 23:45 | #9


    Gold is riding high at over $1000 per ounce but think of it this way: gold is used as a “safe” investment while volatility is riding high. The VIX index shows volatility has falled from over 75 to 25. Still very high but is beginning to flatten out at this rate. Gold could be heading where Oil was last year – inflated by speculators moving in rather than of fundamentals.

  10. Michael of Summer Hill
    September 21st, 2009 at 07:04 | #10

    ABOM, has the price of gold really gone up or is it an illusion because of some currencies depreciating?

  11. ABOM
    September 21st, 2009 at 08:04 | #11

    Moshie, gold goes up because paper money goes down. I don’t “love gold” so much as “hate” fiat paper currencies printed like toilet paper by the central banks (esp. the US).

    The Mogambo Theory of Currency Relativity explains all….

  12. Michael of Summer Hill
    September 21st, 2009 at 08:17 | #12

    Congratulations ABAOM, if you think gold is worth the current price.

  13. ABOM
    September 21st, 2009 at 08:34 | #13

    Congratulations Moshie, if you think negatively geared property will give you a strong return over the next 5 years.

  14. Alice
    September 21st, 2009 at 09:15 | #14

    ABOM – Im inclined to think the unprecedented debt levels have to fall (meaning Im probably with Keen on that one) and that means some are going to have to sell…Just to show what a croc the “stable” unemployment figure of 5.8% is, why have applications for unemployment benefits increased 40% between May 08 and May 09? The number of people employed but in financial stress climbed by 36% and mortgage stress up by 60%? 5.8% ?? Dont believe it. Its a number measured by politicians for politicians and its yet another Denialism (as if we dont have enough already).

  15. ABOM
    September 21st, 2009 at 11:22 | #15

    I agree. It’s going to get unbelievably ugly out there in mortgage land if we have a double dip recession. Who would borrow even more if they think their job is on the line?

    Yes, there is a rental squeeze. But that doesn’t mean housing prices will rise. It might mean the yields will go up. We could have sluggish house price growth AND a homeless problem. Especially once the FHBG is reduced.

  16. Michael of Summer Hill
    September 21st, 2009 at 15:49 | #16

    ABOM, you should have bought gold today for its cheaper than a week ago.

  17. ABOM
    September 21st, 2009 at 16:29 | #17

    And much more expensive than two years ago, or three years ago, or four years ago, or….

  18. Michael of Summer Hill
    September 21st, 2009 at 16:40 | #18

    ABOM, if the price of gold rose to $2000 today then you are in the same position as in 1979. No better and no worse so hang in there.

  19. ABOM
    September 21st, 2009 at 17:05 | #19

    True! Which is why there’s still upside in gold, despite it going from around $200/ounce in 2000 to $1000/ounce today. A gain of around 500%. Question: During the same timespan (2000 – today) what’s been the % change in the Dow and/or the All Ords? Was it better to do nothing other than hoard gold from 2000 or was it better to leverage up and speculate on the stockmarket? (Trick question!)

  20. Michael of Summer Hill
    September 21st, 2009 at 17:33 | #20

    ABOM, the price of gold quoted for the year 2000 does not seem wright but there are other commodities whereby you could have made a mozza in ten years.

  21. SeanG
    September 21st, 2009 at 18:06 | #21


    Keen is correct about unsustainable debt levels. What worries me is that if there is a restriction of credit growth or if total consumer spending falls as individuals deleverage a payback debt, that too much of our aggregate demand is predicated on consumer spending and investment (both public and private) is not enough to pick up slack.

  22. ABOM
    September 21st, 2009 at 18:18 | #22

    Moshie, it might not be “wright” but it’s close enough. And you’ve avoided the question. Tell me about the “returns” on the Dow and the All Ords, where 90% of Joe Public’s superannuation went…apparently into a black hole of fees and skimming and embezzling if you look at the real returns from 2000 – 2009. Physical gold can’t be embezzled. Sure, prices move around. But gold is gold. Shares are bits of paper (not even that!) that custodians can on-sell without you even knowing.

    SG, precisely. At some point the game of debt growth has to stop. The simple reality is that some “sucker” has to get into debt in order for growth to continue and the economy to avoid a reession/depression. Who is that sucker? And how much can he/she leverage up before collapsing under the weight of all that debt? The main “sucker” (in $ terms, looking at Keen’s numbers) so far has been FHBuyers and residential housing buyers. OK. But is that sustainable?

  23. Michael of Summer Hill
    September 21st, 2009 at 18:20 | #23

    ABOM, tell me how much you paid in $A for one ounce of gold in 2000.

  24. ABOM
    September 21st, 2009 at 18:30 | #24

    I only talk US$ in gold.

  25. SeanG
    September 21st, 2009 at 18:30 | #25

    You can buy gold that is cash settled instead of physical delivery.

    USD 300 in 2000 and now just dipped below USD1000.

  26. Michael of Summer Hill
    September 21st, 2009 at 18:35 | #26

    ABOM, I know exactly what you would have paid and it is not the figure you quoted. So no more bulldust please.

  27. SeanG
    September 21st, 2009 at 18:37 | #27

    Exchange rate 2000: 1.73460-1.85640
    Exhange rate 2009: 1.1594

    USD300 @ 1.7955 (mid-range) = AUD538.65
    USD1000 @ 1.1594 (today) = AUD1159.4

    Therefore, the three-fold increase in gold price has been negated by the improvements in the AUD-USD exchange rate. However, you still would be out ahead.

    Don’t take these numbers of gospel, yet a putting a few things down on paper.

  28. Michael of Summer Hill
    September 21st, 2009 at 18:42 | #28

    SeanG, stop spoiling the fun.

  29. SeanG
    September 21st, 2009 at 18:42 | #29

    Sorry, I meant “don’t take these numbers as gospekl”.

    FX risk – the bane of my existence.

  30. Michael of Summer Hill
    September 21st, 2009 at 18:48 | #30

    SeanG, you get the prize for being close.

  31. SeanG
    September 21st, 2009 at 18:53 | #31


    You are forgetting how ABOM financed his purchase.

    Was it done via savings from an AUD account? Or was it borrowed? Floating vs fixed interest rate? Gold doesn’t pay out a stream of dividends or income so we have to discount further.

  32. Michael of Summer Hill
    September 21st, 2009 at 19:02 | #32

    SeanG, time to move on.

  33. ABOM
    September 21st, 2009 at 21:35 | #33

    The Dow, guys. The Dow! Is it not the case that the Dow topped out at 11840 in Jan 2000 and in March 2009 hit a low of 6460?!? A brutal loss of – wait for it – 45%! You lost half your retirement savings in the “sucker’s market”!

    And you think gold and silver are bad bets, Moshie? Time to move on all right. To any argument where you don’t embarrass yourself with your own ignorance. Ha ha ha!

  34. Alice
    September 21st, 2009 at 21:39 | #34

    I think its a suckers market ABOM. Before they lost the 45% in Mar 2009 how much more got sucked out in fees and taxes…

  35. Alice
    September 21st, 2009 at 21:46 | #35

    One brick at a time ABOM. I like bricks. They generally dont fall down but if they lose their value and you havent strangled yourself to buy…then you are OK. Yet even when the stock market is going well there are still the Eddy Groves, the Jodie Richs, the HIHs, even the damn Pasmincos (closed for business…all shareholders wiped in 6 months at same as usual boys…then there are the unit trusts people buy into..only to find come tax time the trust made most of its money selling previously acquired property so really your capital gains tax bill strips your return to nothing…never mind the performance said 10%. (less fees less tax less incomprehensible buried deep charges).

    Just another day on the markets…you cant trust any of the bezzlers.

  36. SeanG
    September 21st, 2009 at 21:48 | #36


    I know about comparative investments.

    Gold has done very well irrespective of the eroding position due to FX appreciation. I was merely chiding you.


    There is still money to have been made with options or short selling.

  37. Alice
    September 21st, 2009 at 22:34 | #37

    I have thought about options Sean…if I could just get excited about the idea! Hasnt happened yet.

  38. Alice
    September 21st, 2009 at 22:50 | #38

    Well well, Fama is Cochrane’s father in law. You learn something new every can I take it Cochrane has been well cared for and trained like a lap dog? No wonder he spat the dummy at Krugman – he may have upset some family links.
    I look forward to seeing who gets the nobel next.

  39. SeanG
    September 22nd, 2009 at 05:44 | #39


    I think it is personal and intellectual and all too often these two aspects are one and the same.

  40. Freelander
    September 22nd, 2009 at 11:12 | #40

    It is alway’s personal when someone is killing your intellectual baby.

  41. SIO
    September 23rd, 2009 at 16:24 | #41

    Alice, you are urgently required to collect a box delivered to the Student Information Office of the Faculty of Economics and Business (University of Sydney) a few days ago from ABOM with no details as to whom this is supposed to be forwarded to besides ‘Alice (John Quiggan (sic) Blogger). If the box is not collected by this Friday, it will be disposed of appropriately.
    the SIO team

  42. ABOM
    September 23rd, 2009 at 17:51 | #42

    SIO, start eating the fruit if Alice doesn’t collect it. Leave the tea for her though…

  43. Alice
    September 23rd, 2009 at 19:39 | #43

    SIO – ABOM – what on earth are you taking about??? – I cant get to Sydney Uni!! Im working at another campus (miles away). ABOM what have you done?
    ABOM – I would have had a better chance of getting it from UTS BUT I cant even get there till Friday. I swear ABOM – this better not be a hoax…. Who the hell is the SIO team? Listen SIO team – give me the number and Ill verify you are real. ABOM – if its fruit – they (SIO) should just eat it, and fast!

  44. Alice
    September 24th, 2009 at 08:04 | #44

    If there is any chocolates in that box dont you dare eat them SIO.

  45. Alice
    September 24th, 2009 at 09:38 | #45

    ABOM – Its OK. SIO are eating the fruit….

  46. Michael of Summer Hill
    September 24th, 2009 at 13:19 | #46

    John, according to Malcolm Turnbull the global financial crisis has promoted a resurgence in ‘democratic socialism’. I wonder why?

  47. September 24th, 2009 at 18:10 | #47

    Because people want simple, even simplistic, answers?

  48. Alice
    September 24th, 2009 at 21:50 | #48

    @Andrew Reynolds
    Andy – they want socialism, ie more regulation where it has been failing…like in the financial sector….it IS a democracy.
    They dont want simplistic answers like “if we do nothing and have no state regulation ..the world will be perfect”…that is simplistic Andy (your remedy..not what the people want).

  49. September 24th, 2009 at 23:20 | #49

    “your remedy”

    Is it because you like lying, or do you really believe this?

  50. September 25th, 2009 at 01:38 | #50

    Ahhh, Alice – so they want to be told what to do. They really are all sheep, aren’t they? They just want an easy life, being told what to do. That’s right.

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