Thursday, July 03, 2014

Cochrane's thoughts on the recession and recovery



John Cochrane has a Wall Street Journal editorial in which he discusses the debate over the cause(s) of the recession. The editorial is generally critical of Keynesians, New Keynesians, and anyone who thinks that the slow recovery is a function of "demand":
Where macroeconomists differ, sharply, is on the causes of the post-recession slump and which policies might cure it. Broadly speaking, is the slump a lack of "demand," which monetary or fiscal stimulus can address, or one of structural sand-in-the gears that stimulus won't fix?  
The "demand" side initially cited New Keynesian macroeconomic models...If you look hard at New-Keynesian models, however, this diagnosis and these policy predictions are fragile...These problems are recognized, and now academics such as Brown University's Gauti Eggertsson and Neil Mehrotra are busy tweaking the models to address them...
In the alternative view, a lack of "demand" is no longer the problem...Where, instead, are the problems? John Taylor, Stanford's Nick Bloom and Chicago Booth's Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago's Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth.  
These views are a lot less sexy than a unicausal "demand," fixable by simple, magic-bullet policies. 
Why do people think that "demand" is the key to understanding recessions? I don't think it's just because "demand-side" solutions are easy or that a unicausal explanation is "sexy". I think it has to do with prices.

Draw a basic supply-and-demand graph, and you see that when you have a negative shock to demand, prices go down, and when you have a negative shock to supply, prices go up:



So if the whole economy behaves like a supply-demand graph, then a "demand-side" recession should see a drop in inflation, and a "supply-side" recession should see a rise in inflation. Here's a graph of core PCE inflation before and after the recession:



You can see that inflation not only plunged during the recession, but remained low after the recession. Thus, if you think of the economy as a supply-demand graph, then you would conclude that the slow recovery is related to decreased demand.

Now, of course, it's unlikely that the economy is as simple as an Econ 101 supply-and-demand graph. In modern macro models, there are rarely pure "supply shocks" or "demand shocks". But the intuition is still there. Consider Cochrane's proposed alternative reasons for the slow recovery: 1) policy uncertainty, 2) regulation and taxes, and 3) redistribution.

All of these things are basically impediments to the production process - i.e., they make it more costly to produce things. If workers are getting paid to sit around at home (by extended unemployment benefits), that should make wages go up, as businesses are forced to pay workers more in order to lure them back to work. If regulation is making it hard to do business, that should make costs go up. Etc.

Higher costs should get at least partially passed on to the consumer in the form of higher prices. Thus, you'd think that if the slow recovery were caused by structural impediments to business, we'd have seen higher inflation at some point in the last 5 years.

Now, it's possible to write down a macro model in which anticipation of higher costs tomorrow actually causes prices to go down today. In fact, for any X, it's probably possible to write down a modern macro model in which X happens. But this idea goes strongly against basic economic intuition. The Cochrane/Taylor/Mulligan/Prescott/Baker/Bloom/Davis thesis isn't obviously wrong, but it's obviously counterintuitive.

So that, I think, is the big reason why "demand-side" explanations for the slow recovery persist.

But there is also the issue of parsimony. Cochrane writes: "These [policy] problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth." I think people naturally see the recession and the recovery as one single phenomenon, and tend to prefer explanations in which there is only one cause for both. If you have two completely separate explanations - one for the recession and one for the slow recovery - you're adding a lot of free parameters to your model. In general, model complexity should be penalized, as with some sort of information criterion. So that's another reason I think people are skeptical of the Cochrane/Taylor/Mulligan/Prescott/Baker/Bloom/Davis thesis.

37 comments:

  1. It could be revealing to see job recovery rates vs inflation rate at onset of recessions, under the presumption the lower inflation the slower the recovery.

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  2. Anonymous11:59 PM

    After being so thoroughly (and rudely) roasted in public by Krugman, Cochrane will never admit any form of Keynesian approach to the economy is right, even if the heavens opened and voice of the economics god rang from horizon to horizon that it was so. Given how this op-ed paints a giant bullseye on Cochrane's head, I fully expect another withering, on-target (and rude) fusillade from Krugman over this, which will only harden the resistance of both sides to consider the others' position.

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  3. Anonymous12:12 AM

    The recovery reminds me alot of the 90's recovery. Slow and steady. The bigger gap has created a longer recovery cycle, but when you adjust for demographics and secular trends in the economy, employment growth is running at the same speed. The 90's was the blowoff of the "mall economy" before the internet changed retail.

    Alot more "part time" temp jobs that are really benefitless full time jobs but aren't counted that way in manufacturing.

    The stock market has had alot of investment from capital to boost the economy. Very similiar to the 90's. Now we just need to create another Y2K crisis to keep business investment heightened later in the cycle lol.

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  4. I think we have to be careful when we apply Marshall's (partial equilibrium) scissors to understand the macroeconomy. I have a hard time distinguishing between supply and demand in GE (everything is interconnected).

    Consider, for example, a "bad news shock" that causes investors to revise downward their forecast of the after-tax return to investment. The demand for investment will decline. But the shock is something that affects expected supply conditions (e.g., future TFP). Btw, we can show that such a shock is deflationary. Does it really matter how we label these shocks--supply vs. demand? The question is what to do about it. It doesn't help by just pointing out that "demand seems to be low." We need to know why "demand" (or whatever) is low. It does not follow that just because it is low that the remedy is an increase in G, which is what a lot of people seem to think, primarily because that is what most people learn in Econ 101.

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    1. I think we have to be careful when we apply Marshall's (partial equilibrium) scissors to understand the macroeconomy. I have a hard time distinguishing between supply and demand in GE (everything is interconnected).

      Consider, for example, a "bad news shock" that causes investors to revise downward their forecast of the after-tax return to investment. The demand for investment will decline. But the shock is something that affects expected supply conditions (e.g., future TFP). Btw, we can show that such a shock is deflationary. Does it really matter how we label these shocks--supply vs. demand?


      I tried to point all these things out in my post. My point was just about intuition, which I think still comes from the Marshallian stuff.

      Out of curiosity, which news shock model are you thinking of? Jaimovich & Rebelo 2006?

      The question is what to do about it. It doesn't help by just pointing out that "demand seems to be low." We need to know why "demand" (or whatever) is low. It does not follow that just because it is low that the remedy is an increase in G, which is what a lot of people seem to think, primarily because that is what most people learn in Econ 101.

      I agree.

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    2. Anonymous4:17 AM

      Good script for a Science Fiction film.

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    3. The narrative that I find not to be counterintuitive is that demand is low because the housing bubble popped.

      http://www.cepr.net/index.php/blogs/beat-the-press/robert-samuelson-wants-people-to-be-unemployed-the-economics-of-the-economics-of-the-great-recession

      http://krugman.blogs.nytimes.com/2014/07/01/learned-macroeconomic-helplessness/

      -------------------

      The remedy doesn't have to be only an increase in G however government borrowing costs are low and there is much in the way needed infrastructure repair. Certainly this isn't the time to cut G and fire teachers and police officers. The Fed can help spur private investment via interest rates and the government can boost exports via the exchange rate. Once the shortfall in demand is gone; the economy is booming and inflation is rising, the Fed can raise rates and government can reduce spending and pay down the debt, saving for a rainy day like the next bubble/financial crisis where it needs to bail out the *entire* financial sector.

      Given the evidence of the housing bubble, the private sector isn't the best at allocating investment.

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    4. As Krugman points out in the link there's also debt restructuring. There's reason we have bankruptcy laws. The RTC that was set up to help sort out the savings and loan crisis helped the economy. They failed to do that this last go around.

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    5. "The narrative that I find not to be counterintuitive is that demand is low because the housing bubble popped."

      So, you must have had a friend or two with a HELOC.

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  5. Anonymous1:07 AM

    This makes more sense than anything I've heard from the Cochranes and Prescotts of the world:

    http://www.cepr.net/index.php/blogs/beat-the-press/robert-samuelson-wants-people-to-be-unemployed-the-economics-of-the-economics-of-the-great-recession

    MDZX

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  6. Who needs free parameters when you can just use intuition and toy models that ignore observables like credit creation?

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  7. Expanding on David Andolfato's points: Micro 101 supply and demand logic is all about relative prices. The core theory of the medium and long run underlying most Keynesians is also about relative prices (examine any RBC model or deterministic neoclassical growth model if you prefer). It doesn't say anything about the aggregate price level or nominal quantities.It only says that if you have certain types of shocks making it harder for firms to produce and sell stuff (be they regulation, uncertainty about revenue, higher matching frictions or just greater rational or irrational pessimism by firms) then the relative price of workers and (the wage) and other production input prices should be below trend (run a TFP or a labor demand wedge shock simulation in a typical RBC model). The only requirement imposed by the core flex price/wage theory of the medium/long run is the Fisher equation so that if market forces push for a certain equilibrium real interest rate and the central bank controls the nominal rates, then this determines inflation expectations eventually. So if the central bank is convinced it has to keep on holding interest rates low forever and ever, you can have all sorts of supply side issues constraining the economy but you'll still have low inflation going forward (see Japan in the last 20 years or so).
    And the Phillips curve underlying the AS/AD diagram in output/aggregate price level space that you've taken from macro 101 is subject to all sorts of econometric/empirical problems. Maybe this stuff is counterintuitive. But hey, macro or general equilibrium can be quite confusing and realistically expectations on these things can deviate from rationality quite a lot if you just rely on macro/micro 101 education (smart people using rational expectations have probably figured out long ago that many of the shocks needed to fit the time series in something like the Smets Wouters model are probably just proxies for expectational biases/irrational market sentiment- not that different from old style macro model and the shocks in their equations in the end?).
    In short, macro AS/AD logic isn't the same as supply and demand logic from micro.

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  8. Too much money chasing too few goods; too much money not chasing too few goods; too much money chasing plenty of goods; too much money not chasing plenty of goods.
    Not enough money, repeat as above?

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  9. The President of the St. Louis Fed attributes the slow recovery to the Fed's "optimal" monetary policy:

    https://www.stlouisfed.org/publications/re/articles/?id=2278

    That is, rapid recoveries from a major financial crisis are supposedly bad for the economy, and the Fed has wisely steered us away from such "disconcerting dynamics".

    (I haven't noticed anyone else picking up this train of thought, since evidently it holds little appeal for either liberal "demand siders" or conservative "supply siders").

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  10. This comment has been removed by the author.

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  11. Anonymous5:54 AM

    demand needs money. thats why negative yield curve predicts recessions.

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  12. foosion6:01 AM

    Uncertainty is a wonderful explanation. Given that there's always uncertainty and that there's no good quantification, it can explain everything and can be used as a policy justification for anything. Things I like reduce uncertainty, things I don't like increase uncertainty. Who needs models when I can just ask myself what the issue in question
    does to uncertainty.

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    1. Anonymous8:12 AM

      http://mrzine.monthlyreview.org/2010/kalecki220510.html

      Yep...

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    2. foosion, I made a similar comment on Cochrane's blog (although I like the way you put it better).

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    3. And who has been working hard to create as much uncertainty as possible? Apparently he has already forgotten.

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  13. Noah, what do you think of David Glasner's criticism of Cochrane's piece?

    http://uneasymoney.com/2014/07/02/john-cochrane-on-the-failure-of-macroeconomics/

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  14. Cochrane:

    "These views are a lot less sexy than a unicausal "demand," fixable by simple, magic-bullet policies. They require us to do the hard work of fixing the things we all agree need fixing: our tax code, our cronyist regulatory state, our welter of anticompetitive and anti-innovative protections, education, immigration, social program disincentives, and so on. They require "structural reform," not "stimulus," in policy lingo. "

    "our welter of anticompetitive and anti-innovative protections," Is this the new Orwellian rebranding of "regulations?"

    Part of the cause of the recession was the success the Cochranes of the world had in pushing deregulation. The rating agencies didn't do their job and gave toxic mortgage backed securities AAA ratings. Mortgage companies were able to push NINJA loans on people who couldn't afford them, etc.

    A "competitive" - i.e. providing higher returns - unregulated shadow banking system arises which is subject to a bank run since it isn't regulated and doesn't have FDIC backing. Lo and behold it does suffer a bank run. See Gary Gorton.

    It's as if Cochrane totally forgot what happened. It's a weird case of amnesia. They argue "our welter of anticompetitive and anti-innovative protections" stifle growth but we've had 40 years of the right successfully pushing Cochrane's policy agenda and the results are low growth and rising inequality. Even Clinton moved the democrats to the right with "free trade," welfare reform and cuts on capital gain taxes, etc. The definition of insanity is doing the same thing over and over again and expecting different results. The manifestation of insanity is the Tea Party.

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    1. I am waiting to hear Cochrane and John Taylor on Yellen's comments on Macroprudential policy. I'd imagine they'll say it creates uncertainty and is "anticompetitive."

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    2. Anonymous3:41 PM

      the last 30 years have been a great time for the Cochrane's of the world. His taxes keep getting cut and the goods he can purchase with a wage permanently fixed thanks to his guild-like employment allows him to buy a wider variety of goods. Now if only those underclass yobs would respect his wisdom and stop whining about inequality he'd live in paradise.

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  15. I gain the sense that you think they are partly (but not completely) right, but cannot see how to show that the recession and recovery are not one phenomenon in a good way - and that the different reasons are not theirs.

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  16. What if AD is flat?

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  17. Replies
    1. Here's the correct link:

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/07/insufficient-demand-vs-uncertainty.html

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  18. Both Cochrane and the Keynesians fall into the trap of thinking that GDP numbers of 2007 were real and sustainable. In truth the "boom" of 2007 was part accounting fraud, part household deficits enabled by the housing boom.

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  19. I think you badly muddled the issue by including the disinflation during the recession as if it supported your argument. Demand always drops during recessions, even supply-shock recessions. This was of course primarily a credit excess cum financial crisis recession, but the oil price surge did make it worse.

    If you had stuck to the recovery era, your argument would make some sense. There was clearly less strong demand growth after the recession than before it, and no evidence of supply constraint.

    But ... so what? Is anyone, even Cochrane, saying that the recovery has been slow because supply has been constrained? I don't buy his claims about regulation, taxes, redistribution and policy uncertainty at all. But if they were true, why would inflation rates have looked any different than they have? You seem to fundamentally misunderstand what any variety of supply-side economics says about a slow-growing economy. The core message is about innovation and productivity drivers.

    You seem to be putting yourself in the simplistic Krugman / DeLong sort of Keynesian camp who don’t understand why the argument isn’t over after they’ve pointed out that we could have higher GDP if we borrowed and spent more. People want to know where the productivity growth is going to come from to justify the debt.

    I would be more sympathetic to someone further left with a New Deal style plan to launch a federal re-employment agency that would hire people and try to prepare them for private employment. Obviously not politically possible in this country, but it would have made great sense in 2009, I think. The Keynesian solution turned into a mix of public works, naive attempts to support favored industries, and tax cuts and rebates. It was a very poorly directed stimulus.

    I also have great sympathy for European welfare states, who, let’s face it, have their acts together better than ours in so many ways, especially health care. But they also have chronically higher unemployment and grow more slowly. They’ve been turning towards supply-side economics in their efforts to revive growth, and I’m certain that will continue, despite the leftward swing after the 2011 crisis.

    But not only does that model come with many trade-offs, including much higher costs, it’s just not politically possible here. Ds should have learned their lesson from 2010. Middle America doesn’t believe in borrowing our way to recovery, and pushing too hard on that only cost the Ds the House. Now it’s going to be almost impossible to win it back again without a substantive retreat from leftism to Clinton liberalism. And I don’t mean Hillary.

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  20. Bill Ellis9:51 PM

    People need to see John Cochrane's "argument" for what it is. It is not really an econ argument at all...it's a political attack on the legitimacy of Obama's presidency.

    When Cochrane evokes the absence of the confidence fairy and then blames it on Obama, implying that his actions are somehow outside of the rules that governed past Presidents * (otherwise we would have always have had the same kinds of troubles )...he is supplying "intellectual" cover for every wingnut from the birthers to our Speaker of the House. Speaker Boehner said that the reason the republicans won't pass laws is because they can't trust Obama to administer them properly...implying that Obama is constantly violating the Constitution.

    From the beginning of Obama's presidency there has been an effort to delegitimize him. To delegitimize Obama the right holds him to a higher/different standard than all our other modern presidents. To do this they have to ignore history. They have to forget about Reagan's Beirut while having a 24/7 "two minutes hate" over Obama's Benghazi; or in Cochranes' case, pretend that Obama is an extraordinarily activist and aimless president.

    * "John Taylor, Stanford's Nick Bloom and Chicago Booth's Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? "

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  21. Anonymous3:31 AM

    Tolstoy said it best:

    I know that most men, including those at ease with problems of the greatest complexity, can seldom accept even the simplest and most obvious truth if it be such as would oblige them to admit the falsity of conclusions they have reached perhaps with great difficulty, conclusions which they have delighted in explaining to colleagues, which they have proudly taught to others, and which they have woven, thread by thread, into the fabric of their lives.

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  22. Excellent post as usual. I would add a few things. Things which cause low investment should cause low stock prices. However, stock market indices recovered very dramatically. I think this is a very serious problem for Cochrane. Overall investment is low. However, equipment investment recovered pretty much normally.

    Cochrane needs a story about why uncertainty causes low housing investment but not low equipment investment.

    On transfers and social welfare generally, there has been a huge huge shift from benefits for the non employed (AFDC etc) to the EITC. This should have caused an increase in labor supply. The temporary partial payroll tax holiday should have reduced labor costs.


    As you note, extended unemployment benefits cause low output via high wages (or a high vacancy rate). Wage growth and the job vacancy rate have been low. Taxes come onnnnn. A top rate of 91% wasn't a huge problem in the 50s. The ratio of corporate income tax actually paid to profits (or GDP or anything) has declined dramatically. The story absolutely doesn't fit the data at all. I note Cochrane doesn't mention unions (which are now pretty much irrelevant in the private sector). They were powerful from the late 30s thorugh the 70s. According to Cochrane's world view, their decline should have caused more rapid growth. Omitting all mention of unions is an clumsy effort to cherry pick variables to fit a story. Ending up with taxes shows just how clumsy this is. The idea that the problem compared to the good years (march 1933-1969) is high taxes could not occur to any reality based economist.

    You are very polite and kind to Cochrane. That is admirable. I sure can't manage it.

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  23. I think a math model will not be able to include every factor and produce a useful story. Here is an animated compartment model, instead:

    https://www.youtube.com/watch?v=-Sm5nVAr4FY

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  24. Forgive me as I am not an economist, but I don't really see the downside of not going all in with Keynes. The worst case is some additional debt, some nice new infrastructure, some happier people with jobs and a positive attitude that WE really tried. Only a bozo would think that spending on recovery is not for a better cause than what we've wasted money on or underfunded before.

    Most of our current debt was purposefully created for political purposes or due to the implosion of the Great Recession. Anyone care to justify the Laffer curve? We've created a lot of debt based on that BS. What a joke. Anyone care to argue that Iraq war debt was worth it as we watch that country fall apart? We should've taken a WWII attitude toward this recession. Terminate the Axis and worry about the debt later. P.S. we were deeper in debt as a percentage then and we dealt with the debt just fine.

    I find Cochrane's regulation argument to be silly. Regulations codify that we are in a Democracy. You don't throw them away for economic efficiency. Additionally, would anyone care to argue that we weren't a few regulations short when it comes to the recession itself?

    I find that things have been more certain politically since 2010 than any other time in my life. Gridlock.

    As for redistribution being only bad, that's yet another joke that subverts Democracy and smears Americans. A pay raise solves redistribution. But, those "lazy ass" Americans are simply too willing to work for those crappy wages. So, those that pay taxes subsidize lower prices at restaurants and Wal*Mart. Never mind that carry forward interest, as one example, works in the other direction. How much you want to bet that Cochrane wasn't talking about that kind of redistribution?






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  25. Noah--You drew agg supply and demand on a chart with Q on the X axis and P on the Y axis, then you took it to the data by acting as if inflation is on the Y axis instead. The graph predicts FALLING prices during a demand shock, while the data show prices rising slowly. This is not to say that positive inflation necessarily supports the supply-side explanation; but clearly we need a dynamic model if we're going to use inflation as an indicator of what's going on. Putting up an AD/AS chart doesn't really score any points against Cochrane.

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    1. A) I don't think "scoring points against Cochrane" was my goal, and

      B Just detrend... ;-)

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