OnthepropositionWeareallKeynesiansnow JohnH.Cochrane UniversityofChicagoBoothSchoolofBusiness March15th2009 NobodyisKeynesiannow,really.Keynesdistrustedinvestmentanddidntthinkaboutgrowth.Now, weallunderstandthatgrowth,fueledbyhigherproductivity,isthekeytoprosperity.Keynesandhis followersfamouslydidntunderstandinflation,leadingtothestagflationofthe1970s.Wenow understandthelinksbetweenmoneyandinflation,andthenaturalrateofunemploymentbelow whichinflationwillrise.Afewmonthsbeforehisdeathin1946Keynesdeclared1Ifindmyselfmore andmorerelyingforasolutionofourproblemsontheinvisiblehand[ofthemarket]whichItriedto ejectfromeconomicstwentyyearsago.Hisejectionattemptfailed:Weallnowunderstandthe inescapableneedformarketsandpricesignals,andthesclerosisinducedbyhighmarginaltaxrates, especiallyoninvestment.KeynesrecommendedthattheBritainpayfortheSecondWorldWarwith taxes.Wenowunderstandthatitsbesttofinancewarsbyborrowing,soastospreadthedisincentive effectsoftaxesmorebroadlyovertime.

. Really,theonlyremainingKeynesianquestionisaresurrectionoffiscalstimulus,theideathat governmentsshouldborrowtrillionsofdollarsandspendthemquicklytoaddressourcurrenteconomic problems.Weprofessionaleconomistsarecertainlynotallinfavour.Forexample,severalhundred economistsquicklysignedtheCATOInstitutesletter2opposingfiscalstimulus. Whynot?Mostofall,moderneconomicsgivesverylittlereasontobelievethatfiscalstimuluswilldo muchtoraiseoutputorlowerunemployment.HowcanborrowingmoneyfromAandgivingittoBdo anything?EverydollarthatBspendsisadollarthatAdoesnotspend.3ThebasicKeynesiananalysisof thisquestionissimplywrong.Professionaleconomistsabandonedit30yearsagowhenBobLucas,Tom SargentandEdPrescottpointedoutitslogicalinconsistencies.Ithasnotappearedingraduate programmesorprofessionaljournalssince.PolicysimulationsfromKeynesianmodelsdisappearedas well,andevenauthorswhocallthemselvesKeynesianauthorsdonotbelieveexplicitmodelsenoughto usethem.NewKeynesianeconomicsproducesaninterestinganalysisofmonetarypolicyfocusedon interestraterules,notaresurrectionoffiscalstimulus.
1

QuotefromDavidKynaston,AusterityBritainp.136. http://www.cato.org/fiscalreality

SeeFiscalStimulus,FiscalInflationorFiscalFallaciesat http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news,foradetailedexplanation.

Oursituationisremarkable.ImaginethatanaugustgroupofNobelprizewinningscientistsand governmentadvisersonclimatechangeweretosayYes,globalwarminghasbeenalltheragefor30 years,butallthesewhippersnapperswiththeirfancycomputermodels,satellitemeasurements,and stacksofpublicationsinunintelligibleacademicjournalshavelosttouchwiththerealworld.Westill believetheworldisheadedforaniceage,justasweweretaughtasundergraduatesbackinthe1960s. Whowouldseemoutoftouchinthatdebate?Yetthisisexactlywherewestandwithfiscalstimulus. RobertBarrosRicardianequivalencetheoremwasonenailinthecoffin.Thistheoremsaysthatstimulus cannotworkbecausepeopleknowtheirtaxesmustriseinthefuture.Now,onecanarguewiththat result.Perhapsmorepeopleignorethefactthattaxeswillgoupthanoverestimatethosetaxincreases. Butonceenlightened,wecannotignorethiscentralquestion.Wecannotreturntomechanically addinguptodaysconsumption,investmentandexportdemands,andprescribegovernmentdemand necessarytoattainsomedesiredlevelofoutput.Everyeconomistnowknowsthattogetstimulusto work,ataminimum,governmentmustfoolpeopleintoforgettingaboutfuturetaxes,anissueKeynes andKeynesiansneverthoughtof.Italsoraisesthefascinatingquestion,ifourKeynesianGovernment wantsstimulustowork,whyisitsoloudlyannouncinglargeanddistortionarytaxincreases? Thereislittleempiricalevidencetosuggestthatstimuluswillworkeither.Empiricalworkwithouta plausiblemechanismisalwayssuspect,andworkheresuffersdesperatelyfromthecorrelationproblem. Quackmedicineseemstowork,becausepeopletakeitwhentheyaresick.Wedoknowthreethings. First,countriesthatborrowalotandspendalotdonotgrowquickly.Second,wehavehadcredit crunchesperiodicallyforcenturies,andmostpassedquicklywithoutstimulus.Whetherthelong durationofthegreatdepressionwascausedorhelpedbystimulusisstillhotlydebated.Third,many criseshavebeenprecipitatedbytoomuchgovernmentborrowing. Neitherfiscalstimulusorconventionalmonetarypolicyexchanginggovernmentdebtformorecash diagnosesoraddressesthecentralproblem:frozencreditmarkets.Policyneedsfirstofalltofocuson thecreditcrunch.Rebuildingcreditmarketsdoesnotlenditselftoquickfixesthatsoundsexyinashort opedoraspeech,butthatistheproblem,sothatswhatweshouldfocusonfixing. Thegovernmentcanalsohelpbynotcausingmoreharm.Thecreditmarketsarepartlyparalysedbythe fearofwhatgreatplanwillcomenext.Whybuybankstockknowingthatthenextrescueplanwillsurely wipeyouout,andallthelegalrightsthatdefendthevalueofyourinvestmentcouldeasilybetrampled? Andthegovernmentneedstokeepitsfiscalpowderdry.Whenthecrisispasses,ourgovernmentswill havetotrytosoakupvastquantitiesofdebtwithoutcausinginflation.Themoredebtthereis,the harderthatwillbe. OfcoursewerenotallKeynesiansnow.Economicsis,oratleasttriestobe,ascience,notareligion. Economicunderstandingdoesnotlieinareturntoeternalveritieswrittendowninlong,convolutedold books,orinthewisdomoffondlyrememberedsages,whetherKeynes,FriedmanorevenSmithhimself. Economicsisaliveandactivediscipline,anditisnodisrespecttoKeynestosaywehavelearnedalotin 2

70years.Letsstoptalkingaboutlabelsandappealingtolongdeadauthorities.Letsinsteadapplythe bestofmoderneconomicstotalkaboutwhathasachanceofworkinginthepresentsituationandwhy. HereissomeKeynesianwisdomIthinkweshouldaccept: Thedifficultylies,notinthenewideas,butinescapingtheoldones,whichramify,forthosebrought upasmostofushavebeen,intoeverycornerofourminds. HowcanIacceptthedoctrine,whichsetsupasitsbible,aboveandbeyondcriticism,anobsolete textbookwhichIknownotonlytobescientificallyerroneousbutwithoutinterestorapplicationtothe modernworld. Practicalmen,whobelievethemselvestobequiteexemptfromanyintellectualinfluences,areusually theslavesofsomedefuncteconomist.