The Cochrane Debate

A few days ago I debated the famous John Cochrane on monetary policy. (No, not the “if the glove don’t fit . . . ” Johnnie Cochran, rather the University of Chicago professor.) He seemed to go easy on me, perhaps because I was from a small school. So it was a pleasant debate. But we certainly found many points where we disagree. I probably talked too much. Here is the link.

I can’t bear to watch myself, so I’ll rely on memory. There seemed to be three areas where Cochrane had trouble accepting my views:

1. He couldn’t understand how I could claim monetary policy was “tight” last fall.

2. He was skeptical that the Fed could do much to create inflation, at least if its tools were restricted to things like setting an explicit inflation target, negative rates in ERs, and quantitative easing. He does believe that a combined fiscal/monetary “helicopter drop” could get the job done. And I recall that his first choice was having the Fed buy riskier assets.

3. He also worried about overshooting toward high inflation.

It’s hard to make complex points in a debate format (or at least it’s hard for me), so I’ll try to briefly sketch out what I tried to say.

I am pretty sure that fiscal theorists like Cochrane have the same basic view of commodity regimes as I do. Thus FDR’s dollar depreciation program was a “foolproof” way out of the liquidity trap, because it directly reduced the value of the dollar against a real good, by essentially changing the definition of the dollar (from 1/20.67 oz of gold to 1/35 oz of gold.)

The question is whether we can do the same under a fiat money regime. Suppose we devalue the dollar against basket of commodities? That’s essentially no different from devaluing against gold, and so I presume Cochrane would accept the effectiveness of that idea as well. We can’t construct a “spot market” for all the goods and services in the CPI, because the values are only know with a lag, and the goods are not easily stored and traded. But both of those problems vanish if we peg a futures contract linked to the CPI. That would work much like a gold standard except that it would stabilize the future expected CPI, rather than the current price of just one good. And again I am pretty sure that Cochrane would agree that that might work. But even that sort of radical regime change is probably too much for the Fed to do right now. So does the Fed have any practical options?

My argument is that they could simply commit to a well-defined target path for the price level, or better yet NGDP. Cochrane seemed to agree that level targeting was better than rates of change. The usual argument for level targeting is that it stabilizes expectations better. So if we briefly fall below target, investors will then expect a fast “catch-up period,” which will help to boost AD right now. But I seem to recall Cochrane was a bit skeptical of whether this sort of Fed promise would be credible.

I really don’t see why a Fed promise for modest inflation wouldn’t be credible. Has there ever been a situation where a central bank promised to inflate and wasn’t believed? And don’t say Japan, because the BOJ never made that promise.

I don’t get out much, and I think over the years I developed a certain naivete about the state of modern macro. I read all these foolproof plans for escaping a liquidity trap by big names like Woodford, Svensson, McCallum, Mishkin, and yes even Bernanke, and just assumed that these published papers were now the start of the art view of the profession. So I was really shocked when this crisis hit to find that most economists still had the simple Keynesian “pushing on a string” view of monetary policy at zero rates, and that they therefore believed that we now needed to rely on fiscal policy.

[By the way, Cochrane does not have that simple-minded view. He also opposes fiscal stimulus, and would prefer that any stimulus involve unconventional monetary policy (such as a Fed policy of buying riskier assets.) So we are actually not that far apart. But I don’t think they even need to buy risky assets.]

Well, I have learned a lesson; just because the textbooks say that monetary policy can be highly effective in a liquidity trap, doesn’t mean that the economists who teach out of those books believe it. And exactly the same applies to the question of how to define the stance of monetary policy. In a previous post I mentioned Joan Robinson’s silly claim that money couldn’t have been expansionary in the German hyperinflation, as interest rates weren’t low. Laugh all you want, but you can’t imagine how often I have heard people say monetary policy couldn’t have been tight last year, because interest rate did fall to low levels.

I suppose some might defend their views by saying that Robinson didn’t understand the Fisher effect, and we now have a more sophisticated view that focuses on real interest rates. But that explanation won’t work, for two reasons. First, a contractionary monetary policy can actually reduce real rates, by dramatically lowering real growth expectations. But more importantly, the only objective estimate of real interest rates that we have—the TIPS spread—soared much higher late last summer and into the fall. So if the response to Robinson is that we should look at real rates, then why aren’t economists looking at real rates? When they do, they usually seem to mention backward-looking real rates, when what we need is (ex ante) forward-looking real rates.

Other economists would point to the big rise on the monetary base, but Friedman and Schwartz showed that that indicator was equally unreliable when people and banks are hoarding base money during a deflation and/or financial crisis. Cochrane did understand this problem, and I believe he mentioned that the monetary aggregates have also gone up in the last year. But even that won’t work. The lesson of the 1980s is that even the monetary aggregates are extremely unreliable indicators of the stance of monetary policy. So what is left? I say the only sensible indicator is Svensson’s idea of the forecast of the policy goal variable. But most economists seem to feel that the right indicator of the stance of monetary policy is something like “whatever my gut instinct tells me after I look at a few indicators like interest rates and the base.” I find that attitude very discouraging. And this is something on which I think Cochrane and I can agree. He puts it much more eloquently in a recent paper on the crisis:

Some economists tell me, “Yes, all our models, data, and analysis and experience for the last 40 years say fiscal stimulus doesn’t work, but don’t you really believe it anyway?” This is an astonishing attitude. How can a scientist “believe” something different than what he or she spends a career writing and teaching? At a minimum policy-makers shouldn’t put much weight on such “beliefs,” since they explicitly don’t represent expert scientific inquiry.

Others say that we should have a fiscal stimulus to “give people confidence,” even if we have neither theory nor evidence that it will work. This impressively paternalistic argument was tried once with the TARP. Nobody could say how it would work in any way that made sense, but it was supposed to be important do to something grand to give people “confidence.” You see how that worked out. Public prayer would work better and cost a lot less. Seriously, as social scientists, economists don’t have any special expertise to prescribe what intrinsically meaningless gestures will and will not give “confidence,” so there is no reason for anyone to listen to our opinions on that score.

“Well,” I’m often asked, “we have to do something. Do you have a better idea?” This is an amazingly illogical question. If the patient has a heart attack, and the doctor wants to amputate his leg, it’s perfectly fine to say “I know amputating his leg is not going to do any good,” even if you don’t have a five-step plan to cure heart attacks. As a matter of fact, as above, there are perfectly good answers to this question, but even if there were not, it simply makes no sense to “do something” that you know won’t work. One of the most important things that scholars can do is to explain ignorance. I often say “I don’t know, but I do know with great precision why nobody else knows either.” Ninety percent of good economic policy is, “first, do no harm.”

When I read this I found it very inspiring. It was great to see another economist make a heartfelt plea to rely on reason, not instinct. How ironic then that Krugman of all people accused Cochrane of going back to a “Dark Age of macroeconomics”. (Krugman doesn’t seem to have read the second half of the paper, where Cochrane relaxes the constant velocity assumption.) If one substitutes “interest rate indicator of monetary policy” or “monetary ineffectiveness” for “fiscal stimulus” in the first paragraph of the quotation, then you pretty much have my view of the whole mess. The economics mess, and the mess within macroeconomics.

Indeed my only objection to Cochrane is that as rigorous as he is, he is not quite rigorous enough. I don’t like hearing him say that although markets indicate low inflation, he is worried about the risk of high inflation. Good University of Chicago economists don’t make predictions, they infer market predictions.

PS. I’ve tried to be fair in this post, but I am 99% sure I misinterpreted Cochrane on at least one or two points. I will email him this post and make appropriate corrections in an update.

Update: After posting this I realized that Krugman’s “Dark Ages” metaphor could be turned on its head. Remember those medieval monasteries in England and Ireland, perched on a rocky islet in storm-tossed seas? The ones that kept the tradition of classical learning alive during the long Dark Ages. Which university played that role during the long dark period in the mid-twentieth century? Who continued to keep classical economic ideas alive while governments were socializing investment? Who preserved models that the world could turn to when it woke from its horrible statist nightmare around 1980? Wasn’t it John Cochrane’s university, perched on the shores of a cold Great Lake?

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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