The tiny little problem with Chicago economics

29 May, 2016 at 13:22 | Posted in Economics | 6 Comments

Savings-and-InvestmentsEvery dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of “crowding out” is just accounting, and doesn’t rest on any perceptions or behavioral assumptions.

John Cochrane

And the tiny little problem? It’s utterly and completely wrong!

What Cochrane is reiterating here is nothing but Say’s law, basically saying that savings are equal to investments, and that if the state increases investments, then private investments have to come down (‘crowding out’). As an accounting identity there is of course nothing to say about the law, but as such it is also totally uninteresting from an economic point of view. As some of my Swedish forerunners — Gunnar Myrdal and Erik Lindahl — stressed more than 80 years ago, it’s really a question of ex ante and ex post adjustments. And as further stressed by a famous English economist about the same time, what happens when ex ante savings and investments differ, is that we basically get output adjustments. GDP changes and so makes saving and investments equal ex ost. And this, nota bene, says nothing at all about the success or failure of fiscal policies!

Government borrowing is supposed to “crowd out” private investment.

william-vickrey-1914-1996The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

In a lecture on the US recession, Robert Lucas gave an outline of what the new classical school of macroeconomics today thinks on the latest downturns in the US economy and its future prospects.

lucasLucas starts by showing that real US GDP has grown at an average yearly rate of 3 per cent since 1870, with one big dip during the Depression of the 1930s and a big – but smaller – dip in the recent recession.

After stating his view that the US recession that started in 2008 was basically caused by a run for liquidity, Lucas then goes on to discuss the prospect of recovery from where the US economy is today, maintaining that past experience would suggest an “automatic” recovery, if the free market system is left to repair itself to equilibrium unimpeded by social welfare activities of the government.

As could be expected there is no room for any Keynesian type considerations on eventual shortages of aggregate demand discouraging the recovery of the economy. No, as usual in the new classical macroeconomic school’s explanations and prescriptions, the blame game points to the government and its lack of supply side policies.

Lucas is convinced that what might arrest the recovery are higher taxes on the rich, greater government involvement in the medical sector and tougher regulations of the financial sector. But – if left to run its course unimpeded by European type welfare state activities -the free market will fix it all.

In a rather cavalier manner – without a hint of argument or presentation of empirical facts – Lucas dismisses even the possibility of a shortfall of demand. For someone who already 30 years ago proclaimed Keynesianism dead – “people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another” – this is of course only what could be expected. Demand considerations are simply ruled out on whimsical theoretical-ideological grounds, much like we have seen other neo-liberal economists do over and over again in their attempts to explain away the fact that the latest economic crises shows how the markets have failed to deliver. If there is a problem with the economy, the true cause has to be government.

Chicago economics is a dangerous pseudo-scientific zombie ideology that ultimately relies on the poor having to pay for the mistakes of the rich. Trying to explain business cycles in terms of rational expectations has failed blatantly. Maybe it would be asking to much of freshwater economists like Lucas and Cochrane to concede that, but it’s still a fact that ought to be embarrassing. My rational expectation is that 30 years from now, no one will know who Robert Lucas or John Cochrane was. John Maynard Keynes, on the other hand, will still be known as one of the masters of economics.



  1. Could you please correct the link to Lucas’ lecture? It doesn’t show the pdf. Thanks.

    • Thanx 🙂 It’s Lucas’ 2011 “Milliman Lecture in Economics”

  2. A model of 20 agents calculated on pen and papper would show problems with the idea that savings always are equal to investmens. In an ABM model the transfer between parties could be incorporated with very basic maths/rules system.
    I think chicago school of economics are using the wrong tool for the job.

  3. Has anybody found a link to Lucas’s 2011 Millman lecture?

  4. Public sector dissaving results in private sector savings. Overall savings a wash.
    No crowding out.

  5. When Cochrane says its just accounting he is referring to :

    Investment = Saving
    Investment = Private Saving + Public Saving
    Hence when Public Saving goes down (a deficit) , Investment would appear to go down – all else equal. This is the Cochrane – Eugene Fama Position.
    However, when Public Savings goes down, Private Saving goes up:
    From above: Private Saving = Investment minus Public Saving or, equivalently
    Private Saving = Investment plus Public Deficit/
    In words, Private Savings is the sum of the savings created by investment plus
    the public deficit. This savings ultimately takes the form of Treasury securities in the U.S.
    So deficits increase private saving and leave investment unchanged. Public sector dissaving keeps the identity investment = savings intact.

    To Prof. Cochrane: It’s just accounting..

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