Reading Krugman's NYT Magazine article (it's long but well worthwhile to get all the way through) I also thought back to discussions I had in grad school. Didn't we talk about the idea that macroeconomics needs micro-foundations but not neoclassical ones? That seems to be the final message of Krugman (that salvation will come from behavioural finance). Another idea I recall vaguely from our discussions is that static maximization--which we use all the time in our micro models--is a decent approximation because people go to the grocery store over and over so they have time to learn... But dynamic optimization over person's lifetime--such as cutting back on spending now so that one can save to pay back expected tax obligations in the future--cannot be instilled by repetition and experience.
Noting that Krugman referred to Cochrane's claim that Keynesian ideas had been "proven false", I wanted to see what the proof was. Here is a link to his article on stimulus.
After reading Krugman and Cochrane, i felt baffled. These are not stupid people. Stupid people can't become full profs at Princeton and Chicago (can they?).
And yet. Each of them writes as if the other person were a complete moron, incapable of absorbing basic facts and theory.
now i feel like i'm the moron... since i can't really untangle this mess of arguments.
here's one idea i had: Compared to the standards of empirical evidence used in labour economics, macro still depends to an astonishing extent on a priori beliefs. Krugman dismisses modern macro because it's intuitively obvious to him that recessions aren't vacations and people just don't behave like Ricardian equivalence requires. Over and over in the article he dismisses their ideas not with statistical evidence but, well, with "dismissiveness."
On the other side, Cochrane doesn't seem to be moved by empirical evidence either. Instead he wants to build up models based on budget constraints ("the money has to come from somewhere"), forward-thinking behaviour, and the notion that government cannot fool people repeatedly. He doesn't actually prove anything false with evidence. Instead, like Krugman's blog entry criticizing Cochrane, he mainly accuses the other side of adhering to "fallacies."
Imagine that in labour economics one side said that the (productivity) return to education was actually zero because it is all just Spence signalling. And the other side said the return was equal to the interest rate because that is what dynamic optimization requires. We'd laugh and say, "look it's an empirical issue. let's just estimate the damn return."
But that's not what either Krugman or Cochrane seem to want to do. Indeed Cochrane tells us the govt spending multiplier is zero. And he refers to a blog entry by Mankiw. So i went to that entry and discovered that Mankiw says the best estimates of the multiplier put it at one or slightly over. OK to me these numbers don't make sense because the keynesian theory says the multiplier depends on the amount of slack in the economy, right? but anyway, my point is that macroeconomics not only needs new micro-foundations but it also needs to become evidence-based. but of course i know next to nothing about macroeconomics so you should have stopped reading this blog entry long ago...perhaps you did!
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