DeLong does not understand what Cochrane is claiming

Brad DeLong has a criticism of John Cochrane's post, which I linked to earlier on here. I think he's missing Cochrane's point. DeLong writes:

"I had thought that we had gotten John Cochrane to admit that the national income identity was not a behavioral relationship--that when the government spent money there was no necessity (or even likelihood) that the people who would eventually pay the taxes to ultimately redeem the debt issued by the government to fund its spending program immediately cut back on their spending by as much as the government increased its. But here we have Cochrane again expressing what sounds a lot like the totally-wrong British Treasury view of the 1920s, again expounding what I call Eugene Fama's fallacy."

Brad is right that the British Treasury view of the 1920s is wrong, but that's not quite what Cochrane is getting at. Cochrane is addressing much the same point that Krugman does in this post: proper specification of the counter-factual in state-level multiplier studies. Take the Nakamura and Steinsson (2011) paper that Cochrane is discussing in the post. They look at military (i.e. - federal) expenditures at the state level to estimate a multiplier. That's not a bad thing to start with. Barro, Ramey, and many others work with military expenditures because they have a better chance than most kinds of spending to be uncorrelated with macroeconomic conditions. But there's a crucial identification problem associated with doing this at the state-level.

Let's start with the theory of the multiplier. What is the biggest reason why we Keynesians don't advocate spending trillions and trillions of dollars in stimulus every single year - depression or no depression? A simple Keynesian cross alone would make that look pretty appealing, would it not? But we don't. Why? Crowding out of private investment and consumption. Brad DeLong and I agree that crowding out is a red herring right now, in this liquidity trap, but we also both agree that it's a real concern in normal circumstances. That's why we're demanding a trillion dollar stimulus in 2008 and 2009 but not 2004 and 2005.

Nakamura and Steinsson use data from 1966 to 2006 - a period when I think Brad would agree with me there was a real issue with crowding out. Looking at this at the national level, like Barro and others, would allow the crowding out to be captured in the multiplier estimate produced. And - no surprise to me - Barro finds relatively low multiplier estimates. It makes sense. We weren't in a liquidity trap, and some of the biggest instances of military spending (Vietnam) came at a time of full employment. I would be surprised if Barro didn't produce relatively small multipliers.

Any crowding out in the Barro analysis is going to reduce the multiplier estimate. That's exactly what we want as empiricists - we want to know how bad of a problem crowding out is. Nakamura and Steinsson's analysis is different. Since taxes and crowding out of private investment to finance military expenditures are going to be spread out across all states, when Nakamura and Steinsson compare low military spending states to high military spending states their counter-factual group (the low military spending states) are going to bear a portion of the costs of the military spending in the treatment group (the high military spending state). Unlike Barro and Ramey and that work, this biases the multiplier estimates upward.

I don't know if Cochrane holds the "Treasury view" for the current downturn or not. I do know that his critique of the Nakamura and Steinsson paper on empirical grounds is solid, and you can agree with him on that without holding the "Treasury view" (I don't hold the Treasury view after all - I don't think massive fiscal stimulus right now would result in much crowding out).

Regular commenter Andrew Bossie thinks these state level analyses still have value. I can sympathize with that. I don't want to impugn the people that worked hard on these studies, and it's true we don't have a ton of options in macroeconomics. But I do think a big, dark, nasty shadow of dubiousness should be cast over state-level analyses. And personally, I really, really hate arguing for a policy based on an upper bound estimate. I'd much rather argue for a policy based on a lower bound estimate, with lots of good reasons for thinking the multiplier could actually be higher.

Not all state-level analyses are upper bound estimates. There are many that are biased downward. Think about the studies that use any sort of spending that originates in the state itself. I think Andrew himself (or maybe someone else?) once showed me a doctoral dissertation that used windfall increases in pension fund investments as an instrument - that would be one could example and a contrast to the military spending that originates at the federal level. These studies are probably going to produce multipliers that are biased downwards because commerce across state lines is going to dissipate any aggregate demand boost (while international trade penetration is not particularly high in the U.S., we exchange a lot across state lines). In Nakamura and Steinsson, it was the cost of crowding out that leaked across state lines. In studies of spending that originates within a state, it is the benefit of the demand boost that leaks across state lines. I'd much rather have a multiplier from these studies that's modest but that I can stand firmly on than a multiplier from the other studies that's huge and that I have doubts about.

This stuff matters. If we're not going to do empirical economics right, what the hell is the point of doing empirical economics?

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BTW - similar issues abound in the literature on the impact of various labor market policies. If you don't specify your comparison group carefully, you may be counting displacement of comparison group workers in the counterfactual, thus biasing your estimates upward. I think I have a neat work-around to this problem in an evaluation of job creation tax credit that I'm working on - I'm hoping to get a lot done on it over spring break, so maybe I'll have more details on that soon.