I’m pretty late getting to this Wall Street Journal op-ed by John Cochrane (here’s an ungated version), and Noah Smith has already given it an admirable working over, but, even after Noah Smith, there’s an assertion or two by Cochrane that could use a bit of elucidation. Like this one:
Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.
Noah seems to think this is a good point, but I guess that I am less easily impressed than Noah. Feeling no need to provide citations for the views he attributes to Keynesians, Cochrane does not bother either to tell us which Keynesian has asserted that the zero lower bound creates the danger of a deflationary spiral, though in a previous blog post, Cochrane does provide a number of statements by Paul Krugman (who I guess qualifies as the default representative of all Keynesians) about the danger of a deflationary spiral. Interestingly all but one of these quotations were from 2009 when, in the wake of the fall 2008 financial crisis, a nasty little relapse in early 2009 having driven the stock market to a 12-year low, the Fed finally launched its first round of quantitative easing, the threat of a deflationary spiral did not seem at all remote.
Now an internet search shows that Krugman does have a model showing that a downward deflationary spiral is possible at the zero lower bound. I would just note, for the record, that Earl Thompson, in an unpublished 1976 paper, derived a similar result from an aggregate model based on a neo-classical aggregate production function with the Keynesian expenditure functions (through application of Walras’s Law) excluded. So what’s Keynes got to do with it?
But even more remarkable is that the most famous model of a deflationary downward spiral was constructed not by a Keynesian, but by the grandfather of modern Monetarism, Irving Fisher, in his famous 1933 paper on debt deflation, “The Debt-Deflation Theory of Great Depressions.” So the suggestion that there is something uniquely Keynesian about a downward deflationary spiral at the zero lower bound is simply not credible.
Cochrane also believes that because inflation has stabilized at very low levels, slow growth cannot be blamed on insufficient aggregate demand.
Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”
Except that, since 2009 when the threat of a downward deflationary spiral seemed more visibly on the horizon than it does now, Krugman has consistently argued that, at the zero lower bound, chronic stagnation and underemployment are perfectly capable of coexisting with a positive rate of inflation. So it’s not clear why Cochrane thinks the coincidence of low inflation and sluggish economic growth for five years since the end of the 2008-09 downturn somehow refutes Krugman’s diagnosis of what has been ailing the economy in recent years.
And, again, what’s even more interesting is that the proposition that there can be insufficient aggregate demand, even with positive inflation, follows directly from the Fisher equation, of which Cochrane claims to be a fervent devotee. After all, if the real rate of interest is negative, then the Fisher equation tells us that the equilibrium expected rate of inflation cannot be less than the absolute value of the real rate of interest. So if, at the zero lower bound, the real rate of interest is minus 1%, then the equilibrium expected rate of inflation is 1%, and if the actual rate of inflation equals the equilibrium expected rate, then the economy, even if it is operating at less than full employment and less than its potential output, may be in a state of macroeconomic equilibrium. And it may not be possible to escape from that low-level equilibrium and increase output and employment without a burst of unexpected inflation, providing a self-sustaining stimulus to economic growth, thereby moving the economy to a higher-level equilibrium with a higher real rate of interest than the rate corresponding to lower-level equilibrium. If I am not mistaken, Roger Farmer has been making an argument along these lines.
Given the close correspondence between the Keynesian and Fisherian analyses of what happens in the neighborhood of the zero lower bound, I am really curious to know what part of the Fisherian analysis Cochrane finds difficult to comprehend.