NYTimes 1, Chicago 0

Paul Krugman is ably taking U Chicago behind the tool shed and thrashing them. I had an email exchange with Prof Cochrane yesterday where I tried to gently point out the error of his ways, but to no avail. Drinking down a tall glass of FAIL may to tolerable if you have tenure, but it still cannot taste that great. I'm sure Fama, Cochrane, and the rest of U Chicago are not enjoying all the egg on their face, so I'll try once again to show them a way out of their conundrum.

The Issue

Essentially, Cochrane and Fama both assert that savings = investment (+ capital account), and so say that any Government stimulus will crowd out private investment. Here's the derivation (by identity) to get you S = I

Y = C + I + G

National savings can be thought of as the amount of remaining money that is not consumed, or spent by government. In a simple model of a closed economy, anything that is not spent is assumed to be invested:

NationalSavings = Y − C − G = I

If you think that banks make (investment) loans based on their deposits, then it's reasonable to assume that all money not spent (ie. saved) is invested. But banks do not take deposits and loan them out. In fact, banks make loans first and then those loans become deposits. Remember -- loans create deposits, deposits do not "enable" loans.

Loans create deposits

Banks, by way of their Federal charter, can expand both sides of their balance sheet at will, subject to capital requirements. This money is created ex-nihilo, but always nets out to zero in the private sector, as each (private) asset that a bank creates must be matched by a (private) liability. Government can create money outside of the system, but banks always need to net out and balance the balance sheet.

People believe that fractional reserve banking, in some weird way, has banks taking deposits, multiplying it (through what seems like a strange and fraudulent process), and then making a larger quantity of loans. In fact, banks make whatever loans they think make sense from a credit perspective, and then borrow the money they need from the interbank market to meet their reserve requirements. If the banking sector as a whole is net short of deposits, it can borrow the extra money it needs from the Fed. If you think this is a weird and pointless regulation you are correct. Canada, for example, has no reserve requirements and yet seems to have a banking sector. The quantity banks can loan out is constrained by capital requirements and credit assessments.

Facts on the ground

If a description of how banks actually work doesn't shatter your belief that savings = investment, consider Reality. From about 2000-2006, American savings went negative, yet banks loaned out huge amounts of money (made huge investments). In fact, they came up with all kinds of clever ways to skirt capital requirements so they could make even more investments. If savings = investments, and savings fall, how can investments rise? By the same token, from 2006 to now, the private sector has actually delevered, saved, but banks aren't making any loans (investments). What's up with that?

More Facts on the ground

Anyone who thought they were saving by putting money in the S&P500 has had a rude wakeup call. They were not saving, they were investing, and now 40% of that money is gone. I don't think they will confuse saving with investing in the near future.

So, what is savings?

A better way to think of savings is to think of it as what's left after taxes, consumption, and investment.

Y = C + I + G

Net Private Savings = Y - C - I - T = G - T

Austrians will howl that it is unreasonable to define savings as a residual, there should be a term S for active savings, but people have to save in currency, and in a fiat, floating fx, non-convertible world, currency is not a store of value. Fiat currency trades bankruptcy risk for inflation risk, and fiat currency is all that's sitting in bank accounts. So the Austrians are right, there should be some way to actively save, but they are wrong, because fiat currency in a bank is not it.

You split out savings from investment and you get Net Private Savings = Government spending - Taxes, also known as the deficit. So, the Government runs a deficit (spends more than it taxes) in order for the private sector to have the extra money it needs, after consumption, investment, and paying those taxes, to net save. This idea totally blew my mind when I first encountered it, but it actually makes total sense.

So, if you acknowledge that savings does not equal investment, then you see that Government deficit enables private savings. This is the OPPOSITE of all the Chicago guys who argue that the Government deficit REDUCES national savings. Government is a currency issuer, why does it need to save? Does a bowling alley need to hoard the points it awards for strikes and spares? Everyone acknowledges that the Fed can print money, but few people actually think about what that means.

The way out for Chicago

Once Chicago makes its peace with the role the Federal deficit plays in the economy (funds private savings) then they way out for them is clear and easy. The private sector went from an unsustainable borrowing binge that is over, and now it wants to save. Those savings can only come from two sources: 1)fewer private sector transactions, and 2)larger government deficit. Right now we're getting both, as aggregate demand falls, generating unemployment, and lower tax receipts and higher unemployment claims increase the deficit. We want less unemployment, so that means we want to increase the deficit in a way that funds the private sector's demand to net save.

The Federal deficit is G - T.

Obama, Krugman, and the New York Times wants to increase G as fiscal stimulus. But G will be stimulated too slowly, will be allocated incorrectly, and cannot be reduced. The overshooting will (eventually) cause inflation.

Reducing T is a faster, broader, less distortionary, and more reversible mechanism to increase the deficit. Paul Krugman says that tax cuts are not stimulative because people will save some of the money. But the whole reason aggregate demand is falling is because people want to save some of the money! People saving money is the entire point of the whole exercise. The private sector, after being told for years it should save more, is finally doing just that, and it's being beat up for it! If the higher deficit funds private saving (which it will), that increases the money available for investment and consumption. If you want to increase investment and consumption, then reduce T some more. Repeat as necessary until you get enough aggregate demand, without too much inflation. Done.

Chicago needs to recognize that a higher deficit is required to fund private savings, which is what's going on right now. It then needs to argue to implement this via a payroll tax holiday. It should attack the Krugman/Obama/NYTimes strategy as being unstimulative -- because it's too slow, and impossible to turn off once it gets started. Long term investment is fine, but that should be separate from a stimulus package.

Both sides are deficit nazis, and want the deficit to be smaller (one would do it through lower G, the other through higher T). Neither sees the role the deficit plays in funding private sector savings. Given that Keynes himself acknowledges higher G is too slow for real stimulative effect, you need to argue for lower T, and understand enough about monetary mechanics to point out that having people save is the point. The spending and investment will come once the demand to save has been met.