Tuesday, October 26, 2010

Chicken and egg

University of Chicago economist John Cochrane in today's Wall Street Journal --

So Mr. Geithner knows that trade surpluses in the end come down to saving and investment. And he knows that in the U.S. people are trying to save right now. Our government is undoing their efforts with massive fiscal deficits.

John Cochrane, during the 2009 stage of a long-running dispute with Paul Krugman --

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any more effect than spending financed by raising taxes. People, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered.

So in the first case above, households are trying to save but the pesky government is undoing their efforts by spending. In the second, the households are saving because the pesky government is spending.

You untie that knot, and you understand a lot about why economists disagree about how to get the global economy out of the mess it's in. Incidentally, Ireland looks an extreme case of the second scenario, where people are saving in an effort to undo the wealth destruction -- not stimulus spending -- caused by the government.

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