John Cochrane on Fiscal Cliff

by Reihan Salam

John Cochrane, an economist at Chicago Booth, has emerged as one of the more influential thinkers on the pro-market right since the 2008 financial crisis. In a new Bloomberg View column, he argues that the CBO’s understanding of why the fiscal cliff will damage the U.S. economy is rooted in a comprehensively misguided Keynesian framework.

The central distinction between Keynesian and regular economics is the assumption that people don’t respond to incentives. In regular economics, prices and taxes first and foremost change incentives. Transfers, though important to the people who pay and get them, have much smaller effects on the overall economy. Keynesian economics and the CBO’s analysis take the opposite view: Transfers matter, incentives don’t.

A good example: What will be the effect of curtailing 99 weeks of unemployment insurance? To the CBO, it will reduce GDP because would-be beneficiaries will consume less. A standard economic analysis predicts that it will have the opposite effect, increasing GDP and bringing down unemployment. That’s because unemployment insurance means some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move.

(Remember that the CBO and I aren’t opining on what’s good or bad. The point is only to project whether GDP and unemployment will go up or down. Some unemployment insurance can be a good thing even though it hurts GDP and raises unemployment.)

To the extent our policy response is rooted in the same Keynesian framework, in which tax increases and spending cuts are considered roughly equivalent, we will be led astray. And so Cochrane argues that a revenue-neutral tax reform that lowers marginal rates would be vastly preferable to more stimulus spending, despite the fact that the CBO would count the former as a wash and the latter as a boon. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.