Via Casey Mulligan and Karl Smith, here is John Cochrane's response to Paul Krugman. It's a very good response. But there is one part where John Cochrane is definitely wrong. It's small, but important. And it's all about Say's Law, and the crucial difference between a monetary exchange and a barter economy.
"Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income."
It's the last sentence that matters; I quoted the rest just to provide context. John Cochrane is saying (unless I have totally misunderstood him) that Keynesian economics is logically inconsistent in requiring that people make plans that violate their budget constraints. If correct, this criticism would apply equally to monetarists as well as Keynesians.
This criticism would be correct in a barter economy; it is not correct in a monetary exchange economy. But Keynesian economics makes no sense in a barter economy, and nor does monetarism (unsurprisingly).
Forget investment and taxes (and forget exports and imports, government expenditure, borrowing and lending, land, used furniture, and everything else, while we are at it). Let's just leave consumption on newly-produced goods, and income. Can people plan to spend more than their (planned/expected) income?
In a barter economy: no. In a barter economy, an offer to buy is an offer to sell. "Wanna swap 5 of your bananas for 10 of my apples?". I plan to earn 10 apple's worth of income and spend it on 5 bananas, but we cannot distinguish the act of earning income from the act of spending it. And anybody who planned to buy goods of a greater or lesser exchange value than those he planned to sell has made some sort of arithmetic mistake.
But in a monetary exchange economy, offers to buy goods with the medium of exchange, and offers to sell goods for the medium of exchange, are distinct acts. I can plan to buy goods of greater exchange value than the goods I plan to sell, if I plan on reducing my stock of money. And if everyone plans to do the same, and if they realise those planned expenditures, they will be surprised to find their incomes rising by the same amount. There is no logical inconsistency in people planning to spend more with the same income in a monetary exchange economy.
General gluts are always and everywhere a monetary (medium of exchange) phenomenon. The very distinction between Aggregate Demand and Aggregate Supply is a monetary (medium of exchange) phenomenon.
Whats wrong with macroeconomics? The same thing that's wrong with Finance, apparently. We need to integrate Finance into monetary theory. We need to integrate monetary theory into Finance.
Hoisted from comments: Jason says "Doesn't sound like a small deal to me. If a guy cannot even distinguish between a monetary economy and a barter economy, then what business does he have in doing macroeconomics?". Yes, it's important. But we need to encourage Finance people to do macro, and macro people to do Finance, and part of the price of doing that is we will make mistakes.
[Addendum: my guess is that the Keynesian blogosphere will mostly ignore this mistake in John Cochrane's response, and instead jump all over him for an alleged mistake in what he says about Ricardian Equivalence, in ignoring the distinction between tax cuts and government spending increases. Actually, what he says about Ricardian Equivalence is not necessarily wrong; it just depends on what you assume about the substitutability between government and private spending (which he forgot to mention).]