Tuesday, March 22, 2011

Price Coordination, Structural Adjustments, and Keynesian Downturns

Brad DeLong mentioned my extension of Steve Horwitz's puzzle analogy again. He writes:

"As Dan Kuehn likes to say, a recession is like somebody knocking your jigsaw puzzle, disturbing the pieces and turning some of them over. When the Federal Reserve ends a liquidity squeeze it turns the pieces right-side-up--and so it is easy to reassemble the puzzle. But right now there is nobody to turn the pieces right-side-up--and so things are much harder.

Pursuing this analogy further, I claim that things are even worse. As long as aggregate demand remains low, we cannot even tell when pieces are right-side-up. New investments, lines of business, and worker-firm matches that would be highly productive and profitable if capacity utilization and unemployment were at their normal levels are unprofitable now. We do need not just demand recovery but structural adjustment. But the market cannot do demand recovery rapidly by itself. And it cannot do structural adjustment at all until demand recovery is well under way."

This is the right way to approach economics, rather than a style that you often see that says that one pet theory is not just correct, but the only correct theory. I obviously don't need to be convinced that we're facing demand problems... what I'm a little confused about is precisely what structural problems we're facing that Brad refers to. Certainly there's the issue with housing. That strikes me as a bubble that popped and we're going to need some reassignment of resources previously dedicated to that. Is that all we're talking about here? Or is there something deeper? The one thing that comes to mind is the computer. Is there large scale technological unemployment associated with skill-biased technological change that we need to adjust to? That seems plausible, I guess. Is that what he's refering to or does he have something else in mind?

The important point, though, is that Keynesianism is all about problems with the price mechanism. The nice, tight, Walrasian system is actually over-identified which interferes with price signals sent to investors especially. You can think of it as an "interest rate wedge" similar to the "tax wedge" that is standard fare in undergraduate economics. I don't know if anyone has talked about it in this way before, but it seems like a useful way of doing it for people who seem to think Keynesians ignore price coordination. When these prices are distorted at the very least a demand problem is introduced - demand is insufficient to fully employ resources because there is excess demand for liquidity (or high quality assets, or whatever else you want to talk about... DeLong is always good at listing a few relevant margins) that would re-equilibrate if the Walrasian system were just-identified but doesn't need to re-equilibrate if it is over-identified (hence the stable underemployment result)*. But this price distortion also prevents any other adjustments that need to take place from taking place - including structural adjustments. If interest rates are artificially higher than the equilibrium rate, you're going to have a stable Keynesian obstacle to structural adjustments just like you have to any other investment. As Brad said initially, ""structural adjustment" takes place when unemployment is low, not when unemployment is high".

In a way, you can think of traditional macroeconomic policy getting us from Keynes (where the interest rate is higher than the MEC) to Hicks (where the interest rate is equal to the MEC), but DeLong is saying that even when we're at Hicks's solution you still need full employment for prices in the goods and services market to be able to coordinate again and respond to structural adjustments. Does that seem like a reasonable way of talking about it?

* - One way to think of why this is true is that slack in a just-identified system is arbitrageable while slack in an over-identified system is not arbitrageable.


  1. In other words, the price system more efficiently allocates resources when the supply and demand for money moves toward equilibrium. Expecting the price system to achieve "sustainable patterns of specialisation and trade" (to borrow Kling's phrase) while the institutions responsible for the money supply are failing to maintain monetary equilibrium is magical thinking. The first priority is to restore nominal expenditures to their pre-recession trajectory (perhaps adjusted for recent disinflation) and create an explicit NGDP level target for the Fed. The price system will then be in a position to start unraveling any lingering structural problems, because only then will prices be sufficiently accurate to guide the productive process. At the moment, the price system is sending too many false positives to the question: should this actor cease his current occupation?

  2. re: "Expecting the price system to achieve "sustainable patterns of specialisation and trade" (to borrow Kling's phrase) while the institutions responsible for the money supply are failing to maintain monetary equilibrium is magical thinking."

    This is still what I'm trying to understand.

    I've always figured that whatever PSST investment and whatever capital structure is still viable in a depression is viable for the same reasons it always was. I'm not sure how much DeLong is departing from this, and that's what I'm trying to figure out.

    Kling assumes the adjustment process is going on now, it's painful, and we may be delaying the inevitable.

    DeLong, I think, is arguing for the same reasons I do that interest rates are too high now (the problem is in the bust not the boom), so you can't really have structural change. Let's say you have a ten step capital structure (since Austrians like to talk chronologically), and steps four and seven don't have a return high enough to be viable under current interest rates. If you lose steps four and seven you lose the whole pattern of production. Maybe that's the argument. I'm not really sure.

  3. I think real interest rates are too high, but I don't like to talk about it. I don't want the Fed to target lower real interest rates. The Fed needs to concentrate on the growth path of nominal expenditures; interest rates will sort themselves out like other prices.

    For policy, interest rates should be as irrelevant as the price of bananas. Both may go through nominal and/or real changes when the excess demand for money is satiated, but there are innumerable other factors that complicate precise prediction.


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