How effective is fiscal policy: Guest post from Roger Farmer

The slavish devotion to remedies to the Great Depression that were proposed more that eighty years ago smacks of religion; not science.

Isn’t this a bit a straw man, not to mention hand waving?

Wouldn’t trying something that worked in a particular situation be worth a shot the next time we have a similar situation? BTW, it did not take WW II to end the Great Depression. GDP was back on it’s pre-depression trend line before we entered the war.

Unemployment is high because nominal prices and nominal wages are too high.

This rings awfully hollow when median wages have stagnated for decades and inflation has been low for several years. Meanwhile, high earners, and in particular a bloated non-value-added finance sector have been capturing a generally increasing percentage of the national wealth for at least 50 years. The story this suggests to me is a massive misallocation of resources into non-productive or even counter-productive ventures, like hyper-sophisticated derivative instruments that nobody knows how to rationally evaluate.

The second is a change in the composition of the balance sheet with the goal of influencing the relative price of assets, with the goal of boosting real aggregate demand.

Unless I’m missing something big, this is an appeal to a wealth effect. This strikes me as more of a religious belief than expecting fiscal expansion to be effective. Quantitative easing has lead to increased asset prices, so it seems that qualitative easing is worth a shot. But what are the specifics, and how does balance sheet adjustment increase aggregate demand? What is the mechanism?

With fiscal policy, it’s pretty straight forward. Put people to work and they have money to spend. That doesn’t take a lot of religion. Plus, with crumbling infrastructure it isn’t terribly difficult to find worth-while projects all over the country that would get people working, and improve the physical plant of the nation.

Cheers!
JzB

Alternatively, we could give private companies the incentive to employ more people by moving the economy from a high unemployment equilibrium to a low unemployment equilibrium. That solution would require bloggers, politicians, journalists and policy makers to consider some new ideas.

Why couldn’t we just directly subsidize the jobs of unemployed people, either with tax credits when people are hired for a certain period of time, or something else?

This isn’t France – if the workers truly aren’t fit for employment at the company, then they’ll just terminate their jobs when the benefits run out. But in the mean-time, the employees get to avoid having a “gap” on their resume and maybe learn some new stuff on the job, the employers get some money while some of the risks of hiring new people are diffused, and so forth.

” Agents are rational.”

No they’re not. And I can prove it.

RF: “financial markets cannot be expected to find the “right” relative price of capital except by chance, . . . . Demand shifts occur when rational forward looking agents, all of whom have rational expectations of future prices, revise their beliefs of what will occur in the future. Agents are rational. Markets are not.

Oh, no, no, no. “Agents are rational. Markets are not.” might sound like a clever, epigrammatic bumpersticker, but it is really, really bad economics.

“Agents” — individuals with agency — can be rational enough in a common sense meaning of the term — greedy, calculating and smart, but individually, outside market cooperation, their personal expectations can only be diverse and idiosyncratic, subjective and radically incomplete (uncertain). You cannot have “rational expectations”, expectations, which have been reconciled and combined into that one “objective” and shared vision indistinguishable in kind from that of the Representative Agent, which characterizes “rational expectations”, without some kind of institutional mediation. You most certainly cannot have anything even vaguely like “rational expectations” in Lucas’s sense, in the real world beyond an a priori analytic model, without an institution within which to form those “rational expectations”. Without an institutionalized market to corral them into a mutually self-aware crowd, there’s no wisdom of crowds.

I think we can stipulate that as a thesis and as an ideological tenet, EMH is crap. But, if financial markets are not at least somewhat (informationally) efficient, and practically superior to idiosyncratic expert opinion, it is difficult to see why anyone would bother.

Here’s the thing, which I really wish (macro)economists could learn to do: think of financial markets as an institutional mechanism, where efficiency is a matter of variable degree, and arises from the operational design and practice. (Obviously, some economists think of them this way — I’m not making this stuff up on the fly, for a blog comment — but, for some reason, very few in macroeconomics or financial economics, do in public.)

Behold the grubby world of “rational expectations”, Wall Street Style. Agents, individually, do not have “rational expectations” — they (individually) have hedges, to balance what they know against what they don’t know (and what others might know). They borrow short and lend long. Some take short positions; some take long positions. Differences of opinion drive the market. And, if the market is reasonably well-designed and run with some minimum of integrity, the aggregate result is something vaguely like “rational expectations”. At the margin, everyone comes to expect that the market price of an asset is a better, more informationally complete estimate, a kind of shared, objective truth. Because those taking long positions drive up price, while those taking short positions tend to drive down the price.

Now, one might say there’s smart money and there’s dumb money at work, in this financial institutional setting. The smart money is working very hard, and, if the market has some minimum degree of integrity (due if you like, to reasonable regulation), the smart money is somewhat self-defeating. I say “somewhat” because the market has to be inefficient enough to make being the Smart Money pay, but the Smart Money, in turn, in rivalrous competition and oppositional greed, has to produce asset prices, which are informationally superior and reliable enough, for the Dumb Money to use and to rely upon.

If the financial institution breaks down, and the smart money avoids regulatory discipline, and the asset prices are fraudulent, then the dumb money finds itself in possession, not of “rational expectations”, but of some big losses.

It is isn’t just a random thing, these breakdowns. It is systematic fraud. It is the Smart Money getting too smart, and undermining the informational efficiency of the institution, imposing possibly huge losses on the Dumb Money, which relies on various “prices” and other benchmarks, to calculate balance sheets and pension fund liabilities. When a Paulson is able to go short, in a way that hides his move from the market, prevents his short from depressing price as it should, and fools some bored bureaucrats routinely investing an insurance company’s annuity funds, imposing losses on the insurance company and its policyholders . . . well that might or might not be criminally actionable in Mr. Lesser Evil’s Justice Department, but one thing it most certainly is not, is rational forward looking agents, all of whom have rational expectations of future prices, revising their beliefs.

Economists need to get cynically realistic about these things. Let’s just put aside all the nonsense about the Housing Bubble as some mysterious psychological kin to long-forgotten Tulip Mania, and let’s start seeing it as a breakdown in the integrity of mortgage bankers bureaucratically checking an applicant’s income against the appraised value of the house, and the appraised value of the house against the income of the population in that area. There’s no short mechanism in the so-called housing market, to keep prices down in the neighborhood of fundamentals — there’s just bankers following the rules. And, there’s no madness of crowds. There’s a bankster named Angelo Mozillo. And, a whole lot of Dumb Money people, trying to buy a house, with the income from a couple of wage earners trying to raise a family and save for retirement, trusting the banker and the System.

In a seriously corrupt and imperfectly reformed financial system, “qualitative easing”, as RF so euphemistically calls it, could be like pouring ether on a barely contained gasoline fire. If RF thinks this would be a superior policy proposal to having the government build some railroads and energy infrastructure, in preparation for climate change, peak oil and other serious, rationally appreciated threats to the survival of civilization, well, from the people, who brought you the Great Depression, the GFC 2008 and Greece 2012 . . . new policy ideas! Whoopee!

Viewed from the perspective of a non-economist who works in a branch of science in which experiments are not possible, what is striking about this argument is the abundance of theoretical claims (in which the word “rational” does a lot of work) and the very small amount of space devoted to discussing actual data.

I think it is not the case that Farmer is saying “Unemployment is high because nominal prices and nominal wages are too high.” JZB and Bruce Wilder are, I think, getting the argument wrong here. Farmer is attributing this view to Samuelsonian Keynesianism, which he is critiquing.
Oddly, perhaps, Farmer has ended with a view of unemployment that parallels Marx’s, even though it comes to the issue from the other side. “In these models there is a coherent account of the idea that there may be a continuum of steady state unemployment rates, and unlike bastard Keynesian analysis, the problem is real not monetary.” Such rates may not be problems, but solutions – ways that capital solves the notorious slowing of the rate of profit

It suffers from the uncomfortable fact that the General Theory does not contain an explanation of unemployment that is consistent with rational behavior by profit seeking firms in the labor market.

Unfortunately, you could say as much about reality. Firms are not, in fact, struggling to fill vacancies at lower wages. Instead, there are more unemployed people than there are vacancies. The framing of sticky wages as being a problem with workers, who are too lazy to accept lower wages or (more civilly) are constrained by fixed nominal commitments like rent/mortgage payments, is a political statement. Where are these employers who could take on the whole pool of the unemployed if they could just cut wages a bit? As Steve Randy Waldman says, sticky quantities are as important as sticky prices…

(Before someone blames the minimum wage, the UK didn’t have one in 1981 or 1992 and we had plenty of unemployment.)

Samuelsonian Keynesians see the issue as one of deficient nominal aggregate demand. Unemployment is high because nominal prices and nominal wages are too high.

As others have pointed out, this is just stupid.

Too high relative to what? In most models they can’t be too high relative to each other, if you multiply incomes and prices by a constant, the results are unchanged. Are they too high relative to other countries? How can that explain high unemployment across many countries?

As Bruce Wilder noted, letting both wages and prices fall benefits lenders, and impoverishes everyone else. You seriously think that “Keynsians” believe this?

Seriously deluded is what you are.

Jazzbumpa: “Wouldn’t trying something that worked in a particular situation be worth a shot the next time we have a similar situation? BTW, it did not take WW II to end the Great Depression. GDP was back on it’s pre-depression trend line before we entered the war. ”

Seconding this; Roger Farmer is a liar (and no, he doesn’t get to pick and choose ‘unambiguous’, the facts are clear, as were the election results for 1936).

Bruce: “This, of course, was something the world witnessed in the deflationary spiral of 1930-34 in the U.S., something the world witnessed and economists unaccountably forgot.”

Question to John Quiggin – are there *any* right-wing economists who don’t do their best to ignore the Great Depression? You mentioned that you had thought that things went wrong in macro in 1958. I’ll maintain that the root of the right-wing macro problem is that they’ve never acknowledged the Great Depression, but have either ignored it, or treated it as an anomaly not needed explanation, or simply lie about it (e.g., by pointing out that unemployment was higher in 1936 than in 1929).

@11 roger gathman –

I think it is not the case that Farmer is saying “Unemployment is high because nominal prices and nominal wages are too high.” JZB and Bruce Wilder are, I think, getting the argument wrong here.

For my part, I will concede this point. But I don’t think it applies to Bruce Wilder, who elaborates at considerable length.

At any rate, RF goes on to say :

What’s wrong with that analysis? It suffers from the uncomfortable fact that the General Theory does not contain an explanation of unemployment that is consistent with rational behavior by profit seeking firms in the labor market.

This is at best a non sequitur, perhaps even another straw man. The content of The General Theory is not part of the argument. And is rational behavior [a construct of the 70’s – 80’s, I believe, and simply a naked assertion at any time] even a relevant concept, in context? The efficacy of fiscal policy is. And, despite the title of this article, the topic remains largely unadressed.

My other two points, which are not contingent on this one, still stand.

JzB

Demand shifts occur when rational forward looking agents, all of whom have rational expectations of future prices, revise their beliefs of what will occur in the future. Agents are rational. Markets are not.

But we know that humans are not rational — for example from psychology experiments at the micro level.

And more significantly, our beliefs about the future are full of guesswork. If I’m playing some kind of gambling game with known odds (like roulette), I can at least choose to act like a rational utility maximizer — even if this is not how people typically act when playing such games. But if I need to guess future prices, I’m not dealing with known odds in the same way. So, OK, futures markets, interest rates etc. tell me what other people think the future will be like … but they’re guessing too. There’s a distinct lack of a ground truth for the market to lock on to (until future arrives and becomes the present),

Keynes used the phrase “animal spirits”…

Anders: “No! What is it with the dyslexia that equates “fiscal expansion” with “a bigger government sector”? A tax cut is an equally valid form of fiscal expansion – not that you ever hear this in the US media!”

Seconding Jazzbumpa on this. Krugman has covered this, when he wrote on the nature and efficiency of the stimulus.

(which leads to my second requirement of economists – if they don’t know what Krugman has said on a topic, then they should be punished)

“We may need a bigger government sector; but that is a logically separate question from the issue of how to cure the unemployment problem.”

This doesn’t make much sense to me. If you employ a person to fix a bridge then he/she are no longer unemployed. Unemployment problem solved!

Unemployment is high because nominal prices and nominal wages are too high.

A possible, almost paradoxical response to this: too high relative to our expectation of their future values. To make the ratio current price/expected future price smaller, you can make the expected future price larger – inflation makes nominal prices go up, but it makes buying something now cheaper relative to waiting a bit and buying it later (and hence encourages consumers to spend now on products, and employers to spend now on hiring people).

Will a big fiscal expansion cure the unemployment problem? Probably.

Will we do it? No.

Why not? Rich people don’t want to, and unemployed people don’t count.

Salem @ 26

A Monetary History of the United States, 1867-1960 was the quintessential effort by a conservative to ignore the Great Depression.

roger gathman @ 11

it is not the case that Farmer is saying . . . Farmer is attributing this view to Samuelsonian Keynesianism, which he is critiquing.

Farmer is way smarter than the general run of academic economists, and way more excited by the circulation of ideas. I think he’s trying to be provocative, by misinterpreting not just the Keynesians, old and New, but also the conservatives. He’s just more flattering in his chosen mis-interpretations of the conservative doctrines. He’s offering the conservatives the tempting bait of a potentially defensible rationale for being opposed to fiscal stimulus, as well as the familiar treat of scorn for the “obvious” problems of the Keynesianism, the conservatives like to claim everyone long ago discarded, in the hope that they might want to get busy with him in discussing such a rationale, or even such scorn.

Bruce Wilder 01.08.13 at 4:53 pm

” Salem @ 26

A Monetary History of the United States, 1867-1960 was the quintessential effort by a conservative to ignore the Great Depression.”

I just bought the e-book, and will read what it says.

“Unemployment is high because nominal prices and nominal wages are too high.”

At least four people here zero in on this sentence, but fail to notice the one before it. Unless I’m misreading, Farmer is NOT advancing this as his understanding of unemployment. He is describing the modern Keynesian theory of unemployment. I agree that much of the rest seems like hand waving, but no more so than Krugman’s hand waving or Mankiw’s hand waving–a commentary on the state of economics as a discipline not any individual practitioner.

I appreciate that they are trying to advance their science. I just wish that economists on any side would quit pretending they have hard answers. You all aren’t chemists yet.

PGD @ 34: “even though that is apparently unappreciated by the main posters”

!!?!
Whoa!
There’s a great comment section at CT, because the posters do yeomans’ work policing the comments. If that sort of scut work makes them a bit grumpy or gruff, I try to be sympathetic, as well as grateful, that the posters are willing to make not just the sometimes glorious effort to post, but to also take the time and pains to keep the place clean and tidy.

I agree pretty much with the sentiments of the OP, and its criticisms of the followers of Samuelson seem true enough to my non-specialist eye. But it’s undoubtedly true that there are no macroeconomic equilibria. Give up that idea. There have to be better ones.

Here’s Gunnar Myrdal in his ‘Political Element’ (from the late ’20s):

‘The concept of equilibrium (….) has proved to be a convenient tool for the elaboration of subtle and elegant theories, although it failed to deal adequately with time and in particular with inertia and expectations. It has always been full of normative implications of the natural law type. Its danger lies in allowing economists to slide too easily from positive theory into ethical and political speculation.’

(Pardon the formatting). He blamed the Physiocrats ultimately, in which case the date it all went wrong would be more like 1758.

TallDave: “It’s a mistake to think unemployment is a problem per se. ”

Given the current economic system, it’s not. For the majority of Americans, being unemployed is miserable and immiserating. And for the majority of the rest, it’s only not because they are either dependent on an employed person, or retired (with support).

I appreciate the torrent of replies that were triggered by my post. In response, jazzbumpa is exactly correct in his interpretation of my statement about nominal wages and prices. That is how Samuelson, following Don Patinkin, interpreted Keynes. Bruce Wilder is also correct to point out that wages and prices must be high relative to something. They are, according to Samuelsonian Keynesians, high relative to the outstanding quantity of nominal assets.

This whole literature (Keynes as sticky money wages and sticky money prices) was the outcome of Patinkin’s attempt to integrate what was then referred to as monetary theory (the quantity theory of money) with value theory (the Lausanne school of general equilibrium). I had many conversations with Don Patinkin about this. He was a regular visitor to UCLA. Don never liked the characterization of Keynesian economics that came out of his work but he didn’t know how else to characterize the main ideas of the General Theory. My own work (articulated here
http://www.amazon.com/How-Economy-Works-Confidence-Self-Fulfilling/dp/0195397916/ref=sr_1_9?ie=UTF8&s=books&qid=1254946079&sr=8-9
and in more depth here
http://www.amazon.com/Expectations-Employment-Prices-Roger-Farmer/dp/0195397908/ref=sr_1_1?ie=UTF8&s=books&qid=1255040846&sr=1-1
) provides an alternative interpretation of Keynes that is not based on sticky wages and prices.

My apologies to John Quiggin for neglecting the 2009 Australian episode. I nevertheless remain skeptical of empirical evidence on the effects of fiscal policy, which always relies on a theory-based identification scheme.

An example of a paper that is often cited in favor of large multipliers is that by Nakamura and Steinsson
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&ved=0CDsQFjAB&url=http%3A%2F%2Fwww.columbia.edu%2F~js3204%2Fpapers%2Ffiscal.pdf&ei=joTsUMLeJa2Y0QX16YGwBQ&usg=AFQjCNHXJe8CbzL1-t0Dsj61GT2QlGsKAw&bvm=bv.1357316858,d.d2k
which uses differential expenditures across US states. The problem with using this as evidence in favor of economy-wide fiscal expansion is that an expenditure increase in Mississippi, for example, will be paid for by a future tax increase spread across all fifty US states. Even a Ricardian model would predict, in the Nakamura-Steinsson world, that differential fiscal policy will have differential effects on output.

The most convincing empirical work that I have seen on fiscal multipliers is that by Valerie Ramey,
http://weber.ucsd.edu/~vramey/research/NBER_Fiscal.pdf
who finds that government expenditure increases are associated with reductions in private spending; implying that the government expenditure multiplier is less than one. This evidence is embarrassing for any justification of fiscal expansion to increase welfare based on the Keynesian multiplier.

It has been argued that something different happens when the interest rate is at the zero lower bound. Perhaps. But I have not seen this idea convincingly articulated in a DSGE model (including all of the recent new-Keynesian attempts). General equilibrium monetary models always have multiple equilibria and we have not yet figured out, as a profession, how to resolve that issue. This is a crucial point. The beliefs of agents, even in a rational expectations model, play an independent role in determining outcomes. (See my work with Plotnikov
http://rogerfarmer.com/NewWeb/PdfFiles/Farmer-Plotnikov.pdf
on the role of fiscal policy in the Great Depression).

We could, of course, give up on the rationality postulate. That would be like abandoning the Newtonian postulate of action at a distance. Rationality is an organizing principle; not a falsifiable hypothesis. Although there are definitions of rationality by which agents could be thought of as irrational; that is not the sense in which I use the term in my work. Human beings are goal oriented. We make choices. We try, more or less successfully, to achieve ends. I cannot conceive of observing an action that I would find helpful to label as “irrational”. This means, of course, that the behaviorists describe rational behavior in my use of the word.

The use of the word ‘rational’ to describe the outcome of the beliefs of a group of interacting agents as in the “rational expectations hypothesis” is unfortunate. This is a very different sense of the word and there is no reason to expect groups of interacting agents to find their way to a rational expectations equilibrium in the sense in which that concept was used by Robert Lucas and pretty much all of DSGE macroeconomics since Lucas.

But although rational expectations is logically distinct from rational behavior; I continue to believe that it is a separate and useful organizing principle. Many, if not all, of the objections to rational expectations are a consequence of other modeling assumptions that can lead to the implication that a rational expectations equilibrium is Pareto optimal. In my own work, (see my 1993 book
http://www.amazon.com/Macroeconomics-Self-fulfilling-Prophecies-Roger-Farmer/dp/0262062038/ref=sr_1_4?ie=UTF8&s=books&qid=1275152780&sr=1-4
) agents are rational and have rational expectations, but the outcome of a set of interacting agents is very far from being the best that we can achieve.
The program of assuming that agents are rational in a broad sense, and that they have rational expectations, is a useful one that has practical and refutable implications. It also suggests how to design social policies that increase welfare. And these policies, in my work, here
http://rogerfarmer.com/NewWeb/PdfFiles/Farmer-QuaE-R2.pdf
and here
http://rogerfarmer.com/NewWeb/PdfFiles/FNV-Inefficient-Markets.pdf
do not look like fiscal expansion. They look, instead, like central bank asset price stabilization schemes.

“Behold the grubby world of “rational expectations”, Wall Street Style. Agents, individually, do not have “rational expectations” — they (individually) have hedges, to balance what they know against what they don’t know (and what others might know). They borrow short and lend long. Some take short positions; some take long positions. Differences of opinion drive the market.”

Bruce: Yes: differences in beliefs are clearly important in practice. But we can go a long way with theories of homogenous beliefs. Take a look at the two NBER papers I cited, one individually and one with Venditti and Nourry. Here, our agents trade different financial assets (debt and equity for example) not because they have different expectations but because they have different discount factors.

“Sure, but significantly less so than in earlier decades. I really think economics in particular and public policy in general would be far better served by looking more at what happens to absolute standards of living. Then we could have more rational debates.”

Yes, back then unemployed people were called lazy good-for-nothing mooches, could only count on a solid meal through the charity of others (often reluctantly given, or with strings attached), and had abysmal health care, if any. Today’s unemployed have is so much better ….

I really think the “absolute standard of livings” people should spend some time studying what it’s really like to be poor — unemployed or “working” — before they make assumptions about poor people based on the average absolute standard of living. If said people don’t want to actually interact with the unwashed poor, there are plenty of ethnographers in sociology and anthropology who aren’t so squeamish.

“In the 1950s, no one called it “funemployment” because going without food is not fun.”

Wow TallDave this is one ignorant comment. I hope that you or no one you love ever has to experience the despair and depression long term unemployment can cause, even if you are in no danger of actually starving.

/Seriously man just an awful series of comments from you.

Call me a socialist if you will, but I think it’s okay for people to not work, and that higher unemployment may even maximize human welfare. Some of the happiest people I’ve met are “just living on the beach for a year” or etc.

Let me try this: let’s say at some point in the future, in say 2070 or so, we are so productive it becomes possible for gov’t to spend a similar (to today) fraction of GDP on welfare transfers with the result that everyone who wants to can live at the same absolute living standards of people who today make $100K (for argument’s sake let’s call this the top 10% of today’s consumers). Is being unemployed “miserable and immiserating” anyway? I think probably yes, at least they will be lower status than those who work. Do you feel sorry for those people?

This scenario is a little less hypothetical than you might think. The average income of the 1950s is about where today’s poverty line lies, and someone in the heavily-subsidized bottom quintile today can probably consume at a level pretty comparable to the top 10% of consumers in, say, 1900 or 1870 or so, albeit at lower status. I think the declining marginal propensity to work is something to celebrate, rather than hide from.

krippendorf,

I’m sensing a trend here — feelings are more important than living standards?

Thanks MPAVictoria, please continue bolstering my point.

I certainly hope so, but so far more of them seem to be like you, attempting to disagree using emotional appeals, but actually proving my point — there is no absolute level of living standards at which people will ever be happy with low status.

My own post @ 49 went wrong, with its last sentence challenging Farmer to “man up”. I regret that sentence for a bunch of reasons.

I think the inability of conservatives and Keynesians to come to some commensurable difference of opinion, relating the aggregate to the disaggregate, is the big unsolved problem of macroeconomics.

How much fiscal expansion or wage erosion would it take to bring back telephone switchboard operator jobs? Typing pools? Desk calculator operators? Eyeball monitoring and hand adjustment of oil refinery operations? Small appliance repair? Hand welding of automobiles? Typesetting with metal slugs?

These are all jobs that were mainstream in the postwar Golden Age, and available without years of educational credentialing. I don’t think they are coming back no matter what happens to wages or fiscal policy.

On November 1st, 1959, the population of New York City was 8,042,783. If you laid all these people end to end, figuring an average height of five feet six and a half inches, they would reach from Times Square to the outskirts of Karachi, Pakistan. I know facts like this because I work for an insurance company – Consolidated Life of New York. We’re one of the top five companies in the country. Our home office has 31,259 employees, which is more than the entire population of uhh… Natchez, Mississippi. I work on the 19th floor. Ordinary Policy Department, Premium Accounting Division, Section W, desk number 861.

– C.C. Baxter, The Apartment

I’d guess that about 90% of those jobs in a circa-1960 insurance office were eventually eliminated by computers and computer controlled machinery. Is it too early to consider that the Luddite Fallacy of technological employment may not be a fallacy? Many people assume that hands-on work was just outsourced to China, but even in China manufacturing employment peaked in 1996!

Well, one response to the current crisis/stagnation could be “heroic” full employment macro, using fiscal deficits, public investment spending, even public employer-as-last-resort programs, which also would likely be far more effective in inducing salutary inflation than unconventional monetary policy. But another, -(which I’m faintly surprised no one here mentions),- which would be functionally equivalent, is simply to put insolvent banks,- (and perhaps raising capital requirements to realistic levels to ensure some degree of “insolvency”),- into public receivership and publicly re-capitalize, downsize/break-up, and re-regulate the system of banking and finance. And following that, instituting a program of orderly debt write-downs to sustainable levels. Either way, the debt overhang problem would be dealt with and the economy set on a renewed path to recovery.

But, of course, neither policy program is allowable for political reasons, rather than economic impossibility, since they would involve allocating losses and re-adjusting the system of economic values in an unacceptable way, which would be a significant step in the movement toward…. No, better to rely on unconventional monetary policy, even if slow and ineffectual in sparking recovering, to prop up financial asset prices and “values” and promote eventual demand recovery through the “wealth effect”.

MPA Victoria: “Wow TallDave this is one ignorant comment. I hope that you or no one you love ever has to experience the despair and depression long term unemployment can cause, even if you are in no danger of actually starving.”

I hope the opposite, that TallDave gets a chance to experience increased leisure, in the Mulligan sense.

This approach to “countercyclical” fiscal policy overlooks the microeconomic reasons that sustained unemployment of labor and capital creates for public spending; the shadow price of both labor and capital fall so public investment become more attractive.

Talldave, I don’t think your interlocutors are being closed-minded. You seem wedded to the idea of consumption as the be-all and end-all of working. Have you never looked into the self-esteem aspects of working? The domestic abuse, depression and alcoholism that can result from being unemployed?

Most people in 2013 aren’t good at building self-esteem and staying healthy without a job. You can say how much better off we would be with more leisure time, but right now, society has a paramount priority to get jobs for those of its citizens who want them.

The slavish devotion to remedies to the Great Depression that were proposed more that eighty years ago smacks of religion; not science.

I find your lack of faith… disturbing.

It suffers from the uncomfortable fact that the General Theory does not contain an explanation of unemployment that is consistent with rational behavior by profit seeking firms in the labor market.

I absolutely fail to understand this part. In the aftermath of a demand shock, rational firms—perceiving a shortfall of effective demand in the economy at large, accordingly a shortfall of demand for their goods and services, and the flight to safety of capital and financing—contract output and cut labor costs. Wages are sticky, so they employ fewer workers rather than pay a lower rate to the same number. Voila! unemployment.

And in fact this is really easy to see. If the complaint is merely that Keynes in his General Theory put it in different terms, well, you say potay-to… I guess everyone says potay-to.

Will a big fiscal expansion cure the unemployment problem? Probably. But the only time it was unambiguously successful in the US was during WWII when government went from 15% of the economy to 50% in the space of two years.

Demonstrably untrue. FDR took office in 1933 with 25% unemployment; the New Deal lowered that 11% in four years—more than half the distance to NAIRU. To ignore the plain consequence of the single most prominent exercise in American fiscal policy—or to wave it away by pretending the fiscal consolidation of 1937 didn’t happen—is what really smacks of religion.

Everyone, please stop feeding TallDave. He’s one of the lurkers in Tyler Cowen’s comment threads; it’s pretty obvious he’s not arguing in good faith here.

Matt @ 63: “How much fiscal expansion or wage erosion would it take to . . . ”

And, you care about this, because . . . ?

TallDave, it seemed to me was just indulging in a little harmless trolling, trying to get a rise out of the inmates at the asylum.

One fairly benign interpretation of his remarks is the insight that we really don’t need to have everyone working so hard. Labor force participation is at very high levels, and, in the U.S., vacation time is quite low. Not being able to get away from the job you have is a more common, if less severe, problem than not being able to find one.

In the U.S., something over half of the labor force is engaged primarily in sales or marketing or finance. If we cut back substantially on that activity, it is not clear there would be much impact on final output. We could tax advertising; close some malls; dump the 500 channel entertainment universe for Netflix-on-demand, eat less meat, wear more sweaters in winter, drink tap water, de-privatize some public goods, and spend more time with family and friends and hobbies. Assuming we shared out the remaining useful and necessary work and income — let the recent graduates out of debt peonage; let the sick out of paying thousands of dollars for prescriptions of dubious efficacy, let patents and copyrights expire — we could all have more genuinely useful stuff and more time, and less annoying advertising in our lives, less life-threatening medical care, and smaller, cozier homes, in smaller, walkable communities. Given the constraints on the earth’s resources, we probably should be thinking about living simpler, less energy and product intensive lives, and organizing collectively, as well as individually, to make that more feasible.

Perhaps it is not perfectly clear to everyone that the increasing immiseration of most is related to the stupendous sums paid to powerful elites. The huge share of income being channelled to Capital and away from Labor in the U.S. can only be accomplished by disinvestment; the capital stock is diminishing, and further declines in wages are to be expected, even declines in productivity will begin to show up, and not just on hold with customer service. The huge sums going to CEOs imply a level of sociopathic corruption that can only make the giant hierarchies of our “free market economy” ever more rigid and brittle and parasitic, over time.

The degeneracy with which Economics has locked itself into a non-discourse over narrowly circumscribed issues, whether it started in 1946 or 1958 or 1969 or 1981, is not as important, in itself, as the handicap it places on our ability to see the Big Picture in the 21st century, and imagine a way forward. Really, every single discussion of macroeconomic policy ought to begin and end with an acknowledgement of climate change, peak oil, ecological collapse, etc. — in short with resource limits and the inflection point they impose on the trajectory of the industrial revolution and civilization going forward.

Matt @ 63: “How much fiscal expansion or wage erosion would it take to . . . “

And, you care about this, because . . . ?

Because there seems to be an assumption, without ever looking at specific fields of employment or processes of production, that employment “naturally” should be higher and that hard tugs on a few policy levers can restore the balance. The right thinks workers need lower wages and fewer protections. Others favor fiscal expansion. I’m sure that direct government employment can reduce unemployment. I’m much less sure about anything else. In particular I don’t know why we “should” expect that a few big policies make private employers restore eliminated positions or create new positions on something like the scale needed for full employment. Capital substituting for labor seems to be a ratchet, not an equilibrium, as the now-obsolete job positions I listed in my post were intended to show.

Usually when the spectre of technological unemployment looms people point to the industrial transformation of agriculture, and how millions of farm boys found new jobs in the first half of the 20th century. Nobody seems ready to complete the analogy by showing what fields are primed to absorb millions of newly surplus workers in the new century.

“Unemployment is high because nominal prices and nominal wages are too high.”

I remain rather surprised – given the decades of stagnant wages and rising costs (college, healthcare, housing, etc.) – that it is possible for any thinking person to believe in some way that high wages are responsible for our current unemployment problem. But again, I am not an economist.

Is there any room in macro to note that demand has fallen because Americans have less money to work with? Then when demand falls, people go into debt and/or spend less, resulting into decreased demand, which leads to more layoffs? Sort of a shrinking wage-shrinking demand death spiral (as opposed to the wage-price spiral)?

From Bruce Wilder @ 77, “The huge sums going to CEOs imply a level of sociopathic corruption that can only make the giant hierarchies of our “free market economy” ever more rigid and brittle and parasitic, over time.”

To that, I say a big YES. According to Bebchuk & Fried’s book, Pay without Performance, “The growth of executive compensation far outstripped that of compensation for other employees. In 1991, the average large-company CEO received approximately 140 times the pay of the average worker; in 2003, the ratio was about 500:1.” So yes, perhaps wages are the issue, but for the fact that macro theories look at the wrong set of wages…

And as JazzBumpa @1 noted, banks have cornered a increasingly fatter share of GDP in recent years.

Banks in 1994 had 17% of GDP; in 2010, they had 63% of GDP (Source: http://bit.ly/U2xFpB) And let’s not forget that the financial sector also got billions in bailouts too. AIG alone got $182 billion just to cover its own losses – I do not understand how “rational agents” can act in a way that led to such a business catastrophe. (Have you seen AIG’s “thank you” video? Vomit-inducing garbage.)

Is it any wonder that there is less money (and more debt) for those outside of Wall Street? Is the ascension of the financial sector just to be ignored in the macro world? How does macro address the grotesque privatization of profit and socialization of loss that we see today?

@81

“AIG alone got $182 billion just to cover its own losses – I do not understand how “rational agents” can act in a way that led to such a business catastrophe.”

That $182 billion could have hired every single unemployed person in the country for a year at a salary of around $15,000.

Which would have given the U.S. economy a bigger boost?

Bruce Wilder @ 77:”Perhaps it is not perfectly clear to everyone that the increasing immiseration of most is related to the stupendous sums paid to powerful elites. The huge share of income being channelled to Capital and away from Labor in the U.S. can only be accomplished by disinvestment; the capital stock is diminishing, and further declines in wages are to be expected, even declines in productivity will begin to show up, and not just on hold with customer service. The huge sums going to CEOs imply a level of sociopathic corruption that can only make the giant hierarchies of our “free market economy” ever more rigid and brittle and parasitic, over time.”

Yes. The high rate of unemployment can be directly laid to this, as I show at:

http://anamecon.blogspot.com/2011/09/unemployment-average-wage-and.html#comment-form

If the rich did not reward themselves so richly, more people would be gainfully employed.

Mr. Wilder does not point out the corollary, that the wealthy, by keeping too much of the money for themselves, are destroying the market for their own capital. The surge in finance is thus destroying the productive economy, as productive firms in the real sense see no point in maintaining investment, and instead hoard their profits.

To the topic, fiscal policy is insufficient, given the current economic environment, and in particular the level of debt inflicted on the rest of society by those who purport to act in all our interests, who claim all society benefits from their actions, and so justify their obscene compensations.

“The rationality concept is empty. No. It is simply part of the hard core of the science”.

What do these three sentences actually……mean?

I always thought Lakatos’ ideas explained the workings of economics very well, much better than for the hard sciences, but that economists themselves would deny the characterization, since it’s very unflattering. This means that I just lost an argument with John Emerson here at CT, who claimed that economists at some point had been exposed to Lakatos’ ideas, and had embraced them. Fortunately I don’t think he reads here anymore, and therefore he will never know.

The reason its unflattering is because the actual historical process makes an idea the “hard core” a purely political and ideological decision. This is particularly dangerous in the social sciences just because confirmation bias is such a strong force when it comes to notions about human behavior and society.

Lakatos also had the idea of progressive and degenerating research programs. In the hard sciences, anything that you could identify as a degenerating research program is strictly a transitory phenomenon, since once enough evidence accumulates in favor of the competitor of a core idea, enough of the people in the field will just switch to the new idea. A recent example in biology is the idea that the only purpose of DNA was to code for proteins, and that any leftover DNA is junk. This drove research in genetics for years, but the evidence piled up against it, and biologists moved on.

Can I direct a question to Roger Farmer.

How can I combine understand, “There is a group of DSGE models that account for unemployment by combining search theoretic models of the labor market with inter-temporal choice by maximizing households “, – other than it takes time for workers to find new jobs, with my understanding of a world in which the number of job seekers far exceeds the number of jobs available. This seems to be just ignoring what employers are doing – the reason so many people are unemployed is because they got sacked (perhaps because their employers went bankrupt). And employers aren’t in a hurry to add workers when they view the prospects for effective demand negatively.

I’m not against seeing finding and accepting employment as a costly process. I just don’t think it gets to the heart of the issue (which I think is household balance sheets).

Re my comment @93
it got a bit garbled. I’ll try again:

Can I direct a question to Roger Farmer?

How can I combine understanding, “There is a group of DSGE models that account for unemployment by combining search theoretic models of the labor market with inter-temporal choice by maximizing households “, – as “it takes time for workers to find new jobs”, with my understanding of a world in which the number of job seekers far exceeds the number of jobs available. This seems to be just ignoring what employers are doing – the reason so many people are unemployed is because they got sacked (perhaps because their employers went bankrupt). And employers aren’t in a hurry to add workers when they view the prospects for effective demand negatively.

I’m not against seeing finding and accepting employment as a costly process. I just don’t think it gets to the heart of the issue (which I think is household balance sheets – there is an obvious “shock”).

Balance sheet shocks involve a huge transfer of wealth – and you need to counteract this transfer in some way (one way is via debt forgiveness or bankrupcy) – the otherway redistribution of some sort.

John, do you think of Lakatos’ description as a positive description, or as a normative one?

roger gathman, the point you make there is actually pretty close to what I had in mind. If you squint a bit, you can find a “hard core” in each hard science, but it’s not unusual for a core idea to get discarded.

Walt: Yes, the Lakatosian view is unflattering but not a bad description of what happens. Sometimes, we may cling to a degenerative research program for a very long time because it is so hard to find events that clearly distinguish one explanation of events from another.

Reason: The process of job-finding is a technology with two inputs. One is the search time of unemployed workers. The other is the recruiting effort of firms with vacant jobs. One hundred jobs can be filled when 1,000 unemployed workers search for 200 vacancies and 100 of them are successful. One hundred jobs could also be filled when 200 workers search for 1,000 vacancies and 100 of them are successful.

The search process is like a production function. We can produce wheat with a combine harvester and one man. Or we can produce wheat with 100 men with hoes. It is the wage/rental ratio, a relative price, that directs the impersonal forces of the markets to choose the right combination. In the search market, those relative prices are missing. We do not see employment agencies that pay unemployed workers for the right to find them a job. Nor do wee see agencies that pay firms for the exclusive right to fill their vacancies. The general equilibrium model breaks down because these markets are missing. We do not have enough relative prices for markets to work well. As a consequence, we often end up with more unemployed workers than is socially optimal.

The search process is a dynamic one and, in the best of all possible worlds, we should expect to see some unemployment as a result of search costs. The problem is that, because of missing markets, we often see too much unemployment. That is the insight of the General Theory, translated into the language of search theory.

Anders @98
Should I pass that over to Uncle Milton (lifetime income hypothesis). Tax holidays only benefit those who are already earning, and in periods when they think their jobs are at risk they are likely to save what they see as windfall gains.

re me @101 to Anders @98
P.S. I think EVENTUALLY such tax breaks will feed into spending as marginal balance sheets start looking better. But I suspect initially there will be a lot of inertia. To get real traction you have to help people in real trouble and give them better prospects.

Prof. Farmer:

The New Deal was an almost invisible ripple on the surface of the pond. Take a look at the time series of goverment purchases as a fraction of GDP. Krugman is correct when he asserts that fiscal policy was not effective in the early years of the Depssion because it wasn’t tried. Yes: the economy recovered slowly after the initial drop that followed the 1929 crash. But what makes you think that this derisory “recovery” could be attributed to the New Deal.

Couple points: One, the economy recovered very slowly after 1929, but a heckuva lot faster after 1933—nominal GDP rose 13% annually during the first four years, and real GDP 9.5%. Coincident with that was a move from austerity (the federal government ran a surplus in FY 1930!) to fiscal expansion. Further, in 1937, when the government went back to austerity, the recovery was immediately reversed. That seems to me clear evidence—not conclusive proof, but clearly evidence—the recovery not just could but should be attributed to the New Deal.

Without a citation, I’m not sure where you think Krugman says that, but I’m pretty sure you’re being a tad slippery. Krugman certainly believes the fiscal retrenchment in 1937 caused the second recession, and I’m reasonably sure he thinks the New Deal operated in the right direction, if not sufficiently. To say “Krugman is correct … fiscal policy was not effective … because it wasn’t tried” can’t be justified, unless you mean it wasn’t perfectly effective because it wasn’t entirely tried. Suffice to say, that is not the argument people are actually having.

My bigger problem is that I can’t even tell what your argument is. Was the problem with the New Deal that it wasn’t big enough? I (and most Keynesians) agree! But what logically follows from this is that fiscal policy is the appropriate remedy to persistent slumps. The conclusion you draw:

Will a big fiscal expansion cure the unemployment problem? Probably…. We could put all of the unemployed people into the army…. Alternatively, we could give private companies the incentive to employ more people by moving the economy from a high unemployment equilibrium to a low unemployment equilibrium. That solution would require bloggers, politicians, journalists and policy makers to consider some new ideas.

Is, to put it lightly, a non sequitur. There are perfectly conventional alternatives to mass conscription; a trillion dollars of stimulus spending would do the trick, just as a f’r’instance; Paul Krugman has suggested just hiring back all the teachers and firefighters the states have laid off as an adequate remedy, and several other commenters have noted the troubling shortage in infrastructure spending. These are not “new ideas,” and they aren’t even particularly difficult to think of.

The problem I have with arguments of this sort is they seem to wave away the practical question in favor of some analytical abstraction—as you do, distinguishing between “what causes unemployment” and “why does unemployment persist“—seemingly unaware that the question Samuelson et al. are attempting to answer is not how to think about the problem but rather what to do about it. There’s nothing wrong with doing so; how to think about the problem is important. But when you make that argument, you are emphatically not making a rebuttal to the Samuelson position.

Roger,

A better way to achieve the stabilization of asset values that you propose would be to change the structure of money. The problem with money whose value is defined by an explicit consumption guarantee (inflation target) by government is that it provides a psychological mass focal point in times of crisis that in intrinsically dangerous because governments cannot, in fact, guarantee the ability of money to transport consumption from the present into the future. This is what brings about the paradox of thrift. A better solution would be if money was just a representative basket of capital assets so that a flight to money in a time of crisis would, in fact, just be a flight to capital assets. The fact that this also solves the problem of the indeterminacy of the value of money is not incidental to the likely highly positive benefit of such a policy.

How could such a system of money be achieved? It wouldn’t be very hard. Government would only have to define the constituencies of such a basket (the unit of account), and leave it up to the private sector synthesize the actual vehicle (the medium of exchange). In case anyone is worried that price stickiness or other nominal rigidities would leave capital assets *too* stuck to the price or wage level, it would be easy for the central bank to announce purely nominal adjustments in the numeraire via the equivalent of stock splits. The benefit of such splits would be that it would have no real impact on the holders of money: they would still hold the same quantity of capital assets.

It’s certainly a longer term plan than just for the Fed to go out and stocks and low grade (high beta) mortgage bonds. But it feels a lot less like an opportunistic bailout, and it has a hope resolving the paradox of thrift dynamic in an intrinsic, rather than arbitrary and subjective way.

Roger Farmer writes of a crisis that “finds most western economies operating” with “high and apparently sustainable unemployment rates.” …Sustainable? I am unclear on this, is that the jargon of a mathematical model, a bow toward NAIRU, or does it mean “sustainable” like most other people use it?

If I may translate for what I think Farmer is saying – the high unemployment rate is sustainable in that it will not automatically self-correct. We could find ourselves, like the British in the 1920s, with a decade of 8-10% unemployment that won’t fix itself by lower worker wages, or by inflation bringing the general price level up to the point where “overpriced” workers with sticky wages will suddenly reach their equilibrium price and everyone gets hired.

The notion that one can get caught in a slump and stay there for a long, long time is one of Keynes central insights.

I think people are also missing the point on the “people are rational, markets are not.” If you look at his linked paper – the argument is that even in a model with allegedly rational agents who have any sort of heterogenious outlook, then markets do not behave “efficiently” and do not produce optimal allocation of investments. I don’t entirely buy the people are rational bit, even if the definition of rational does account for all of the behavioral econ issues, but making the case that markets don’t work even with rational individuals is huge.

RF:

” Yes: the economy recovered slowly after the initial drop that followed the 1929 crash. But what makes you think that this derisory “recovery” could be attributed to the New Deal.”

This is the kind of off-hand remark, which makes any sensible person go ballistic. If you don’t know the history of the Great Depression, don’t pontificate on it. The “initial drop” after the Crash took 40 horrifying months to complete, and the “derisory” recovery, whether the “New Deal” contributed anything to its pace or not, was measured in double-digit growth from the trough.

RF:

“The use of the word ‘rational’ to describe the outcome of the beliefs of a group of interacting agents as in the “rational expectations hypothesis” is unfortunate. This is a very different sense of the word and there is no reason to expect groups of interacting agents to find their way to a rational expectations equilibrium in the sense in which that concept was used by Robert Lucas and pretty much all of DSGE macroeconomics since Lucas.”

“Rational expectations” in Lucas’s sense is so abstract that it is difficult to see how it ought to map to an operational understanding or factual observations. But, one thing I’m pretty sure of, “rational expectations” can not be a property of a real individual person, in social isolation. Such a person might be said to be “rational” in any number of senses, but cannot be said to be in possession of “rational expectations” without being in strategic interaction with others.

This is the most serious confusion you’ve promoted. “Rational expectations” in the Lucasian sense has to refer to the properties of a group, or the outcome of a group interacting. Lucas’s “rational expectations” are shared expectations, socially constructed expectations distinct from an individual’s subjective and idiosyncratic notions or private information.

You are certainly correct that there’s no general reason to expect a particular and actual group, interacting, to arrive at anything like rational expectations. A DSGE model is not a map of any territory, and that’s a serious problem. But, so are “magic of the market” explanations, which presume rational expectations are formed or that pareto-optimal results are realized, with no mechanisms to achieve that result.

Roger Farmer @ 106
“the relative price of houses … is too low, relative to both the money wage and the prices of consumer goods.”
Whether that may be true for the US I cannot say. That it is true for the UK, only those holding on desperately to housing purchased near the top of the unsustainable property bubble could agree. Query: is economic advice for USAians always relevant to other places?

Bruce Wilder @ 111

With terrified trepidation: when you, as a great expert, write “If you don’t know the history of the Great Depression, don’t pontificate on it” could I tentatively ask whether accounts I remember to have read, claiming that the Treasury-controlled recovery from the Great Crash in the UK was actually no worse if not better than the wonderful New Deal-driven recovery in the US, were entirely inaccurate?

Not trying to pontificate at all, you will understand, just trying to build bridges. If non-US experience may be reguarded as relevant to anything.

RF:

Unemployment is high because demand is low. Demand is low because unemployment is high. That is the main insight from the General Theory.

Why do we need to reconcile that insight with the Lausanne school of General Equilibrium theory? Because when there are obvious large gains from trade (a firm offers to hire a worker for lower wages) we would expect both sides of the transaction to agree to the trade. Keynes did not explain in a satisfactory way, why that trade does not occur.

I’m never quite sure why Walras is not the one being asked for further explanations.

If we look at the actual economy, we don’t see a lot of actual markets, but, for the sake of argument, let’s say that we accept the metaphor of a market as broadly applicable. Then, what we see, if we look, are a lot of markets, which do not clear — there’s no equilibrium, and, therefore, no equilibrium price, and the price that is observed, does not act to clear the market. What we observe, when we walk through the aisle at the supermarket are a whole lot of administered prices. Corporate administration and marketing takes the place of tatonnement, and instead of clearing the market, they engage in price discrimination schemes and administrative management of demand.

Have you ever gone to the movies? Is that a market-clearing price? Why do they charge the same ticket price for the bad movies as the good movies? Do they auction off the empty seats, just before the curtain goes up?

Have you ever hired a newly minted Ph.D. in your department? Think about how the offer letters get put together? Does that describe a market-clearing process?

Alan Blinder 15 years ago, lead a research project on prices, and published a book, Asking about Prices, on the results. Shocking, I know, but most firms are not in competitive markets, of even the metaphoric sort; their marginal costs are below average cost and, often, declining over the relevant range. Increasing returns to scale are common, and firms price, strategically.

Are there going to be “obvious large gains from trade” for the worker, when the firm offers a lower wage? That seems a patronizing presumption, at best. If the firm is a restaurant, which does not have enough business to fully employ the waiter, cook or busboy, and offers them fewer hours or a lower wage, while we wait around for the economists pulling on their chins to debate the application of the Lausanne School’s dubious insights, something is obvious, but it is not large gains from trade.

Walras needs to explain how many price and wage adjustments in an economy in which many industries are not anywhere near a long-term equilibrium and in which many, if not most, (metaphoric) markets do not clear in price, is going to get the economy to full-employment or a fair and efficient distribution of income in any finite length of time.

“My own reading of the evidence is that the government spending multiplier is positive, but less than one.”

If this is the case how do you explain Greece and the eurozone more generally? Also if this is true wouldn’t it make sense for the government to spend nothing?

Stephen @ 115

The proximate cause of the Great Depression was the gold-exchange standard and the misguided efforts, by austerity and tight money to hold to it.

Barry Ritholtz has advanced the generalization that how soon a country abandoned the gold standard correlated well with how severe the initial slump became and how soon recovery began. In that respect, the U.S., Germany and especially gold-loving France may have erred badly. The U.K., one might say, had their depression early thanks to the misguided efforts of Winston Churchill in 1925 to bring the pound sterling back to gold at pre-war parity. The political effort to stay with gold was tremendous in the U.K. — it nearly destroyed the Labour Party — but it failed a bit earlier than in the U.S., which had to wait for FDR.

Beyond that, it would be difficult to connect outcomes with policy in general terms, without sinking into the swamp of circumstantial detail. The Great Depression can be said to have been less severe in the U.K. than in U.S., in several broad senses. First, the U.K. did not experience a boom in the 1920s, and so the slump may have seemed less severe, though the depths to which employment and trade fell were great. The U.K. had a more developed social welfare state, and so was more aggressive in providing a dole and relief. Finally, in the late 1930s, London and southeast England did experience something of a boom, due to electrification, autos and the same kind of New Economy technological advances as drove the 1920s boom in the U.S., and U.K. income growth was pretty good overall as a result, although large areas of the country remained mired in severe poverty and high unemployment.

I almost always agree with Bruce Wilder, but (1) his posts in this thread have been extraordinary (2) even given 1, his observation that Mr. Farmer is a very, very clever writer is brilliant.

Cranky

“the relative price of houses, factories and machines is too low, relative to both the money wage and the prices of consumer goods.”

Sorry, I’m just not understanding what this claim means. If the relative price of real capital assets, not just financial ones is cheap, compared to dear wages and consumer prices,- (but what the evidence for the latter, when there has been a clear drop off in AG and when high unemployment virtually guarantees stagnant wages),- then why wouldn’t that spur real investment, since high consumption prices and the pressure of high wages should be a boon to ROI?

To get back to Keynes, well, I’m no expert on him, but it does seem his account is a bit sketchy, referencing the “declining marginal efficiency of capital” (presumably meaning further real investment) and then quickly moving on to the “animal spirits” of investors, (financial or real?). B.W. does this schtick better than I, but when significant sectors of the economy responsible for a high share of total output are large-scale capital-intensive oligopolies, with both large sunk-cost fixed investments and endemic excess capacity, (for a number of reasons, but the upshot is that excess capacity maintains market share by deterring competitors), then the price of labor, i.e. the wage is only a small part of the cost equation. Such firms would always like to produce and sell more, and are thus demand constrained, since the more they produce and sell, the lower their unit output costs and the higher their profit mark-up at once, with wage costs being only a small factor, which can’t adjust significantly to reducing costs, even as lowered wages reduce consumption demand. Because the situation works in reverse as well, since when there is a sharp drop-off in AD, the unit output costs sharply rise, even as market prices decline, in ways that the wage rate is largely irrelevant to.

From a Marxian POV, that’s not hard to explain. The prior investment boom has led to an over-accumulation of productive capital and, as the available technical possibilities/opportunities for investment dry up, the ROI declines, leading to a drop off in capital goods production and employment that then spreads to consumption goods sectors, since the wage rate will always lag the increased returns to capital from investment. If the boom however is prolonged through increased flows of investment into speculation on inflated financial asset prices, then the bust and crisis will be all the worse, since large accumulations of fictitious capital become unpayable debt will need to be written down before any recovery can occur. (Since “financial assets” of whatever sort are merely paper legal claims on incomes from production, profits and wages, and claims that can’t be paid off from such incomes won’t be). The classic Marxian formula was that the value of capital would need to be “destroyed” until such a point where it once again accords with the available mass of labor value, at which point the cycle of accumulation can begin anew, (or lead to some much different system). That’s the sort of thing that leads B. Delong to fulminate that Marxist and Austrians are really the same thing, against august neo-liberals such as himself. But the common thread between the two, despite much different aims and auspices, is the notion that crises result from the failure of inter-sectorally balanced, thus sustainable reproduction. And the relevant application here is why wasn’t the pre-crisis economy not displaying ample signs of unsustainable imbalances and why would we not want to correct those imbalances toward a more sustainable recovery, but, one way or another, writing down unsustainable debt-loads and replacing our current financial system and its exorbitant rent-extractions, (which are not unrelated to the MNC FX arbitrage strategies underlying huge CA imbalances), with a much more regulated and sustainable “model”.

AFAICT, Roger Farmer is relying on reflating financial asset prices to induce recovery through the “wealth effect”, which is exactly the sort of thing that caused the crisis in the first place, rather than addressing the underlying imbalances that prevent really sustainable growth, (which requires both re-distribution and re-regulation). So for all his “technical” prowess, he strikes me as just another neo-liberal ideologue.

A meta-comment. Even by blogosphere standards the variation in quality of comments here is high. But I think the distribution has a fat tail – a few of the comments are learned and wise and may lead to furious thinking.

What I’m saying is – Roger, don’t be deterred from further engaging in the thread or from posting again by the tone or content of some of the comments. Many CT readers are quite educable – despite appearances you can change minds if what you say is persuasive enough. Also experienced bloggers learn that there is little correlation, positive or negative, between comment tone and content – even ill-mannered posts can be worth responding to.

Roger Farmer, you seem to be a strong support of Ramey’s work, but I haven’t seen her address, in a detailed way, the impact that the policy environment at the time–namely, rations and wage and price controls–might have on her findings. These sorts of policies would have a dampening affect on demand responses in fairly straightforward ways, eg no higher prices => no entrepreneurial response; rations => no increased consumer response. Well her econometrics may be quite careful, it seems like the external validity is low.

Bruce @ 7: if financial markets are not at least somewhat (informationally) efficient, and practically superior to…expert opinion, it is difficult to see why anyone would bother

I’m not finding it too difficult. Roughly, and using your subsequent schema, the ‘smart money’ obviously has a good reason to bother, while the ‘dumb money’ is too stupid to know any better.

And: Without an institutionalized market to corral them into a mutually self-aware crowd, there’s no wisdom of crowds.

I’m not convinced that the ‘wisdom of crowds’ technique – subtype: determinative (guess the weight) rather than heuristic (design a poster) – is as great as recent chatter would suggest, and in particular not for complex and specialised problems like estimating the present value of a dividend stream. (I’m personally also not convinced that discrete firms offering dividends need be part of a well-run economy, but whatever.)

While an institution of some kind is always required to elicit and aggregate the estimates of crowd-members, it need not be a market, and indeed shouldn’t be: for aggregated-estimate flavours of crowdsourcing, the participants should precisely not be mutually self-aware. In the specific application under discussion, this mutual awareness gives us groupthink, false estimates intended to influence the market, and all the convoluted second-guessing of the Keynesian beauty contest and worse.

———-

& @117: Walras needs to explain how many price and wage adjustments in an economy in which many industries are not anywhere near a long-term equilibrium and in which many, if not most, (metaphoric) markets do not clear in price, is going to get the economy to full-employment or a fair and efficient distribution of income in any finite length of time.

Also, even if there were such an equilibrium, those things would still need to be explained. Why is an equilibrium to be regarded as an optimum? Because there’s a new kind of ‘optimality’ in town (apropos not much, Pareto was Walras’s student, I believe).

This kind of optimality is defined so that it’s exhibited by all and only (notional) end-states (which are thus equilibria, of a kind anyway) of the process of market trade (where we include giving away stuff you don’t want as a limiting case of market trade). It has no specification independent of such a process, really – I can’t see what remotely plausible objective-function one could come up with that would be satisfied by all and only possible end-states of the trading process. (This is of coure a purely notional trading process in which, for example, all participants – unlike central planners when they are put in charge of notional allocation schemes – are handily equipped with perfect information, which is nice.)

Saying that a distribution is Pareto-optimal tells us nothing about how desirable – by any other non-gerrymandered standard – that state of affairs is compared to all the multitude of other feasible distributions in which someone is better off and someone is worse off, and which are thus not Pareto-commensurable with it.

Once a dynamic kind of approach is taken, in which it’s recognised that the Pareto-improvement system is the market economy itself, or the shifting collection of things and people on which it supersists, I think one probably has to allow that preferences and the total stock of goods change during, and as a result of, the process. This adds yet more path-dependence/arbitrariness, and the idea that all and ony the possible future local ‘optima’ (were any of them to be reached and not superseded) are tied for the status of ‘best feasible outcome’ relative to the situtaion ex ante (when the Pareto machine was set in operation) becomes still harder to swallow.

Of course technical reasons can be supplied for the use of Pareto criteria rather than some independently specified objective-function. One can argue about how good these reasons are and to what extent ‘ideology’ has shaped those too (spoiler: not that good, and quite a bit), but even if it should be established that economists couldn’t possibly do better, that would of course still just mean that economists can’t do better – we should not conclude that Pareto-efficiency/optimality is after all efficient/optimal (never mind the fairness side of things) in any ordinary sense of those words.

Pareto died in 1923, according to Wikipedia; I imagine that the state of the art in analyzing dynamic systems has advanced, and possibly significantly advanced, since that time.

I’m not a game theorist (obviously) but it does seems to me that perpetual disequilibrium has to be the fate of any system in which the pieces parts are perpetually trying to game one another. It may not really be turtles all the way down, but surely it’s the motion, either of the whole system on its way someundefinablewhere, or the eddies within it that are interesting, not some snapshot taken along the way, and put under a microscope for the purposes of this or that very iffy analysis.

Roger Farmer @86:

Roger, I agree that different general systems can settle into sub-optimal regimes — and that in macro, perhaps labor search problems could combine with asset price expectations to create just such a sub-optimal attractor, or “chreod”.

In our case, however, the problem appears to be mostly concerning house prices. Job openings in construction are lagging behind other sectors, (which are mostly growing, though spottily). But construction should be the least costly of all labor search and match: the housing industry is geographically widespread, the construction firms are very decentralized, entry-level construction jobs are easy to qualify for (even easier than mass retailing), and wage expectations are small.

So, while there is good cause to think that demand depends (partly) upon beliefs of market participants about the future value of assets, it is difficult for someone who has spent a lifetime in the construction industry to believe that the unemployment equilibrium is mainly due to frictions in the labor market and in recruiting externalities.

Note that there was a crash in the future values of two asset markets: mortgage derivatives and house prices. These were linked, but only the bank balance sheets were bailed out.

Repair of household balance sheets would seem to be the best way to correct a handful of problems at once: to improve consumer credit, to increase house prices and sales, to increase construction and remodeling, and to increase the wealth effect.

Yet qualitative easing does not seem to leak through into mortgage write-downs. Do you have a proposal for making this happen?

If not, then what remains to pay off debt, and to pay it off in a liquidity trap with tighter credit standards, but fiscal policy? Fiscal policy isn’t only meant to increase aggregate demand, it looks like the only remaining way at present to quickly increase incomes to fix household balance sheets for participation in the housing market.

P.S. The fiscal multiplier may benefit from the fact that construction laborers are likely to be consuming based on current income, not lifetime wealth or expectation of asset values, so they provide immediate and widespread demand for other consumer goods.

P.P.S. You wrote, “…when there are obvious large gains from trade (a firm offers to hire a worker for lower wages) we would expect both sides of the transaction to agree to the trade. Keynes did not explain in a satisfactory way, why that trade does not occur.” –Could this be explained by assuming that job-seekers may not accept lower wages right away because they have observed that consumer prices are downward-sticky under monopolistic competition?

Why didn’t the U.S. and other nations fall back into Depression after the war ended as many economists such as Samuelson expected given demobilization?

Was it inflation that wiped out war time debts and remobilization for the Cold War? Can we thank the GI Bill and Sputnik?

Also, Professor Quiggin, does Australia have a debt ceiling? Does any other advanced nation besides the United States have one?

Bruce, @140
I’m of the view that there is another very plausable explaination – healthy household balance sheets. Pent up demand after war time rationing, combined with the financial resources to spend allowed a rapid replacement of public consumption by private consumption.

reason @ 141 In many ways, “healthy household balance sheets” is just another point-of-view on, or aspect of, the broad income distribution story.

Your point is well-taken, though, about a large stock of accumulated private sector savings (in the form of government cash and securities — public debt) being a key to the mechanics of a “successful” austerity policy. Of course, this example also undermines RF’s Ricardian Equivalence argument that the gov’t debt incurred now to raise employment and incomes will somehow be cancelled out in the future by increased taxes. It seems our wartime experience (even allowing for the important circumstance that we won the wars in question) suggests that employment and income can be higher in both the stimulus period and post-stimulus period, as a result of adding to the debt and spreading that debt around as wealth.

Why no discussion of what the New Deal and the war actually invested in? If industrial linkages and dependencies are important, and economies of scale factored in, then huge investments in production of the basic feedstocks of the new technologies – aluminium, refined oil, electricity, chemicals and such, in delivery systems (airfields, pipelines, ports, modern ships) and a massive re-training of the agricultural and service sector workforce in the production and use of these technologies must surely have laid the ground for the private sector to take off post war. A different kind of investment would surely have had a different result. Much of the different histories post the two wars is surely because of very different patterns of investment and mobilisation.

Again – why does not economics follow other similar disciplines and build on multiple detailed studies? Instead, we see repeated high-level hand-waving.

Bruce Wilder @143
“. It seems our wartime experience (even allowing for the important circumstance that we won the wars in question) suggests that employment and income can be higher in both the stimulus period and post-stimulus period, as a result of adding to the debt and spreading that debt around as wealth.”

Nobody wins wars, some just lose less badly. Yes, but the point about before and after the stimulus holds, much to anger of “Austrians” who think believe in equal and opposite reactions.

There are two unanswered “big theoretical issues” in macroeconomics. The first is; what causes large sustained shocks to aggregate demand of the kind we saw in 1929 and again in 2007? The second is; why does high unemployment persist?

This is a very important point.

I wouldn’t develop it exactly as Farmer does, but I agree with him 100% that Leijonhufvud is the right starting point.

Monetary policy is ineffective once a deep recession has gotten underway because a sustained equilibrium leads to a high-unemployment equilibrium: a situation where people rationally reduce expenditure because they believe their permanent incomes are lower than they previously did, and these expectations are self-fulfilling.

*In the crisis*, there is excess demand for means of payment, and monetary policy can be very effective in arresting the downturn through interventions to increase liquidity, including lender-of-last-resort interventions as well as conventional expansionary policy. Once the new equilibrium is established, however, there is no excess demand for liquidity, and the same interest rate that was consistent with full employment before the crisis may now be consistent with high unemployment. Under these conditions policies that raise incomes directly will be much more effective than policies to increase the supply of liquidity, regardless of whether you are at the ZLB.

Roger Farmer is right that the fatal flaw of New Keynesian approaches is that they posit a unique Walrasian equilibrium, which correct policy can bring the economy to. In fact, there are many possible equilibria, and the question of what maintains the economy in a low-employment equilibrium is analytically distinct from the question of what causes a transition from a high-employment one.

I should add that while I like Roger F.’s post quite a bit more than I had expected to, I also like (and mostly share) Bruce Wilder’s criticisms of it.