How effective is fiscal policy: Guest post from Roger Farmer

by John Quiggin on January 8, 2013

Roger Farmer, professor of economics at UCLA, has sent a response to my post on the fiscal multiplier, which is over the fold. I’ll make some substantive points in comments, but I’d like to start by saying that this is a good example of a discussion to which blogs are ideally suited. Contributions from people like Roger who have something important to say, but not the time or inclination for a regular blog, make it even better.

John. You ask for responses from DSGE theorists to the question; how effective is fiscal policy? Let me provide a personal response.

In the opening paragraph of your post you assert that: “The biggest theoretical issue in macroeconomics is ‘what causes unemployment’.” I prefer the following characterization of the state of our subject:

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?

Distinguishing these two puzzles is central to arriving at an understanding of the crisis that finds most western economies operating with high and apparently sustainable unemployment rates.

There is an active discourse in the blogosphere that characterizes the debate as a battle between a group of classical fiscal policy deniers and a rearguard group of Keynesian realists who carry the truth of the Master. In this characterization of the intellectual discourse the evidence is plain: fiscal policy matters and it matters in a big way. If stubborn government ministers would recognize this simple truth, a large and sustained fiscal boost by leading economies would solve all of the world’s problems.

I consider myself to be equally entitled to the label ‘Keynesian’ as the leading proponents of fiscal expansion, but I do not share the consensus view of self proclaimed Keynesians that a large fiscal expansion is the solution to our dilemma.The slavish devotion to remedies to the Great Depression that were proposed more that eighty years ago smacks of religion; not science. As Keynes himself said on leaving the Bretton Woods convention in 1946, “I was the only non-Keynesian in the room”.

Writing in 1968, Axel Leijonhufvud made the distinction between Keynes and the Keynesians. That distinction is useful because it clarifies the idea that the formulation of the General Theory that was popularized by Samuelson in the third edition of his undergraduate textbook misses the key idea of Keynes’ masterpiece; that high unemployment is an equilibrium phenomenon, not a temporary deviation from a classical ideal state. Samuelson’s interpretation is, to quote Joan Robinson, “bastard Keynesianism”.

In my introductory paragraph, I raised two questions. Let me begin with the second question first: Why does high unemployment persist? Samuelsonian Keynesians see the issue as one of deficient nominal aggregate demand. Unemployment is high because nominal prices and nominal wages are too high. We can wait for nominal wages and prices to adjust, or we can boost demand through monetary or fiscal policies taking existing wages and prices as given. Since the money interest rate is at its lower bound, monetary policy will not work. That leaves fiscal policy to boost demand.

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. There is no coherent theory of unemployment in the General Theory; there is simply an assertion that households are not on their labor supply curves. That lacuna pervades all of the new-Keynesian models developed before the 2007 crisis and many of those developed since. In almost all of these models there is no unemployment since households are always on their labor supply schedules. A recession is, to quote James Tobin, “a sudden attack of contagious laziness”.

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. These models are surveyed in a piece I wrote for a special issue of Macroeconomic Dynamics that is available here. 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. That is a disturbing thought to those who would boost demand by purely monetary means since it suggests the possibility that we may end up with 8% unemployment and high inflation simultaneously.

Nothing I have said so far is inconsistent with the notion that fiscal policy is the answer to our dilemma. That is where we would be wise to ask ourselves the first question posed in my introductory paragraph.  What causes large sustained shocks to aggregate demand? The answer to that question is contained in a second strand of research that I have been engaged in both individually, here, and jointly here. Competitive unregulated financial markets cannot be expected to find the “right” relative price of capital except by chance, for the reasons expounded more than thirty years ago in a research agenda that was initiated at the University of Pennsylvania.  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.

This brings me back to the correct policy response. Monetary policy has two dimensions. One is the expansion of central bank balance sheets to increase the money supply with the goal of boosting nominal demand. 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.Willem Buiter has called the first policy; quantitative easing and the second; qualitative easing.We need more qualitative easing.We may need a bigger government sector; but that is a logically separate question from the issue of how to cure the unemployment problem.

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.We could put all of the unemployed people into the army. I do not think that is the right response. 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.

{ 152 comments }

1

jazzbumpa 01.08.13 at 4:56 am

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

2

Lord 01.08.13 at 5:00 am

There could well be both nominal and real problems, nominal due to debt and asset mispricing, and real due to a lack of perceived investment opportunities. This makes me wonder how effective depression era employment programs were. They did employ millions, with work then, not someday, and did create much of infrastructure of next half century. It also makes me wonder what investments we are failing to make now, like universal high speed broadband and wireless because the perceived returns are too low.

3

Brett 01.08.13 at 5:00 am

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.

4

Bruce Wilder 01.08.13 at 5:13 am

Let me begin by saying that I like your frame of the chief puzzles of macroeconomics somewhat better. What is the nature of the big busts (e.g. 1929, 2007)? Why does high(er) unemployment persist? You pose the basic questions, well.

RF: “Unemployment is high because nominal prices and nominal wages are too high.” I think you need, for the sake of your own argument, to complete this sentence’s predicate. Too high relative to what?

There is a theory of unemployment in the General Theory, whether you consent to acknowledge it or not. It is implicit in the notion of twin circular flows, as measured by the double-entry system of national accounts: a flow of money in one direction, and goods in the other. Unemployment is high because nominal prices and nominal wages are high relative to the volume of (money) flow, but the money flow of income is drawn directly from nominal wages and prices, as they are. Reducing wages and prices simply reduces the aggregate flow of income. Our intuition, drawn from disaggregate experience, is that reducing relative prices or wages, can increase demand, but there is no easy way to reduce prices and wages in the aggregate relative to the aggregate income, since one is a composite of the others; prices and wages, are, in the circular flow, the source of income — reduce one and you reduce the other.

As one would think would be well-known to students of the business cycle, the aggregates of the circular flow vary, cyclically, and can spiral up or spiral down in response to “shocks”, as in late 2008 and early 2009, as the U.S. economy experienced a particularly severe inventory cycle.

This vision, of aggregate income in circular flow, driven forward in cycles, based in large part on fluctuating enthusiasm for investment spending and changing stocks of consumer durables and capital equipment and business inventories, suggests that the phenomena of the macro economy are different in kind and behavior from what one might expect, given intuitions drawn partial equilibrium models of single markets — labor search, etc. One can imagine in cyclical models of flow, for example, a race condition developing, in which a change in a price signal fatally lags behind changes in the quantity of employment and income, an economy spiraling downward, drastic cuts in wages and prices unable to arrest each further decline, and, in fact, exacerbating the fall. 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.

In smaller, less lethal scenarios, though, if you want to see, you can witness much smaller waves ripple across the economy, from regular changes in labor demand, such as the Xmas season, or, say, the recent small blip due to Census hiring.

5

Hidari 01.08.13 at 5:38 am

” Agents are rational.”

No they’re not. And I can prove it.

6

The Raven 01.08.13 at 6:30 am

“…rational behavior by profit seeking firms…”

Name of the gods, are there any firms which display “rational” behavior?

7

Bruce Wilder 01.08.13 at 6:35 am

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!

8

John Quiggin 01.08.13 at 6:52 am

My main objection comes right at the end with the sentence

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.

Sure, but why confine attention to the US? Australia had great success in 2009 with a stimulus of around 3 per cent of GDP, for which the multiplier was probably close to 1. Moving away from particular cases, the empirical work of the IMF (which could scarcely be accused of a pro-deficit bias) seems pretty convincing.

9

DCA 01.08.13 at 7:29 am

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.

10

Bruce Wilder 01.08.13 at 8:53 am

How does financial crisis lead to the draining away of effective demand from the circular flow and the associated fall in aggregate demand?

What’s the arithmetic? What’s the mechanism? A black hole?

In light of the arithmetic, what is case for letting wages and prices fall relative to the claims of banksters financial claims holders? How would that “help”?

11

roger gathman 01.08.13 at 9:17 am

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

12

Anders 01.08.13 at 9:21 am

RF: “We may need a bigger government sector; but that is a logically separate question from…”

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!

13

Alex 01.08.13 at 10:13 am

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.)

14

Kien 01.08.13 at 10:17 am

I am sure Singapore’s government uses fiscal policy to tackle downturns. I think most Asian governments including China think that fiscal policy is effective.

15

SJ 01.08.13 at 10:57 am

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.

16

James Wimberley 01.08.13 at 1:56 pm

An attractive institutional explanation is that monetary policy is broken since banks have created a make-believe closed universe of purely financial transactions, dwarfing the banking system’s vestigial contact with the real economy through business loans to non-financial companies and mortgages to households (see Vickers report: the UK ratio is 3 or 4 to 1). In a depression like now, monetary expansion stays in the make-believe world and rarely leaks out into the real one. (In a boom the banks overlend to the real economy. The point is that the linkage is unstable.)
An attractive theoretical speculation, at least to me, is that real economies are not in equilibrium at all. Money allows transactions to take place out of equilibrium, which is impossibly expensive to secure, even in Walras’ neotlithic village market. In permanent dynamic disequilibrium, averaged herd expectations are king and self-fulfilling. Individual expectations are almost always wrong.

17

Barry 01.08.13 at 1:59 pm

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).

18

Barry 01.08.13 at 2:09 pm

Sorry, not that what they’re pointing out is a lie, but the conclusions they draw are.

19

jazzbumpa 01.08.13 at 2:16 pm

@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

20

jazzbumpa 01.08.13 at 2:25 pm

@ Anders, #12

A tax cut is an equally valid form of fiscal expansion

Only maybe, certainly not always and everywhere. If tax rates are high [relative to some theoretical optimum] then yes. If they are lower, then no, they won’t be effective.

Also – taxes on whom? I’ll posit that low taxes on the hyper-wealthy will almost never be a valid form of fiscal expansion. On the middle class – maybe. On the working poor – very likely yes.

IMHO, one of the big problems in economic thinking – especially on the right – is absolutism. If caster oil is good for constipation, then it’s also good for vertigo or a broken leg.

JzB

21

SusanC 01.08.13 at 2:42 pm

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”…

22

Charlie W 01.08.13 at 3:20 pm

Jeepers, the comment quality … in an inverse relationship to the quality of posting, by the look of it.

23

Barry 01.08.13 at 3:23 pm

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)

24

Robert 01.08.13 at 3:28 pm

I find interesting the idea of a continuum of equilibria. I would like to like Farmer’s work. But I fear it is most helpful for boring from within, not explaining actually existing capitalist economies. In some ways, he seems to take on too much of the baggage of DSGE modeling.

25

MPAVictoria 01.08.13 at 3:42 pm

“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!

26

Salem 01.08.13 at 3:44 pm

are there *any* right-wing economists who don’t do their best to ignore the Great Depression?

This work is probably the most famous and influential book on macro since the General Theory, written by perhaps the most famous right-wing economist of the 20th century, and it has become (with some modifications) the generally accepted narrative of the Great Depression. You may not like the Monetarism and its offshoots (*which include the New Keynesians*) but it’s a bit rich to complain that it’s not a thing.

27

SusanC 01.08.13 at 3:55 pm

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).

28

Barry 01.08.13 at 4:16 pm

How does it treat the New Deal? How does it treat the trend change from 1929-32 vs 1933-36?

29

Niall McAuley 01.08.13 at 4:20 pm

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.

30

Bruce Wilder 01.08.13 at 4:45 pm

James Wimberley @ 16

JW: An attractive institutional explanation is that monetary policy is broken since banks have created a make-believe closed universe of purely financial transactions . . .

Typically, in analysis, economists barely concede money/finance an existence, making it at best and at most, a shadow of the so-called real economy. As long as every financial/accounting asset is only the shadow of some real factor resource, the financial stream of money income that gives the asset value is a mirror of the factor income stream that arises from the factor’s employment in production. This would seem but an extension of the practice in the quantity theory of money, in which the level of activity in the economy required a fluid money moving at fixed velocity under pressure to fulfill each market transaction at a particular market price; vary the quantity of money — the hydraulic fluid — and prices could adjust to restore the balance, where the available quantity of fluid was sufficient to allow every market transaction to be fulfilled.

This “quantity” intuition lurks in Farmer’s interpretation of the first neoclassical synthesis — what he refers to as Samuelson’s Keynesian-ism. It is a conservative’s misinterpretation of the concept of “sticky price”, “sticky prices” being central to the first neoclassical synthesis (and the synthesis’ interpretation of Keynes, who may or may not have had any such idea). Conservatives want to believe that “sticky price” means a price “too high”, and that if the economy’s “market structure” allowed prices to adjust quickly enough, fluidly enough, full-employment of resources would be restored quickly and “naturally” and automagically after a “shock”. The business cycle would be just like the life cycle — from dust to dust, from equilibrium to equilibrium.

In the days, when precious metals figured more prominently in monetary arrangements, the quantity interpretation was, at least, occasionally operative. Under the gold standard, a liquidity crisis was driven, in the end, by a shortage of specie, that is, gold coin or bullion. Supply the coin, as the Bank of France was able to do for the Bank of England in Brad DeLong’s Ur-Crisis, the Panic of 1825, or as J.P. Morgan was able to do for Grover Cleveland in 1894, and it was as if oil were cast upon the waters, calming the storm.

A fiat money, without any reference to gold, would seem to have only fiat, and fiat is the fiscal capacity to make good the fiat. A fiat money is backed. A fiat money has value, because it is a claim on goods and services, and the backstop to that backing is the fiscal capacity to collect taxes and make purchases in the sovereign’s currency.

Where the quantity intuition about the relationship of money and money prices to the aggregate level of economic activity (i.e. the “velocity” of transactions, in quantity-speak) goes wrong is in envisioning that money is primarily a means of token exchange, and price a rate of token exchange to mirror the exchange of goods: money as a shadow.

Every transaction is a warranted, contingent exchange, not discrete, but continuous in time. There’s a guarantee of satisfaction and merchantability, when you buy toothpaste at the supermarket, for heaven’s sake. Insurance, in a very broad sense, is ubiquitous, and money (and credit) supply not tokens, but that insurance. Unexpected, unanticipated changes in the nominal value of money can be very, very disruptive, breaking many, many deals — explicit and implicit contracts, which involve some warranty or debt.

There’s a basic failure of imagination in the discourse of economists, who fail to unpack “sticky prices” as something far richer and more complicated than “prices are too high”. The so-called Keynesians are as guilty of this failure of imagination as their conservative interlocutors. And, it is a failure, especially, of historical imagination — the “sticky prices” of the Great Depression, after the deflation of 1930-34 were not “too high” — in many cases, they were, if anything, “too low”, which everyone at the time instinctively understood, which is why there was a panicked effort to form cartels to supply the security of market power to back the insurance, that deflation had drained away.

JW: “An attractive theoretical speculation, at least to me, is that real economies are not in equilibrium at all.”

Indeed. And, all the evidence, frankly, indicates that the economy — the capitalist economy of the last 300 years or so — is only in equilibrium occasionally, and then only in the sense that a moving bicycle is in a gyroscopic equilibrium, stabilized by the inertia imparted by a rhythmic pattern of forward motion. Schumpeter’s on-going torrent of creative destruction is very much a continuing disequilibrium process, and the bicycle and its riders are prone to hitting bumps (“shocks”), and being thrown to the ground.

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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.

32

Bruce Wilder 01.08.13 at 5:05 pm

roger gathman:

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

Frankly, I found Roger Farmer’s swirl of smoke and mirrors too thick here to hazard my own interpretation, but I found yours suggestive. Maybe, he really wants to paraphrase, not Marx, but Scrooge: “Are there no workhouses? Are there no prisons?”

33

Bruce Wilder 01.08.13 at 5:33 pm

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.

34

PGD 01.08.13 at 6:18 pm

Bruce Wilder has made some really brilliant comments in this thread (particularly 7 and 30). I’ll say it again: CT has one of the best comment sections on the internet, even though that is apparently unappreciated by the main posters. The issue is that the variance of comments is quite high, so the worst are pretty bad, but the need to ignore them is a small price to pay for the very best ones.

I join JQ in saying that Farmer’s contribution is excellent as well (even if one might disagree with the ways it adopts to many of the assumptions of DSGE economics) and thanking him for starting the conversation in a fruitful way. I hope he returns to comment on the thread.

35

Barry 01.08.13 at 6:29 pm

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.

36

Anders 01.08.13 at 6:35 pm

Jazzbumpa @ 20, Barry @ 23:

You’re right: my comment “a tax cut is an equally valid form of fiscal expansion” was far too categorical. I actually hold the weaker claim that a tax cut can be just as valid as a rise in spending.

The point is of course that the popular preconception “fiscal expansion ≡ increase in spending”, which Farmer’s post repeatedly endorses, is a harmful false dichotomy. If the economic problem is inadequate demand (which I think you both believe), then let’s find whatever ways we can to get demand back again, taking account of multiplier / MPC / political considerations. Let’s first build agreement that more stimulus is required, and only then argue about how that stimulus should be provided.

Look, an increase in spending may well the right answer (looks particularly compelling when it comes to infrastructure), and the Dems should by all means push for more spending, but let’s not have the perfect be the enemy of the good: let’s not have an insistence on higher spending mean that politically the economy isn’t able to get the fiscal loosening it needs.

37

Sebastian H 01.08.13 at 6:46 pm

“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.

38

Vaidas 01.08.13 at 7:19 pm

“This brings me back to the correct policy response. Monetary policy has two dimensions. One is the expansion of central bank balance sheets to increase the money supply with the goal of boosting nominal demand. 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.”
Here is a market monetarist treatment of these two dimensions:
http://marketmonetarist.com/2012/12/22/guest-post-market-montarism-and-financial-crisis-by-vaidas-urba/

39

Bruce Wilder 01.08.13 at 7:41 pm

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.

40

TallDave 01.08.13 at 8:02 pm

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.We could put all of the unemployed people into the army.

Those people were conscripted, and rationing was pervasive. As the song goes, “pretty perverse to call THAT prosperity.”

Will a big fiscal expansion cure the unemployment problem?

It’s a mistake to think unemployment is a problem per se. People don’t want to work, they want to consume. As we get more productive and more progressive, it gets easier and easier to consume at higher levels with less work (this is why we like higher productivity). In the 1950s, no one called it “funemployment” because going without food is not fun.

41

Agog 01.08.13 at 8:08 pm

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.

42

jazzbumpa 01.08.13 at 8:23 pm

Anders @36 -

I actually hold the weaker claim that a tax cut can be just as valid as a rise in spending.

This baffles me. If the problem is a demand short fall, then the solution is more demand. A tax cut only serves if it leads to more spending [e.g. more demand], it can’t serve as an alternative to more spending.

Help me if I’m misunderstanding, but if a tax cut doesn’t lead to more spending, then all it does is increase the deficit. Objectively that might not be a bad thing, but it’s bad politically, and per se won’t do much good.

JzB

43

Barry 01.08.13 at 8:27 pm

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).

44

TallDave 01.08.13 at 8:33 pm

“For the majority of Americans, being unemployed is miserable and immiserating.”

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.

45

Roger Farmer 01.08.13 at 8:46 pm

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.

46

Neil Levy 01.08.13 at 8:47 pm

“People don’t want to work, they want to consume”.

Lots of evidence that’s false. Look at work on women returning to work, for instance, after childbirth. Women often return despite the fact that childcare costs may make them no better (even worse) off. There are several reasons for this, but among them seems to be the fact that people often want to feel useful, productiv and engaged.

47

Roger Farmer 01.08.13 at 9:03 pm

“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.

48

TallDave 01.08.13 at 9:07 pm

Look at work on women returning to work, for instance, after childbirth.

If they were working for free, you’d have a strong point. As it stands, they’re demanding to be paid, which is the same as saying they’re demanding an ability to consume in compensation for work.

Women often return despite the fact that childcare costs may make them no better (even worse) off.

That’s more of a preference for one kind of work over another.

It’s entirely possible to feel useful, productive and engaged while doing unpaid volunteer work, but people with no other means by which to consume almost never make that choice. I think it’s easy for us rich Westerners to forget that work is traditionally the alternative to starvation.

49

krippendorf 01.08.13 at 9:18 pm

“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.

50

Neil Levy 01.08.13 at 9:23 pm

It is also true that volunteer work is not recognised as having the same social value. As I said, there is data on people’s preferences, stated and revealed. Go and look.

51

MPAVictoria 01.08.13 at 9:27 pm

“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.

52

Bruce Wilder 01.08.13 at 9:29 pm

Sebastian H @ 37

My comment @ 4 above does quote the sentence, as a jumping off point. I can see why that’s confusing; what I am actually reacting against is the combination of this sentence and a later statement,

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. There is no coherent theory of unemployment in the General Theory; there is simply an assertion that households are not on their labor supply curves. That lacuna pervades all of the new-Keynesian models . . .

There’s an intellectual history, which Farmer is artfully alluding to, that begins with Hicks’s IS/LM kludge, and continues with the first Neoclassical Synthesis of Alvin Hansen, which Farmer calls, Samuelsonian Keynesianism. Its present-day heirs are the New Keynesians, and their DSGE-informed second Neoclassical Synthesis. It is an intellectual history of retreat in the war against conservative dogmas of general equilibrium of markets and the neutrality of money, and not, unfortunately, a history of progress in understanding the world in which we live.

Farmer is like a boxer dancing around the ring, using this history like a series of short jabs, as he circles round and round. Bretton Woods – boom Leijonhufvud – bam Joan Robinson – slam There’s no way to follow him, point by point. I chose to nail him on this single sentence, precisely because of the preceding sentence. I wasn’t ignoring the preceding sentence.

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

Farmer is saying, in this second sentence, that “too high” is equivalent to the SKs’ understanding of “deficient aggregate demand”. And that simply isn’t true. The SKs would say that wages and prices are “sticky”, not that they are “too high”. Conservative critics of Keynesian theory have said that the quasi-Keynesian “sticky” means “too high”.

Farmer endorses the views of the conservative critics (“sticky” = “too high”) in relation to the General theory later on, saying

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

That’s practically code for a certain class of arguments, which conservative fans of market-clearing prices think is logically compelling (see Nick Rowe, if you want an example), but which Keynesians tend to think may be practically irrelevant, if not patently absurd. So, though he wants plausible deniability, “Unemployment is high because nominal prices and nominal wages are too high” is Farmer talking; this is not a general Keynesian claim or proposition, by any imagining. Farmer wants to press the claim that there must be a “real” labor market problem of some kind — let him man up and try to prove it in his own voice.

53

TallDave 01.08.13 at 9:34 pm

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.

54

TallDave 01.08.13 at 9:36 pm

MPAVictoria,

Thanks, that’s exactly the sort of comment that tells me people aren’t used to thinking rationally about this.

55

TallDave 01.08.13 at 9:39 pm

krippendorf,

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

56

MPAVictoria 01.08.13 at 9:40 pm

“Thanks, that’s exactly the sort of comment that tells me people aren’t used to thinking rationally about this.”

Take a long walk off a short pier TallDave.

This magical world where being unemployed is not “miserable and immiserating” may exist one day but that day is not today. My partner has been struggling to find paying work for over a year and we are truly struggling right now both emotionally and financially. This is not an abstract conversation for me. If it is for you, well you are very lucky.

57

TallDave 01.08.13 at 9:45 pm

Thanks MPAVictoria, please continue bolstering my point.

58

MPAVictoria 01.08.13 at 9:46 pm

“Thanks MPAVictoria, please continue bolstering my point.”
Happy to Dave. I think everyone here knows exactly what your “point” is.

59

TallDave 01.08.13 at 9:49 pm

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.

60

Bruce Wilder 01.08.13 at 10:00 pm

and, not surprisingly, really, low status will still be associated with anxiety, depression and ill-health, no matter the cellphone and the flat-screen teevee

61

Bruce Wilder 01.08.13 at 10:06 pm

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.

62

TallDave 01.08.13 at 10:10 pm

I’ll just leave with this: misery is perception. I really doubt anyone here has experienced true poverty (I certainly can’t claim to, and I’ve been homeless), the kind where basic sanitation is an unknown luxury and not working is often a death sentence.

But I’ve met people who have lived that way. And I’ve helped some come here, for a chance at a better life. And they are generally amazed at the incredible standards of living here, even at the lowest quintile. So you have two sets of people, who look at the same circumstances and some find it awful and others wonder at its munificence. Who’s wrong? My point is not to attempt to answer this question, but rather that it is not a question for economic policy to answer.

63

Matt 01.08.13 at 10:32 pm

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!

64

Mao Cheng Ji 01.08.13 at 10:35 pm

“I really doubt anyone here has experienced true poverty (I certainly can’t claim to, and I’ve been homeless), the kind where basic sanitation is an unknown luxury and not working is often a death sentence.”

Yes, you always can break a store window, and get yourself arrested. Voila: right away you have a roof over your head, three square meals, and even medical care; who could ask for more? As described in The Cop and the Anthem.

65

john c. halasz 01.08.13 at 10:38 pm

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”.

66

Barry 01.08.13 at 11:33 pm

Sebastian H @37: “I just wish that economists on any side would quit pretending they have hard answers. You all aren’t chemists yet.”

That’s odd; ISTR many comments from you over the years where you didn’t have that agnostic attitude, but believed that right-wing economics was indeed reliable.

67

Barry 01.08.13 at 11:34 pm

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.

68

ciaran 01.08.13 at 11:41 pm

Id call you a lot of things , there Dave, but a socialist certainly wouldnt be one.

69

ThomasH 01.08.13 at 11:42 pm

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.

70

Anders 01.09.13 at 12:12 am

Jazzbumpa @ 42

“Help me if I’m misunderstanding, but if a tax cut doesn’t lead to more spending, then all it does is increase the deficit. Objectively that might not be a bad thing, but it’s bad politically, and per se won’t do much good.”

Agree that a tax cut which is entirely saved (or spent on Tsys) would not constitute fiscal expansion (At least not in the near term: assuming we’re in a balance sheet recession, the govt objective should be to move debt off the backs of the private sector ASAP, and on to the back of the govt, who can better withstand it. So in the longer term, even a hoarded tax cut would be beneficial.)

The elephant in the room which Farmer ignores, and which Krugman barely acknowledges, is a tax cut which leads to more private sector spending. A cut to payroll tax in the US, or VAT in the UK, would both increase demand, and stand a better chance of gaining popular acceptance than an increase in the size of government spending would.

71

Anders 01.09.13 at 12:18 am

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.

72

Matt 01.09.13 at 12:48 am

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.

Doesn’t this get back to the point about status? Young adults from wealthy families can go years without something that their non-wealthy cohort would recognize as a job, but they don’t seem to exhibit low health, depression, or abusive behavior more than the larger population. The same goes for stock-sale millionaires who stop working for an employer at 35. Or hereditary aristocrats before World War I. Or American children under the age of 16. Or millions of people who enter retirement age with ample savings or investment income. These are people who have consumption without employment, and they seem fine for it.

On the other hand I have to call out TallDave’s sly trick of comparing today’s bottom quintile with the middle quintile of the 1950s. Why stop there? Why not proclaim a homeless person living out of her car royalty in comparison with a Russian serf of 1700? People do (rightly, IMO) compare their circumstances to their contemporaries, not just to their ancestors. Some future middle-quintile people who have a 30 hour work week, live to the age of 90, and travel the Earth agitate quite rightly if the future-wealthy work 3 hours, live to the age of 150, and travel the Solar System.

73

Pat 01.09.13 at 12:57 am

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.

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Consumatopia 01.09.13 at 12:57 am

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?

Whatever the answer to your first question, that should be your answer to the second. You should feel sorry for people in miserable and immiserating situations.

Whether it’s miserable and immiserating depends on aspects of the situation other than consumption. Does this consumption involving living with debt or some other kind of stressful uncertainty? What are the conditions attached to this welfare (e.g. drug testing, work requirements?) What is the social status of unemployed people in such a world? We need not insist that everyone have equal status, but is unemployment merely uncool, or does it mark you as an outcast?

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Pat 01.09.13 at 1:07 am

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.

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derrida derider 01.09.13 at 1:20 am

I see some people here have jumped on the “people are rational, markets are not” line and screamed “but people are NOT rational!”. They’re right in that statement, but wrong in their conclusions from that statement and certainly quite wrong in thinking economic theorists – even “right wing” ones – haven’t put a lot of thought into the meaning and implications of the term “rational”. As used by people like Roger Farmer it does not mean exactly what you think it means anyway.

A more accurate, if far less elegant, way of making Roger’s point is to say that the ways in which individuals are predictably irrational (eg loss aversion, prospect theory, etc – the whole behavioural economics box and dice) doesn’t seem to affect the macro economy much, while the ways that they are unpredictably irrational are, well, unpredictable and therefore useless for founding any testable models you can derive policy from.

None of this is a defence of other points in the post – still less of the New Classical macro guys (of which Roger is not one). But the “individual rationality” assumption here is in fairly innocuous and, as he says, doesn’t preclude group irrationality anyway. In fact I think the defining feature of New Classical macro compared to other schools is that it denies the possibility of various forms of market irrationality that are consistent with individual rationality.

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Bruce Wilder 01.09.13 at 1:22 am

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.

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Charrua 01.09.13 at 1:24 am

“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.”
Interesting, but unexplained personal beliefs will not get you very far here (explain why you find Ramey work superior, and we’ll talk).

“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)”
Hmm…DSGE models are imperfect, simplistic simulations of parts of reality, as all models. Why would the fact that something can’t be modeled in such a way matter? Explain it, please.

“Rationality is an organizing principle; not a falsifiable hypothesis.” Well, that’s good news. The mathematical model is based on an unfalsifiable belief, so it has to be really, really reliable, right?

Sorry for the snark, but I find that the words equilibrium and rationality (which is not used in the normal sense of the word, right?) do too much work here.

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Matt 01.09.13 at 1:57 am

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.

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Lee A. Arnold 01.09.13 at 1:57 am

I think we should pay the greatest attention to unemployment. I think one of the most important graphs in the whole universe is the “employment-to-population ratio” of 16-to-19-year-olds, here at FRED:
http://research.stlouisfed.org/fred2/series/LNS12300012?cid=32445
Please look at that graph before reading the following. It will be on The Test, up when you have to answer at The Pearly Gates. I think the first blogger to point to it was Mike Konczal, over a year or two ago, and I agree with him, it is one of the most frightening things I have ever seen. That little tail at the end has stagnated for four years now. This slumped tail appears in almost all the other categories of the employment-to-population ratio, and here they are:
http://research.stlouisfed.org/fred2/categories/32445
The repeated slump pattern suggests by the way that it was an across-the-board slump, not a mismatch of skills in one sector… But it is the 16-to-19 year olds that should concern you, should concern you so much that it keeps you awake at night. This graph shows the future, being destroyed right now. We know from data that these people are likely to have permanently lower lifetime incomes, there will be more crime and more incarceration, more broken families and more social spending. Make no mistake about it: It is the deficit hawks who are hurting the future. Big time. These policy people who are against any and all attempts, including fiscal, to get everybody who wants a job back to work immediately, are hurting the U.S. and hurting the Euro and hurting all of the other countries by austerity and fear of deficits (and after bailing out the ONLY the financial system, by the way — no biggie, there!) They are hurting the future, indeed the deficit hawks and fiscal doubters are ensuring the very future of larger government spending that they have been complaining about, and want to reduce. Yes of course the government was already going to be large, because of necessary transfer spending. But these deficit hawks are on course to make government even LARGER than it has to be, in the future.

Do they think this is going to make a productive economy, by causing fear and despair now?

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?

My question about “qualitative” easing is this: Didn’t we already do it, with various facilities and some QE’s? AS we are now having more easing, how will it get liquidity into the housing market, the place where demand dropped from? Vacancies just fell a little, but close to 30% of mortgages are still underwater.

After we bail-out only one sector of a double bubble, how does that NOT show up in any macro discussion about the drop in demand? I mean I know it is not in the model, but realistically…

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Main Street Muse 01.09.13 at 3:23 am

“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?

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b9n10nt 01.09.13 at 4:44 am

Bruce: Maybe it’s a good thing that ideologically-mainstream economists won’t be part of the policy reaction to climate change, peak oil, etc…Maybe it’s a good thing that their silence will discredit them?

Lee: Maybe some of the unemployed 16-19 year olds will be the caregivers to old & young alike. Those who contribute to society beyond the boundaries of the formal economy are a great salve to our wounded public psyche. Also, read Kevin Drum at Mother Jones re: crime & lead. (You mentioned an increase in crime resulting from the low employment ratio for this cohort).

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ponce 01.09.13 at 6:02 am

@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?

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Hidari 01.09.13 at 7:07 am

” Also, read Kevin Drum at Mother Jones re: crime & lead”

Now there is an interesting topic for a future CT seminar.

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greg 01.09.13 at 7:11 am

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.

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Roger Farmer 01.09.13 at 9:29 am

Pat. 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.

Charrua: Valerie’s work is the best I have seen because she pays careful attention to the identifying assumptions that are needed to disentangle cause and effect. I have witnessed first hand, a series of exchanges between Valerie, Roberto Perotti and others on the other side of the debate. Her explanation of why the timing of identification schemes matters is carefully articulated and, to me, convincing. I recommend reading her work carefully. One of the main messages from her work is that, in the US context, the only events that add useful information are WWII and the Korean War. All else is too small to disentangle cause and effect.

The zero lower bound. Krugman and friends have argued that there is a sound theoretical grounding for the idea that fiscal policy should be more effective at the zero lower bound and he relies on forward looking DSGE new Keynesian models to make that claim. Although these models do pay lip service to sticky prices, they do not contain unemployment in any meaningful sense. (Take a look at Woodford’s book, Interest and Prices.)

Further, the impact of fiscal policy in a new-Keynesian DSGE model relies on the assumption that an infinitely lived agent with rational expectations of future prices, makes a particular assessment of the likely path of future prices. These models must be closed with a theory of what determines beliefs (in addition to the rational expectations assumption). Different ways of closing the models have different implications for the effectiveness of fiscal policy.

The rationality concept is empty. No. It is simply part of the hard core of the science. See Lakatos
http://www.amazon.com/Criticism-Growth-Knowledge-Proceedings-International/dp/0521096235
on the philosophy of science for my views on falsifiability. In a nutshell, all hypotheses are joint hypotheses and when our predictions are falsified, we keep the hard core and amend the protective belt.

Lee Arnold. In my view, there are many (a continuum) of sustainable unemployment equilibria. Unemployment is high because demand is low. Demand is low because unemployment is high. That is the main insight from the Genarel 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.

Recent work on search unemployment does offer an explanation by providing an equilibrium account of unemployment where there is a continuum of equilibria. Here is a link to a paper that provides the theory
http://www.rogerfarmer.com/NewWeb/PdfFiles/fa-con-cra.pdf

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Hidari 01.09.13 at 9:35 am

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

What do these three sentences actually……mean?

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Mao Cheng Ji 01.09.13 at 10:13 am

“Demand is low because unemployment is high.”

Why frame this as a problem of unemployment, rather than income and wealth distribution? If you work for $20K/year and I’m unemployed and get $0, it’s still less of a disparity, far far less, than when someone makes a billion/year. That billion, taken out of circulation, really does affect the demand, while your $20K, if it’s split between two of us, won’t make any difference at all.

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Walt 01.09.13 at 10:22 am

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.

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roger gathman 01.09.13 at 10:48 am

Walt, I applied the idea of a negative heuristic, taken from Lakatos, to the persistence of the idea of equilibrium in economics. See the preface to my translation of The Basho of Economics.
Just a little horn tooting. I couldn’t resist.
http://books.google.fr/books?id=mucMlmcFME8C&printsec=frontcover&dq=the+basho+of+economics&hl=fr&sa=X&ei=ykrtUJXTJcSwhAeVloCoDg&ved=0CDcQ6AEwAA

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John Quiggin 01.09.13 at 10:50 am

I’m certainly a fan of Lakatos as applied to econ, as is Mark Blaug, but I doubt that we are typical of economists. There was a bizarre debate in the 1950s between Samuelson and Friedman, which started with Friedman espousing an extreme instrumentalism (the test of a theory is good predictions) totally at odds with the largely a priorist methodology actually followed by the Chicago School. Samuelson offered plenty of commonsense arguments against this, but never really put forward an alternative.

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roger gathman 01.09.13 at 10:59 am

PS – interestingly, there is a history, in economics, going from Walras and Pareto to Lucas, that pins the scientific nature of economics frankly and completely to the idea of equilibrium. Pareto I believes says somewhere that without viewing economic phenomena as a system in equilibrium, we couldn’t view it as a system at all.

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reason 01.09.13 at 11:25 am

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).

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reason 01.09.13 at 11:35 am

Anders @12

No it is not relevant in this case. We have as BW says a “disruption to the circular flow” (actually it occured a long time ago in the form of a trade deficit – but that is another story), so that the velocity has fallen. Government spending will raise the velocity of circulation, tax cuts will lower it further.

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reason 01.09.13 at 11:48 am

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.

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reason 01.09.13 at 12:20 pm

By the way Bruce Wilder I think your comments are very apposite and are driving the thread.

I remain to be convinced by Rogers rejoinder @47. Basically, I think the DIFFERENCES between agents are what is interesting in economics. Assuming some of those differences away, is refusing to address very important questions. (After all if people where all 90% employed instead of having 10% of the population with 0% employment – people wouldn’t be quite so concerned – would they?)

And I think Agog @41 has it pretty right. I remain underwealmed, by the ultimate value of the idea of equilibrium, no matter how useful a device it is. Change is the essence of the economy, and adjustments seem to me always slower than the changes to which they are adjusting. This implies the essential need of trying to anticipate the changes before they occur, no matter how uncertain they are. A fundamental part of the strategies of firms have to do with coping with the uncertainty that results from this dynamism. Bruce Wilder probably expressed it better.

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Walt 01.09.13 at 1:00 pm

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.

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Anders 01.09.13 at 1:28 pm

reason @ 94

So why don’t you think an indefinite US payroll tax holiday or a UK VAT cut would increase velocity?

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Roger Farmer 01.09.13 at 2:09 pm

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.

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MPAVictoria 01.09.13 at 3:05 pm

Dr. Farmer you still haven’t answered why larger government spending will not solve unemployment? Are there not bridges to be fixed and unemployed people who could be fixing them?

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reason 01.09.13 at 3:11 pm

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.

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reason 01.09.13 at 3:18 pm

Roger Farmer,
perhaps I expressed myself poorly. Let me try another approach. I understand that search theory may mean that unemployment will not be solved overnight. But the problem is to get it to move in the right direction. My understanding is that normally there is a lot of churn in employment markets – people are being thrown out of jobs and finding new jobs all the time. It is not the level of churn that is the problem – it is the ratio of new positions opening up to old ones closing that is the issue. I don’t see how your answer addresses this at all.

We need (relatively) more new positions opening up. One possible solution is for some of those new positions to be government financed. Why might it not work?

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reason 01.09.13 at 3:27 pm

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.

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Anders 01.09.13 at 4:42 pm

reason @ 101/103

Yes – I suppose Milton’s PIH is relevant, but only insofar as it tells you that if you want to implement a fiscal stimulus via a tax cut, you may need to announce “this cut is intended to be permanent; we believe that marginal tax rates will work so that when the economy picks up again, the stimulus will be self-unwinding”

Look, I’m just saying, don’t ignore the possibility that tax cuts can work. They surely had some relevance in 1980s in the US (well, that and defence spending). I agree with you (and I think contra Farmer) that stimulus is required; let’s get everyone agreed on this point first, and only then squabble about how to implement the stimulus.

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Pat 01.09.13 at 6:03 pm

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.

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Roger Farmer 01.09.13 at 6:24 pm

@MPAVictoria. Do we need more fiscal stimulus: Perhaps. We could solve the unemployment problem by increasing the size of the government sector from 20% of GDP to 50% as we did in WWII. While there is a case to be made for more public infrastructure, that case is logically separate from the unemployment question.

My own reading of the evidence is that the government spending multiplier is positive, but less than one. That implies, (see the work of Valerie Ramey) that there is a real danger that increased government spending will crowd out private spending, even at the zero interest rate lower bound and even when we are in an unemployment equilibrium with unemployment currently at almost 8%.

I was pleased by Paul Krugman’s modesty in his discussion at the recent AEA meetings. Unlike his NY Times op eds, the argument he gave in favor of fiscal spending was nuanced. Paul recognized, in that discussion, that there are others who disagree after looking at the same facts. Although I am one of those dissenters, I am not a strong opponent of the massive fiscal boost that Paul proposes. We need to do something. And we need to do it soon. Relative to doing nothing, a massive fiscal expansion would be a step in the right direction.

Is there a better alternative? I believe so. In my view, the problem we now face has two components, both related to the asset markets. First, the relative price of houses, factories and machines is too low, relative to both the money wage and the prices of consumer goods. Second, investors are scared that the relative prices of assets will fall further. That is why there is more than 2 trillion dollars held as liquid assets.

I want to see more large-scale central bank intervention in the asset markets with two ends in mind: First; to increase the value of paper assets until the unemployment rate falls below 5%. That would boost consumption demand through a wealth effect: And second; to intervene on a systematic and regular basis to prevent both bubbles and crashes in asset markets in the future. That would boost investment spending by removing the fear of another crash. This is not the same as quantitative easing, which is an expansion in the money supply. It is what Willem Buiter has called qualitative easing.

Why do I think that the key to prosperity lies in the asset markets: Because there has been a systematic and stable relationship between unemployment and the value of the stock market in post-war data. See my piece here, which documents that fact. The asset markets may well be informationally efficient in the sense that an uninformed trader cannot make money by trading in the asset markets. They are clearly not Pareto efficient.

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K 01.09.13 at 7:04 pm

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.

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reason 01.09.13 at 7:08 pm

I don’t see why a fiscal multiplier < 1 implies crowding out. There are other leakages – taxes, imports and savings.

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ragweed 01.09.13 at 7:28 pm

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.

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MPAVictoria 01.09.13 at 7:49 pm

” While there is a case to be made for more public infrastructure, that case is logically separate from the unemployment question. “

Let me stop you there Dr. Farmer. Of course they are linked! We need work done and we have people who need jobs. Surely you are not arguing that the government investing in fixing a dam or a bridge would somehow crowd out a private investment? With interests rates this low, companies hoarding capital and an infrastructure debt in (at least) the hundreds of billions the fact that the federal government is not engaging in a massive building program is near criminal.

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Bruce Wilder 01.09.13 at 8:08 pm

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.

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K 01.09.13 at 8:20 pm

On Rat Ex

“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.”

I agree. But it’s even worse than that. As Martin Weitzman has shown, perfectly rational agents cannot determine the dynamics of even quite trivial stochastic model economies, even granted unbounded powers of observation. So even Farmer’s ratex agents could not, *in principle* even have found out the parameters of their puny little economies.  How bad is it? In Weitzman’s simple economy, agents’ subjective pricing measures, derived from their sane priors and excruciating unbounded observations and econometric analysis, were shown to be pathologically fat-tailed and critically dependent on relatively insignificant variations in their priors. If anything, Weitzman has trouble explaining the remarkably *small* value of the equity risk premium

The implications are pretty clear that “rational” really doesn’t constitute anywhere near the constraint on agent and model behaviour that Lucas would have had us believe. It certainly doesn’t imply Rational Expectation or anything that follows from it.

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Stephen 01.09.13 at 8:24 pm

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?

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Stephen 01.09.13 at 8:29 pm

MPA Victoria @110:

I may have misunderstood the Japanese experience entirely, but from what I have read their Government built roads, bridges, etc all over the place for FSA effect.

Am I wrong? Or should we consider the dreadful possibility that USA =/= rest of world?

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Stephen 01.09.13 at 8:37 pm

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.

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MPAVictoria 01.09.13 at 8:44 pm

Stephen from what I understand the Japanese in the 1990s followed the same failed formula we in the rest of the world are now repeating, namely insufficient stimulus.

Also it is worth noting the Japanese never had the huge infrastructure deficit that the United States has built up over the last 30 years of neo-liberal rule. So even if you think a spending program will not help the economy at the very least we will get some much needed infrastructure improvements out of it.

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Bruce Wilder 01.09.13 at 8:56 pm

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.

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Bruce Wilder 01.09.13 at 9:12 pm

The typical labor employment contract is not a negotiated agreement to the transfer of labor services at a metered rate. The agreement is more along the lines of the firm offering a take-or-leave-it deal, specifying a fixed wage, conditional on good behavior and following instruction. The implicit core of the deal is a contingency, a threat to fire the worker, if instructions are not followed. For this deal to work in the sense of setting up a situation in which the worker is motivated to follow management’s instructions, being fired has to be costly to the worker.

One possibility, in an economy near full-employment, is an efficiency wage. The worker is paid more than the “market wage” because such a premium does reflect high marginal productivity, and because it makes the worker loyal and reluctant to chance getting fired, even when other jobs are readily available at the market wage (because the worker is earning a rent in the efficiency wage that makes the efficiency wage higher than the going market rate).

Another possibility is Marx’s Reserve Army of the Unemployed. Keep lots of workers unemployed, so that the employed workers are afraid of being fired, and will accept lower wages. Job search becomes extended and costly, for fired or laid off workers. The firm or its managers can keep the economic rent, generated by management, which improves worker productivity.

What RF appears to be arguing, somewhat disingenuously, is that there are large gains, which can be transferred from lower wages to firms and their managers, by undermining the credibility of Keynesian full-employment policies.

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MPAVictoria 01.09.13 at 9:40 pm

“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?

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Roger Farmer 01.09.13 at 10:07 pm

@ragweed Thank you for your clear restatement of my main points and for taking the time to read the papers that I linked.

@Stephen. The UK experience is different but related. Your reading of the Japanese experience is the same as mine.

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Bruce Wilder 01.09.13 at 11:13 pm

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.

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Alex 01.09.13 at 11:50 pm

The UK went off gold and devalued early on. Everyone can’t devalue competitively (although they can inflate), but it’s one case where there is first mover advantage. Further, we were early in going for protectionism. People had been talking for years about giving up free trade and turning the empire into a protectionist zone, but it didn’t happen until 1931.

Rearmament played a role; the qualitative breakdown of it was important. The RAF got most of the money, followed by army mechanisation, and a surprisingly small navy programme focused on radar, fire control, and aviation. Given that the biggest RAF projects were the interceptor fighters and their engines, the radar chain, and the telecomms network needed to use them, and army modernisation meant mostly road transport, some armour, a lot of anti-aircraft artillery with very modern control systems, and radio networks, this looks a lot like a programme focused on new technologies.

And of course, the UK created an industrial development bank in ’31 that we don’t talk about now.

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Cranky Observer 01.10.13 at 12:01 am

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

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Consumatopia 01.10.13 at 12:15 am

While there is a case to be made for more public infrastructure, that case is logically separate from the unemployment question.

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

I’m not sure what “logically separate” means. As long as the multiplier is positive (even if less than one) doesn’t that mean that the cost of additional public infrastructure, in terms of foregone national consumption, is smaller when unemployment is high?

Say you propose a bridge for $20 million. If we’re at full employment, that means $20 million less in private spending. Perhaps people decide the bridge isn’t worth forgoing that much consumption.

But if we have high unemployment, maybe the multiplier is 0.5, and that means $10 million less. Is it irrational to think that the bridge might be worth forgoing $10 million but not $20 million of private consumption?

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john c. halasz 01.10.13 at 2:05 am

“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.

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john c. halasz 01.10.13 at 2:38 am

Oh. Just to add on a small point I forgot. The reversal of oligopoly cost-price curves is why, when the Great Depression struck, one of the first responses, in the U.S. as in Germany, the two largest industrial production economies, was attempts at cartelization, to maintain output prices. In the U.S., the success of that was poor, but in Germany, a plan was put forward in 1932 by the industrialists’ trade association…

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derrida derider 01.10.13 at 3:41 am

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.

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TGGP 01.10.13 at 4:42 am

Roger Farmer, Scott Sumner has placed a lot of weight on the “dog that didn’t bark” that is the 1987 stock crash. He argues that, contra your theory, it shows that stock market declines share causes with recessions rather than being causes of them. It is just one incident, but it was quite an extreme crash so I’d like your opinion on why the impact on the “real economy” was so different that time. Sumner’s theory of course is that the Greenspan fed “leaned against the wind with credibility” (actually quoting Hetzel there) so that expecations of NGDP were raised. My layman’s understanding is that the Fed engaged in standard OMOs, buying Treasury debt with newly issued money, which would be quantitative easing under your framework. Did they actually engage in qualitative easing?

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d_embee 01.10.13 at 6:01 am

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.

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oldcobbler 01.10.13 at 11:16 am

Professor Farmer, there seems to be a lot of concern on your part about whether the value of the fiscal multiplier is greater than one. Why is this so crucial, if the main aim of the fiscal stimulus is to increase aggregate demand ? Which presumably it does, as long as the multiplier is greater than zero ?

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Tim Wilkinson 01.10.13 at 3:33 pm

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.

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James Wimberley 01.10.13 at 4:29 pm

roger gathman in 92: “Pareto I believes says somewhere that without viewing economic phenomena as a system in equilibrium, we couldn’t view it as a system at all.”
A lack of imagination or a poverty of technique? In biology, you have predator-prey cycles. See also Conway’s Game of Life. These are clearly systems. So are cycling and running.
My crumblies’ league pennyworth here suggests – I make no greater claims – that it’s possible, maybe useful, and certainly more realistic to think about economies in perpetual disequilibrium.

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Barry 01.10.13 at 4:45 pm

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.

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john c. halasz 01.10.13 at 4:53 pm

@131:

Cf. Richard Goodwin’s endogenous growth model.

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William Timberman 01.10.13 at 5:00 pm

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.

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Jim F. 01.10.13 at 6:56 pm

Can we not lower the tax burden and incidence on labor?? The combined burden from federal, state, local burdens is significant and completely discouraging of people who are thinking about expanding and would then need to employ people so the work can be accomplish appropriately. If we dropped the burden by 20% or more then employers with competitive ideas would need move into the hiring market quickly to head off competitors both to get the better employees and to get the increased market share they are seeking by expanding (or price room, or whatever reason). This is a fiscal matter; tax policy comes from government – shift the burden to other taxation types. The burdens need to be shifted away from the incidence of labor, our burdens are way too high (our policy support for a computer-enabled financial sector may in fact be anachronistic and unbalanced, causing speculation forces and failure in the market for cash). We want people to hire people because the returns are much more likely to be better than owning financial products.

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Lee A. Arnold 01.10.13 at 7:44 pm

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?

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roger gathman 01.10.13 at 8:10 pm

132 and 133 – I absolutely agree. More than agree – speaking of disequilibrium still anchors us to an equilibrium center. Myself, I think it is a mistake to take a local economic phenomenon – the ideal of “markets” which emerged as an ideological artifact in the 18th century (and not, I think Bruce Wilder would agree, as a fact of real economic life) – and place that at the center of economics. But when the market move was made, equilibrium followed, supplanting and absorbing the older idea of fortune’s wheel.

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Peter K. 01.10.13 at 11:07 pm

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?

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Bruce Wilder 01.11.13 at 8:55 am

Peter K: “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?”

It is one of the odd curiosities of human affairs that so many could not figure out why the country fell into Depression, and then so many could not figure out why it did not fall into (a second) Depression.

The Second World War combined with the structural reforms of the New Deal — agricultural policy that stabilized farm incomes, the financial repression of Glass-Steagall, the rise of industrial unions, public utility regulation, the widened geographic spread of electrification and roads — to radically change income distribution. Economists call it the Great Compression. The mass production technologies of the New Economy that had emerged in the 1920s finally had a mass consumer middle-class that could afford its output. 17 million men and women had been in the Army or Navy, experienced bureaucratic life, and many came home, cash-in-hand or in savings accounts and savings bonds, to get a college education and to work in the giant corporate behemoths, and populate the new suburbs.

In retrospect, the Great Depression looks to me like a prolonged political stalemate in the struggle over income distribution.

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reason 01.11.13 at 9:18 am

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.

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reason 01.11.13 at 9:20 am

P.S. The same explains what happened after WWI which the “Austrians” often crow about – just that then the transition was a bit mismanaged so there was a short sharp recession during the transition.

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Bruce Wilder 01.11.13 at 11:34 am

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.

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Mao Cheng Ji 01.11.13 at 11:44 am

@140, and don’t forget the 90+% top tax bracket; how’s that for shifting the ‘equilibrium’?

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Peter T 01.11.13 at 12:18 pm

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.

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Barry 01.11.13 at 1:43 pm

Peter T: “Why no discussion of what the New Deal and the war actually invested in?”

As I’ve said before, I believe that John is wrong about macro going wrong in 1958; the heart of the Chicago error (if not fraud) is that they refuse to deal honestly with the New Deal. He or another economist commented that Chicago considered it to be an anomaly never to be repeated (oops!) or something to be dealt with never later.

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reason 01.11.13 at 3:30 pm

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.

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Peter T 01.12.13 at 4:27 am

Running out of thread anyway, but felt this needed qualification:

Nobody wins wars, some just lose less badly

Nobody wins modern wars, and nobody won most earlier wars. But some people surely won some wars – two obvious examples being the ones that built the British and Roman empires.

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JW Mason 01.12.13 at 7:06 am

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.

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JW Mason 01.12.13 at 7:07 am

“because a sustained equilibrium” in my third paragraph should be “because a sustained downturn“.

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JW Mason 01.12.13 at 7:19 am

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.

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Senexx 01.15.13 at 2:47 am

It doesn’t look like this question was answered but Australia does have a debt ceiling of about $300 billion according to our Commonwealth Inscribed Stock Act 1911.

I read one left wing current mainstream Australian economist that said “As GDP grows the nominal value of the ceiling rises”.

In mainstream theory this seems sound.

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