Coordination Problem

Keynesians stories do not imply Keynesian policies.

|Peter Lewin|

In a recent WSJ opinion piece, Jeffrey Liebman, a professor of public policy at Harvard’s Kennedy School of Government, articulated the current establishment understanding of the economic situation and the policies needed to deal with it. It is unabashed, one might say, simplistic, Keynesianism. Yet it represents a large and powerful consensus position. All the bad things that have happened to the economy are the spontaneous result of malfunctions in the market system – a system that has been insufficiently regulated and supported. The President proposed a reasonable and necessary jobs program and the Congress blocked it. Sensible people, Republicans and Democrats, know in their hearts this is true and need to get behind the president and support his spending-stimulus programs. (This is a very liberal interpretation – you can read the original for details).

The interesting thing for me is not so much the extent of the buy-in to this nonsense, as it is how they get there. I have always maintained that there is a sophisticated Keynesian story to be told, but it doesn’t get you Keynesian policy prescriptions unless you make some very unreasonable assumptions.

The essential element on which this turns is behavior in disequilibrium. There is no good theory of this. Yet all real behavior occurs in disequilibrium, in a situation in which different people have different expectations (including expectations about what things are worth), a situation in which their actions are bound to be inconsistent. Errors are inevitable. Do they on balance tend to get eliminated by feedback in the form of price (and other)  signals? What does “tend to get eliminated” even mean? What does this mean for the employment of resources?

To be more specifically Keynesian, imagine a situation in which, because of irrational exuberance, there is overinvestment in some sector that goes bad. The result is a precipitous fall in consumer spending as people reassess their wealth situations – revalue their assets and their net worth. There is contagion. The decline in spending precipitates quantity adjustments. Instead of prices falling rapidly to counteract the decline in spending (which would mean people made swift decisions to reduce prices), producers cut back on production and employment and so it goes. As John Hicks put it, this is a fix-price rather than a flex-price world.

I have no doubt that there are elements of truth in this. The world is neither completely fix-price nor flex-price, but is a bit of both, and sometimes more of one than the other depending on the circumstances. So what? So, what does this mean for economic stability? Does it mean that the market system is, therefore, habitually unstable, poised on a cliff’s edge in danger of being tipped over by the barest of bad speculative bubbles? Or is it rather a robust system, embedded in a set of multiple complex institutional networks that can deal with, and profit from, the inevitable errors that are made? Theoretical models can be created to support both stories, and, therefore, the matter is at bottom not a theoretical (logical) one. It is fundamentally empirical. I believe that we “know” from experience that the market system is robust and stable. But if people behaved differently, more erratically and if institutions did not provide the anchors that they do, the market system would be more unstable than it is. So what, again?

That the market economy is inherently prone to cyclical swings is, at best, a necessary condition for policy-intervention to stabilize it. It is not sufficient, not nearly. For sufficiency one needs to show that somehow macroeconomic policy-makers know enough to mitigate the cycles, rather than exacerbating them; and further that they can be trusted to do so. That is to say, pretty much all of the Keynesian policy prescriptions fail to come to grips with the familiar knowledge and incentive problems – with the central ideas of modern Austrian and Public Choice approaches. While the Post-Keynesians and Austrians may share the conviction that economic agents face unavoidable uncertainty, the latter see no reason to exempt policy-makers from that uncertainty. Why should policy-makers know any more about the future than the agents in the field? And why should we trust them to want to mitigate the cycle, rather than exacerbate it to their advantage?

 

Here is a riddle. Who said this?

"It has been more than four years since the US economy first entered recession—and although the recession may have ended, the depression has not. Unemployment may be trending down a bit in the United States (though it’s rising in Europe), but it remains at levels that would have been inconceivable not long ago—and are unconscionable now. Tens of millions of our fellow citizens are suffering vast hardship, the future prospects of today’s young people are being eroded with each passing month—and all of it is unnecessary.

For the fact is that we have both the knowledge and the tools to get out of this depression. Indeed, by applying time-honored economic principles whose validity has only been reinforced by recent events, we could be back to more or less full employment very fast, probably in less than two years. All that is blocking recovery is a lack of intellectual clarity and political will."

Housing Policy, Labor Mobility, and Unemployment Duration

Steven Horwitz

One of the distinguishing features of this recession is that the duration of unemployment has been notably longer than in other recessions.  See this graph:

This weekend, I've seen a couple of online pieces (second one gated) arguing that one possible explanation for these data is that unemployed folks are less mobile than they used to be thanks to having homes that they cannot sell for a price that comes close to breaking even. [UPDATE:  to be clear, I'm not, nor are they, arguing that this is the only explanation for the increased duration of unemployment.  Surely benefits extensions matter as well as other factors, but this is one that we perhaps haven't seen before.] Housing policy that subsidized low- or no-equity loans have left a fair number of people in situations where they would like to move to greener pastures in search of employment, but are unable to make the move because they are stuck with houses they can't sell, which in turn prevents them from affording a new home or even a rental in the new location.  It's worth noting that the same argument would apply to currently employed people looking for better work elsewhere, opening up their own job for others.

A comparison to Canada is interesting as they did not have the perverse housing policies we had and still have a home ownership rate similar to ours, yet they have not had the fall in housing prices that would limit labor mobility the way that is being hypothesized for the US.  The latest Canadian data that I could find has their current unemployment rate at 7.9%, lower than the US, and although their median duration of unemployment in 2009 was 17 weeks, which was slightly higher than the US one was on average, that number was actually just a bit higher than their 2007 and 2008 numbers and the same as 2005.  That 17 weeks was also notably lower than their average for the last 15 years.  Canadians have always had longer unemployment duration thanks to differing unemployment policies and a weaker economy, but what they have not seen is anything near a comparable jump in duration during this recession.  That would appear to be some evidence for the "can't sell the house" explanation for labor immobility and unemployment duration in the US.  But I'd love to hear alternative hypotheses.

If this argument is right, it's an interesting unintended consequences story in the way that housing policy interacts with labor market mobility.  One can also tell a Lachmann type story here:  housing and a job are complementary goods in a household production function.  In the face of dynamic change that changes the value of one of the goods, substitution will be called for.  Unemployment requires a revaluation of one's human capital.  And changes in one's human capital that might make a new job attractive may require rethinking the housing side by moving.  But substituting a new job for the old one means that it has to be complementary to the housing piece of the puzzle.  In a healthy housing market, swapping out the housing component is not as difficult, which makes it easier for the household to make the necessary shifts in employment/human capital in the face of dynamic change.  Where households are stuck with the housing capital, they are also stuck with the range of jobs available in that area.  The result is, apparently, longer spells of unemployment and a higher unemployment rate.

I also think this poses some interesting questions for the whole "recalculation" process.  Much like the Hoover high-wage policy (though much less dramatic), one of the effects of the housing debacle has been to reduce labor mobility.  In the Hoover case, it was a matter of being unaffordable to hire, and in today's case, it's that people can't sell their houses to move to where opportunities might be.  In both cases, interventions prevent human capital from finding the places where it is complementary to the new post-crash structure of production. If we want households to recalculate effectively in the face of economic change (e.g., adjust their labor supply when the structure of production changes), we cannot distort the various markets and prices that inform that recalculation process.

If all of this is correct, it would suggest that we're in for a long period of fairly high unemployment until the housing market settles.  It may well be the case that some folks who would like to find a (new) job elsewhere will have to wait until they have sufficient equity in their homes to afford to sell.  This is yet another reason to get rid of the policies that created this mess so that we don't exacerbate or repeat it in the long run.  As for what, if anything, can be done through policy (including, of course, eliminating bad policies) to alleviate this situation in the short run, I have no brilliant ideas.  Feel free to suggest some below.  The answer, of course, may be "nothing, let the process play out and heal itself."