Thursday, December 11, 2014

John, Paul and Say's Law

I've followed, with a great deal of interest, the debate between John Cochrane and Paul Krugman. I have a lot in common with both of them.

I agree with Paul that, for the most part, the IS-LM model provides the right answer to policy questions. I agree with John, that we have learned a lot since 1955, when Paul Samuelson invented the Neo-classical synthesis.

But there were a couple of ideas in the General Theory that have been buried by MIT macro. The first, and most important, is that high unemployment is an equilibrium. Repeat after me. E-Q-U-I-L-I-B-R-I-U-M. The second is that animal spirits are an independent causal factor that determines which equilibrium the private economy will select.

Let me ask a simple question that you should feel free to answer. And do please also try to guess the PK and JC answers. (To answer this question, you will need to arm yourself with a knowledge of the textbook IS-LM model. A good introduction would be Greg Mankiw's textbook or, the book I learned from, the intermediate text by Dornbusch, Fischer and Starz.)
Figure 1

Start from a world with no inflation, and no expected inflation. Suppose that the IS curve intersects the LM curve at a position where the interest rate on T-Bills is 5% and unemployment is 4.4%. This is pretty much where we were in December of 2006, as depicted in Figure 1. (Yes I know the zero expected inflation assumption is not quite right, but thats a bell and a whistle).

If you measure Real GDP (equal to real income) by dividing nominal GDP by the money wage (as I do here and as Keynes advised in the GT) you may plot the stationary value of GDP in wage units on the horizontal axis. That will be at 95% of its maximum value. (Incidentally, this is not synonymous with GDP deflated by the price level, even in a one-good economy).

Now suppose that the IS curve shifts to the left as a consequence of a crash in house prices caused by a loss of confidence that prices will continue to keep going up. Suppose that there is no corrective fiscal action and that the Fed allows the interest rate to fall by lowering interest rates as GDP collapses.  

The textbook theory says that we will slowly track down the LM curve, and as people lose their jobs, demand will fall, supply will fall, and we will end up at a new lower level equilibrium. The key word here is equilibrium. This is the prediction of the Hicks-Hansen model before it was polluted by Samuelson’s neoclassical synthesis. That's pretty much what happened between December of 2006 and September of 2008, and thats what I show in Figure 2.

Figure 2:
Now suppose that the initial drop in asset values gets much much worse as the crash in house values hits the balance sheets of financial institutions.  Initially, those institutions were baled-out by the treasury but after the collapse of Lehman Brothers, US financial institutions were left to fend for themselves. The situation, post Lehman Brothers, is depicted in Figure 3.
Figure 3:
Ok. Here’s the question.

If the Fed keeps the interest rate at zero, and IF ANIMAL SPIRITS REMAIN PESSIMISTIC: What will happen to GDP, the interest rate, inflation and real wages, once we have reached the new lower steady state (Y3 on Figure 3)? My answer is nothing. Repeat after me. N-O-T-H-I-N-G.

Long before it became fashionable, I made the distinction between old Keynesian and new Keynesian economics. Using my definition, old Keynesians would assert that there are many steady state unemployment rates. In contrast, new Keynesians view high unemployment as a disequilibrium caused by sticky prices. They agree with John that there is a unique natural rate of unemployment, determined by supply side factors, and that the private economy is gravitating towards that rate. They disagree on the speed of adjustment and in the role of government in achieving that adjustment.

It ain't so. There is no natural rate of unemployment in the sense that Friedman used that term. But by accepting some version of the Neo-classical synthesis,  both John and Paul are agreeing that Say’s Law holds in the long run. Supply creates its own demand. By accepting Samuelson’s interpretation of the GT, Paul is playing in John’s backyard. 

If we don't accept the MIT worldview: how do we reconcile Keynesian economics with Walras? My answer explained here, is that multiple equilibria arise as a result of missing factor markets. I explain WHY there can be multiple equilibria where there is no incentive for firms to change wages and prices. High unemployment, in the absence of a recovery in animal spirits, is an equilibrium in the sense in which physicists use this term. This  is not rocket science. But you do have to read my work, rather than assume you know what it says, in order to get this point.


  1. It seems to me that the statement "if you measure Real GDP (equal to real income) by dividing nominal GDP by the real wage..." is confusing. I know what you mean, and indeed what Keynes meant, namely that GDP be measured In terms of wage units but to speak of "nominal GDP" being divided by "real wages" is, as the current terminology goes, misleading. It should be I think "real GDP" = nominal GDP/nominal wage.

  2. Why aren't animal spirits a form of behavioral economics? It's a strange metaphor!

  3. Roger,

    Suppose that your IS curve above shifted left because agents became rationally pessimistic (owing to a change in various fundamentals relating to lower TFP growth, increased uncertainty, etc.) And, moreover, suppose that all markets cleared in the conventional sense and that the equilibrium is unique.

    Then the answer to your question of what would happen if the Fed kept the interest rate at zero would be exactly the same, no?

    The more general observation is that there seems to exist an observational equivalence between an "animal spirits" interpretation and a "rational optimism/pessimism" interpretation. Maybe you've written about this before. If so can you point me to the post. If not, what's your take on this issue?

  4. I’m not sure that the multiple equilibrium issue has anything necessarily to do with Say’s Law.

    Almost every agent in the economy is at the same time both a supplier and demander of goods and services. Every agent has suppliers and every agent has customers. They demand goods and services from their own suppliers, and produce output to supply to the market, at a level based on their expectations of the demand for the goods and services they, themselves supply to their customers.

    It seems to me prima facie plausible that the economic agents in an economy could settle into a Nash equilibrium of low supply, low demand, sub capacity output and low employment. This could be the case even if the long term Say’s Law were true. If the latter is true, then any aggregate increase in supply by X% would be eventually met by an X% increase in demand. But even if that is the case, there is no reason to think that the agents who make up the economy can solve the coordination problem needed to make it the case. No economic agent can control aggregate supply decisions – they can only control their own supply decisions. So each agent might rationally choose to stand pat with their current level of demand and supply, given the fact that nothing they do to increase supply and demand themselves will measurably dial up the actual value of aggregate supply and the actual effective value of aggregate demand.

    1. Dan
      You seem to be offering an alternative theory of persistent low employment based on coordination failures. I am sympathetic to any and all theories of that nature. My understanding of the debate over Say's law is that it denies the validity of explanations of this kind, both mine, based on search theory and yours based on on coordination failures.

  5. David
    I talk about this here on page 14. Yes there is an observational equivalence. If there had been an obvious fundamental event that preceded the crisis, we wouldn't be discussing this. It's the lack of such a candidate that, for me, lends credibility to the multiple equilibrium explanation.

  6. I think society badly needs to have a more realistic conversation about unemployment. Personally I’m not much concerned with how to model unemployment, but since “search” seems an obviously more relevant topic than “wage stickiness,” I’m inclined to support that part of what you’re doing.

    One way I suggest to get the conversation rolling is to ask: in what kind of society does the classical model of always-clearing labor markets hold true? Well, that would be a poor society, where people can’t afford to be unemployed and so must take the highest-paying job on offer, no matter how low-paying it is. And it would also have to be a not very sophisticated economy, which needs lots of low-skilled labor and can always put more to use if the price of labor is low enough. Sticky wages roughly updates to incorporate unions while retaining the unsophisticated economy.

    I think you can see where I’m going. If we’re going to have a serious conversation about unemployment, we have to understand that the most basic reason for prolonged unemployment (and involuntary exit from the labor force) is that we are affluent and our economy is very complex. Labor markets are globalizing. Employment decisions are more and more about assembling a long-term team and less and less about hiring day jobbers. Modern companies are mostly not easily or quickly scalable. We have a public safety net that will support people while they are job searching, and to some extent even if they stop. We can lean on our families. People who lose jobs are increasingly choosy about what new jobs they will take. It’s also increasingly difficult to change careers.

    This is a difficult conversation for America to have. The right mostly only wants to talk about the moral hazard of public safety nets, which is a real issue but needs to be put in context and judged against alternatives. The left tends to paint the modern unemployed as wronged by the system and earnestly unable to find any employment at all. What I want to get across is that the increasing persistence of high labor slack episodes is mainly, though not exclusively, a function of life overall getting better.

    What I disagree with here is the use of the IS-LM model, which I think goes against everything I’ve been arguing. According to the IS-LM model there is always some real interest rate at which all slack is absorbed. There’s no allowance for the complexity and gradual nature of slack absorption in a sophisticated economy.

    Looking at recent US experience I see a traumatic adaptation to off-shoring of lower-skill labor. I see during that a traumatically failed attempt to absorb some of the labor slack created by expanding production of homes financed with creation of phony credit assets. I see since then a respectable albeit moderate growth rate and gradual absorption of labor slack, which relies partly on generational turnover. I think it’s obvious that we could have made a political decision to publicly employ more people, publicly fund more private employment and/or subsidize more consumption by the temporarily unemployed. But I think the field of economics is still a very long way from knowing what would have been best for most people in the long run.


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