Are Recessions Efficient?

Stephen Williamson weighed in recently on Keynesian Economics versus Regular Economics in his New Monetarist Economics blog.  Responding to Paul Krugman’s post citing my criticism of Robert Barro’s column in the Wall Street Journal contrasting Keynesian economics and regular economics, Williamson took Krugman to task for not acknowledging that old-style Keynesian economics has actually been replaced by a newer version (New Keynesian economics) that actually tries to deduce standard Keynesian results from regular economics.

Although Williamson aimed his criticism at Krugman, not me, he did criticize this passage of Krugman’s blog in which I was mentioned

As Glasner says, there’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did and a half years ago despite population growth and advancing technology. Of course there’s some kind of market failure, which means that there’s nothing at all odd about asserting that better policy can yield free lunches.

Williamson comments:

We cannot observe a market failure. To deduce that a market failure exists, one needs a model. Given that we cannot observe market failure by looking at the state of the economy, we also can’t say what a “better policy” is. Again, for that we need a model.

Fair enough; we do need a model.  But it is not clear what kind of model Williamson thinks is needed to infer the existence of a market failure.  The standard model used in regular economics posits a process of price adjustment in which unsatisfied demanders bid up the price or frustrated suppliers drive it down until a price is established that clears the market, i.e., transactors can execute their offers to buy or sell as planned.  In recessions and depressions, as opposed to “normal” periods, the standard model of price adjustment doesn’t seem to work.  So there seems to be a prima facie case for saying that recessions and depressions involve some sort of market failure.  The case may be rebuttable, but Williamson seems to acknowledge in responding to a comment 0n a subsequent post that at least one rationalization for cyclical unemployment is unacceptably implausible.

In the later post Williamson sends us to an essay published by the Richmond Fed in which Kartik B. Athreya and Renee Courtois argue that the first theorem of welfare economics teaches us that to justify intervention into the private market economy, it is necessary to establish that the array of existing markets is incomplete or not fully competitive.  This is a remarkable assertion inasmuch as I am unaware that anyone ever asserted that the set of markets in existence is anywhere near the set required to satisfy the completeness conditions of the first theorem of welfare economics.  (But maybe I am ill-informed).  So what exactly must be shown to establish what is self-evidently true:  that the necessary conditions specified by the first theorem of welfare economics do not obtain in the real world?

Here is how Athreya and Courtois characterize the practical implication of the first theorem of welfare economics for macroeconomic policy. 

The preceding result implies that in a well-functioning market system [i.e., a perfectly competitive economy with a complete set of markets, a theoretical requirement with no real-world analogue], the adjustments made by individual and firms in response to a shock in fundamentals, even when they are contractionary, will be efficient.  If something bad has happened to the ability of firms to produce output (say, a shock to the financial sector that hinders the allocation of labor and capital to their best uses), then each hour of labor becomes less productive.  In this case, it make little sense for firms to continue producing, or for workers to work, at previous levels.  After a storm, for example, a fisherman may find that each hour spent in the boat produces less fish; an efficient response is for him to spend less time fishing (hire less labor) and more  hours consuming leisure (or, perhaps working on boat maintenance and repair), given that the cost of leisure or other activities, measure in terms of fish foregone, has fallen.

This example is meant to show that even if there is a shock causing a decline in output and employment, it does not follow that the adjustment – reduced output and employment — to the shock was inefficient.  This is a basic proposition of real-business-cycle theory, regarded by some as quintessential regular economics.  Negative productivity shocks imply reduced output and employment, so who is to say that observed output and employment reductions in business-cycle downturns are not characteristic of an optimal adjustment path?

Athreya and Courtois acknowledge that “frictions” can cause responses to a negative productivity shock to be inefficient, e.g., frictions in capital and labor markets, and in insurance markets.  But in discussing inefficiencies in capital markets, they merely refer to banks’ difficulties in discovering good investment projects.  Their discussion of labor-market inefficiencies is no more helpful, referring to problems of matching workers and employers, which can cause the search process to be long and drawn out.  But just because matching workers and employers is costly and time-consuming doesn’t tell us how much search is optimal or whether the actual amount of search in response to a recessionary shock is optimal. 

They do provide a somewhat more helpful discussion about the process of reducing labor input, suggesting that there is an inefficiency in laying off workers rather than evenly reducing hours across the entire work force.  But this too is problematic, because, as they acknowledge, there are various reasons why letting some workers go and keeping the rest fully employed rather than cutting hours is less costly for employers than trying to reduce hours worked equally across their employees.  The hardship is concentrated on a subset of workers rather than shared by all workers.  But is there an inefficiency?  We aren’t given a model from which to draw an inference. 

Finally, there is the absence of a private market for unemployment insurance.  In the absence of such a market, and because most of the reduction in labor hours is concentrated on a subset of workers, workers respond to the increased probability of losing their jobs by increasing precautionary saving.  Athreya and Courtois admit that they cannot demonstrate any inefficiency in the increase in precautionary saving except insofar as it is related to frictions  in labor and insurance markets, but they provide no proof of such inefficiencies, leaving the impression that the inefficiencies are not that significant.  That impression is reinforced by the following remark.

The preceding suggests there may be a role for policy.  However, it also suggests that productive policies will likely be those which directly address the specific frictions in capital, labor, and insurance markets that make the observed decline in aggregate consumption inefficiently large.

We are not told exactly what the specific inefficiencies are, but, presumably, if we can find them, then it’s fine to do something about them.  But there is little if any justification for trying to increase aggregate demand through fiscal (or monetary?) policy.

[C]urrent spending-based stimulus, while it may marginally increase the probability of a laid-off worker regaining employment, will also likely draw employed workers away from other productive uses – further hindering efficient resource allocation.

Their most explicit recommendation is actually somewhat surprising (what would Robert Barro say?): 

We think a more fruitful approach would be to leverage the existing unemployment insurance and social safety net infrastructure to better insure the unemployed while more strictly monitoring their job search efforts.

What amazes me about the real-business-cycle approach exemplified by this paper, apparently much to Williamson’s liking, is that it ignores any transmission mechanism amplifying a shock as its effects spread through the economy.  Such transmission effects are completely suppressed in the representative-agent model, a characteristic real-business model seeking to deduce all the relevant properties of a business cycle from the analysis of a single agent supposedly representing everything that one needs to know about how an economy behaves.  This is not just a retrogression from Keynesian economics, it is a retrogression from pre-Keynesian classical and neo-classical economics. 

Despite Keynes’s misguided attack on Say’s Law, the notion that supply creates its own demand, an idea Keynes misconstrued to mean that classical economics held that there could be no lapses from full employment, or if there were, that they would be temporary and quickly rectified, Say’s Law actually explains precisely how shocks are transmitted and amplified as they spread through an economy.  If supply creates its own demand, then a failure to supply entails a failure of demand.  So a technology shock that causes some workers to lose their jobs, by preventing them and complementary factors of production from supplying their productive services, necessarily forces those workers, as well as owners of complementary factors unable to supply their services, to reduce their demands for products.  That is precisely the idea of the Keynesian multiplier, except that Say’s Law views it from the supply side and the multiplier views it from the demand side.  At bottom, these two supposedly contradictory ideas correspond to the same phenomenon, viewed from opposite angles.  But the phenomenon is completely suppressed in the representative-agent model.

But where is there any inefficiency?  Well, as we have just seen, it is really — I mean really – hard to find an inefficiency if you try to understand what happens in a recession in terms of a representative-agent model.  In a representative-agent model, the entire analysis collapses to finding the equilibrium of the single representative agent.  You have necessarily assumed that social and private costs are equal, because you have collapsed all of society into the representative agent.  Private and social costs are not only equal they are identical, because that is how you set up your model.   You have taken regular economics to its outer limit, and you have annihilated the multiplier.  Good job!

But if you think of economics as the study of interactions between independent decision-makers rather than the study of a single decision-maker in isolation, and if you recognize that production and exchange between individuals may not just transmit, but amplify, disturbances across individuals, you may prefer to think of an economy as a network of mutually interdependent transactors whose decisions about how much to supply and demand reverberate back and forth across the network.  Because it is so highly interconnected, private and social costs in the network need not be equal; indeed externalities are a characteristic feature of networks.  The pervasiveness of externalities is well understood in payments networks in which the insolvency of a systemically important transactor can cause the entire network to collapse.  The looser interconnections of the real economic network of production and exchange is less brittle than a specialized payments network, but that doesn’t mean that the former network is not also pervaded with externalities, a point beautifully articulated by the eminent Cambridge economist Frederick Lavington when, when referring to an economy at the bottom of a recession, he wrote in his book The Trade Cycle, “the inactivity of all is the cause of the inactivity of each.”

So is there any inefficiency in a recession?  Of course.  And is there an economic model that identifies the inefficiency?  Absolutely.


40 Responses to “Are Recessions Efficient?”

  1. 1 Bill Woolsey August 31, 2011 at 3:28 am

    Stabilizing output in the face of a productivity shock is a bad idea.

    Assuming that all decreases in output must be due to productivity shocks is also an error. An argument needs to be given and evidence provided.

    I can understand the claim that keeping GDP (nominal) on a stable growth path would have no impact out output and employment and simply result in a someone different path of nominal prices and wages–counter cyclical, but how exactly is is supposed to result in a misallocation of resources?

    Fish productivity falls. Fish prices go up. Is it that the particular fisherman whose productivity fell who will get confused?

    Suppose there is an increase in the demand to hold money. Each person reduces money expenditures to build money balances. We know that if prices and wages fall to a lower level, real money balances will rise to match the amount demanded. At lower prices and wages, a given money flow of expenditures will purchase the productive capacity of the economy.

    To assume that prices and wages make this adjustment, and so that when we observe a drop in money expenditure and a drop of output and only modest drops in prices and wages, that there must have been a negative productivity shock appears to me to be a mistake.

    When firms are asked what is there key problem, and when no one says that they have less productivity, but instead say that they can’t sell as much, the presumption should be the problem is an excess demand for money.


  2. 2 João Marcus Marinho Nunes August 31, 2011 at 4:50 am

    …And trying to stabilize prices in the face of a productivity shock is also a bad idea. Therefore it seems that if you stabilize the product of the two (p*y) you will do a better job. But in the RBC world there´s no need for stabilization policy, every economic move is an equilibrium one!


  3. 3 JW Mason August 31, 2011 at 7:11 am


    The arguments in this post are solid and (IMO) completely correct; but the problems with RBC approaches are probably familiar to most readers of this blog. The question is, what is the specific theory we are offering in its place?

    Do you agree with Bill Woolsey (and most mainstream Keynesian economists, it seems) that excess that a shortfall of aggregate demand is equivalent to excess demand for money? Or is an increase in the demand for money just one possible cause for a fall in AD?

    Do we think that the economy is best characterized as occupying a unique equilibrium, one that just happens to include demand for a good that is uniquely produced by the government (money or safe assets) and whose price can’t adjust, so that aggregate output adjusts instead? Or do we think that the positive feedback between expenditure decisions and income means that there are many possible paths (or equilibria) for an economy with a given set of fundamentals, so that demand constraints can bind even in a world without any special role for government-produced money? And if the latter, what’s a good statement of how we model such an economy?

    I’m probably one of your few readers who’s actually read (well, glanced at) Lavington’s The Trade Cycle. But presumably there’s something you like from the past 90 years?


  4. 4 David Glasner August 31, 2011 at 9:19 am

    Bill, Don’t you need to distinguish between the initial impact of the disturbance and the follow-on effects? I agree that if there is an adverse productivity shock, there is likely going to be an optimal adjustment towards a lower level of output and employment (though it could be that if people perceive themselves as being poorer they will want to work more, remember the old backward-bending labor supply curve), but if the initial disturbance triggers a cumulative contraction, isn’t there a case for counter-cyclical policy to limit the contraction?

    I agree with you that there is no a priori basis for assuming that all shocks are real. There is a classic identification problem, but we can look at monetary variables to see whether there is evidence of an increase or decrease in the demand for money. In the present episode, at any rate, all the evidence suggests that the demand for money rose.

    Marcus, The RBC world is a funny one, isn’t it?

    JW, I generally agree that an excess demand for money is an aspect of the disturbance, but I don’t necessarily agree that that is all there is to it. The mechanism that I have been thinking of over the past couple of years is a decline in the MEC (to express it in Keynesian language) that implies that the real interest rate would have to fall to keep AD from falling. At some point, the fall in equilibrium real rate may have hit the zero lower bound, while a financial crisis, exacerbated by the Fed’s thoughtless tight money policy in 2008, produced deflationary expectations and a general crash of asset prices beyond just the residential housing market. I not only think that there may well be multiple expectation-dependent equilibria, I reject the notion that you can even specify a set of fundamentals that are not themselves expectation-dependent. (See my post, if you haven’t already, “What’s Fundamentally Wrong with EMH?”) I don’t think that I am in a position to tell you how to model all this. Maybe that will come to me, but I think others will have to try to come up with a model if they think that my intuition could be useful. I like Lavington and I especially appreciate the quotation that I picked up form him, expressing, from a totally orthodox neo-classical perspective, the interdependent nature of macroeconomic decisions. But obviously he is not the last word. Hawtrey of course is an inspiration, as well as Hayek in his Economics and Knowledge paper, as well as Clower, Leijonhufvud, David Laidler, and especially Earl Thompson.


  5. 5 JW Mason August 31, 2011 at 10:43 am

    I agree that the principle of effective demand cannot be reduced to excess demand for money.

    Keynes, as you say, emphasizes the fluctuations in investment demand (MEC in his language), which is connected to the fact that the distribution of future states of the world relevant to returns on new investment is not just stochastic but fundamentally unknown, so expectations about profits on long-lived fixed capital are essentially conventional and unanchored.

    “The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse of the marginal efficiency of capital… Liquidity preference, except those manifestations which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.

    It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and probably a necessary condition of it. But for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough [to offset it]. If the reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But in fact, this is not usually the case.”

    So Keynes actually agrees with RBC that the cause of a decline in output is not fundamentally located in the financial system, but is due to a fall in the expected profitability of new investment. The difference is that they think a decline in expected profitability must be due to a genuine decline in the true expected value of future profits, while he thinks expectations are basically irrational. (“Enterprise only pretends to itself to be actuated by the statements in its prospectus … only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.”) But the theory that you find in DeLong, for instance, that the fundamental cause of a downturn is an autonomous increase in demand for safe assets, i.e. liquidity preference, is explicitly rejected by Keynes.

    The other thing to recognize is that Keynes never mentions the zero lower bound. He describes the liquidity trap as theoretical floor of the interest rate, which is above zero, but nothing in his argument depends on it. Rather, he says,

    “The most stable, and least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in the future, the minimum rate of interest acceptable to the generality of wealthowners. (Cf. the 19th-century saying quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 percent.”) If a tolerable level of employment requires a rate of interest much below the average rates which rules in the 19th century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.” I think this is a very important part of the argument that tends to get ignored, but is quite visible today. Well before the policy rate reached zero, the interest rates faced by business borrowers had stopped binding. And of course the hurdle rate from the point of view of a firm considering investment includes an additional premium on top of the interest rate.

    So since Keynes thought that the MEC was subject to wide, unpredictable fluctuations and probably also a secular downward trend, and since he doubted that very large movements in the interest rate could be achieved by monetary policy and that moderate movements would have much effect on investment, he was left “somewhat skeptical of the success of a merely monetary policy directed toward influencing the rate of interest”; instead, the government must “take an ever greater responsibility for directly organizing investment.” That’s part of his argument that today’s “Keynesians” have largely forgotten.

    Whew! that’s a lot of Keynes. But this seems to be one of the few spots in the blogosphere where this conversation is possible.


  6. 6 Luis H Arroyo August 31, 2011 at 12:04 pm

    David, I agree with you that the problem is to reduce social problems to individual ones. For me the best counter example is the systemic risk in the financial sector: a bank with some individual problems (tail risk) can originate a systemic crisis.
    In similar manner, in any market a sectorial shock can create a macroeconomic shock. Individual adjustments is not a guaranty of a return to previus equilibrium.
    but I don´t agree with the idea that just controling NGDP is suffcient to elude all the shocks. For example I think that currently it would be necessary pursuing a higher rate of inflation.


  7. 7 David Glasner August 31, 2011 at 12:35 pm

    JW Thanks for that very useful summary of Keynes’s key views on interest rates and investment. There’s a lot going on there and although his views do hang together in a certain way, it is obviously possible to pick and choose. What strikes me as crucial to our situation is that current expectations are very pessimistic. Unlike Keynes, I don’t think that expectations are entirely irrational, but I do agree with him that expectations are interdependent, so that optimism and pessimism tend to be transmitted. The point of monetary policy should therefore be to increase expectations of the future price level which will make real investment relatively more attractive than holding liquid assets of whatever kind. That kind of stimulus to investment and employment would, I believe, be self-reinforcing by bolstering entrepreneurial expectations. From September 2010 to February 2011, QE2 seemed to be working in just that way, stock prices rose sharply even as real interest rates rose rapidly. Then the still fragile recovery was hit by the quadruple whammy of a bad winter, the loss of Libyan oil, a recurrence of European debt problems, and the Japanese tsunami.

    Luis, I agree with you.


  8. 8 Luis H Arroyo August 31, 2011 at 12:38 pm

    … RBC don´t distinguish between creattive destruction and general contration.


  9. 9 David Pearson August 31, 2011 at 1:55 pm


    The “QE worked but for the shocks” argument needs more fleshing out.

    -are you saying a bigger QE might have overcome those shocks? How big?
    -should the Fed “mark-up” its next QE by, say, 40% to insure against supply shocks?
    -If not, is there something in the nature of a shock during a recovery that renders stimulus useless no matter the size?
    -given the obviously temporary nature of the “shocks” shouldn’t deferred spending/investment already be recovering?

    Finally, if $600b in QE “worked”, why not do $5tr next time? If QE has little influence on commodity prices or the potential for high inflation, and if it demonstrably produces real growth, I cannot think of a hypothesis that should prevent you from arguing for that level.


  10. 10 David Pearson August 31, 2011 at 2:20 pm

    As an aside, the word “shock” is a stand-in for “a surprising exogenous event.” War and weather classify. A lack of Greek fiscal discipline; or an inability of the European periphery to stage robust recoveries; or the fact that under-capitalized European banks are vulnerable to contagion: these are not a set of characteristics that fit that definition.


  11. 11 Bill Woolsey August 31, 2011 at 7:44 pm

    An excess demand for money doesn’t have to appear as a bolt from the blue (an exogenous shock.) Perhaps it is caused by a decrease in expected profits from investment. The zero negative bound on nominal interest rates is entirely an artifact of an excess demand for money. Holding money rather than lending it is _holding money._

    As for possible propagation, because the demand for money is negatively related to real income, falling real income leads to an excess supply of money and increased demand–ceteris paribus. Of course, it is possible that falling real income might have other effects that raise the demand for money.

    The problem is fundementally a monetary.

    The first step to seeing this is to consider a monetary economy without currency–solely checkable deposits. How is it that a lower marginal efficiency of capital results in reduced money expenditure on output?

    If the quantity of money (deposits) remains equal to what the demand to hold it would be with nominal expenditure on its existing growth trajectory, exactly how is it that reduced income leads to reduced expenditure?


  12. 12 Morgan Warstler (@morganwarstler) August 31, 2011 at 9:11 pm

    More small businesses say the problem is “regulation” and “taxes” combined than blame lack of demand.

    The only reason those things are split is to raise up lack of demand in the polling.

    Fiat: let’s assume the problem is taxes and regulations, and this is what businesses report… after all, when you can dump chemicals in the river, your costs do go down, and demand does go up… if you can pay employees $2 per hour, you hire more employees.

    These are extreme examples, yes, but….

    Question: What does it take for you economists to demand the government change its policies BEFORE monetary policy changes? Do you always say they are separate issues?

    How offended by government regulation do you have to be before you stop bailing and look for the hole int he boat?


  13. 13 Herman September 1, 2011 at 6:10 am

    A small additional point to the many you make:

    “… I am unaware that anyone ever asserted that the set of markets in existence is anywhere near the set required to satisfy the completeness conditions of the first theorem of welfare economics. ”

    Indeed yes. And so you concede too much when you ask “Are Recessions Inefficient ?” For this question seems to imply that at least at “full employment” the economy is in a Pareto-optimal steady-state. Given incomplete markets, this does not follow at all. And in any case, given the impossibility of complete markets, what makes the Arrow-Debreu framework the right GE framework to study macro issues?

    John Geanakoplos:

    “It is a very old idea – which, for example, my adviser Kenneth Arrow often repeated – that when markets are missing, competitive equilibrium should not be expected to be Pareto optimal. There may be a useful role for the government or other institutions to act in place of missing markets. The GEI [ General Equilibrium with Incomplete Markets – H] model strengthens the role for intervention in a non-trivial way. In the Arrow-Debreu world, if a market is missing, a central planner can improve the final allocation, but only in effect by replacing the missing market. An illuminating real world example is the so-called ‘operation bubble’ that is in place in some mid-western American states, where polluters must buy the right to pollute the air on an artificial government-run market. In the Arrow-Debreu model, if the planner has no ability to affect the allocation of goods that would have been traded on the missing market, then it should not intervene at all. If, for example, apples cannot be traded on the market, there is no reason for the government to induce firms to change the mix of pears and oranges they are selling. In the GEI model this is not the case. If some kinds of ‘risk’ cannot be traded, then the government indeed ought to intervene and induce consumers and producers to alter their trades of the existing assets”

    2. Geanakoplos, J.D. and H.M. Polemarchakis, 1986, Existence, regularity and constrained suboptimality of competitive allocations when the asset structure is incomplete, in: W.P. Hell&, R.M: Starr and D.A. Starrett, eds., Uncertainty, information and communication: Essays in honor of K.J. Arrow. Vol. 3 (Cambridge Universitv Press, New York) 65-95.


  14. 14 Morgan Warstler (@morganwarstler) September 1, 2011 at 6:28 am

    Question; why would we not say that regulatory / fiscal policy changes from 2008 onward are not an exogenous shock, even though they were avoidable?

    Meaning the system was set up for Obama to behave like Clinton… small raise in taxes, giant cuts to government “investments.”

    Obama juked and ran the wrong way.

    It was shocking and outside the boundaries of what Dem Presidents are allowed to do.


  15. 15 Bill Woolsey September 1, 2011 at 6:37 am


    You must be joking.

    If $600 billion in quantitative easing is good, why not $5 trillion?

    Because of scarcity.

    The amount of goods and services that can be produced is limited.

    Now, if $600b gets spending on output a bit closer to the 1984-2008 trend and $5 trillion closer still, then $5 trillion would be better. But the concern would be that $5 trillion would result in spending on output surpassing that trend.

    And, as above, there is no claim that more spending on output is always better.

    My view is that keeping spending on a stable growth path is best. If you fall below (or rise above) get back ASAP.

    How much quantitative easing should there be? Whatever it takes. $600 billion, $4 trillion, it doesn’t matter.

    On the other hand, if you are talking about shifting the growth rate of money expenditures on output, I don’t see much value in that.


  16. 16 W. Peden September 1, 2011 at 8:05 am

    David Glasner,

    Apropos nothing in particular, are you aware that Churchill College Cambridge has an interview of Ralph Hawtrey by Alec Cairncross? If not, I’ll be in Cambridge doing a masters degree next year, so if you want me to read it and give you some notes I’d be happy to do so.


  17. 17 Barry September 1, 2011 at 8:26 am

    Morgan Warstler (@morganwarstler) August 31, 2011 at 9:11 pm

    “More small businesses say the problem is “regulation” and “taxes” combined than blame lack of demand.”

    Do you have a cite? Because I’ve heard otherwise, and it’s pretty frikkin’ obvious that there’s been a radical collapse in demand (look at household saving rates, household incomes, labor force participation).


  18. 18 David Glasner September 1, 2011 at 10:46 am

    David, My use of the term “shocks” may have been imprecise, but certainly there was an unexpected deterioration in the European debt situation that started in the late winter or early spring. Going back to the Great Depression, the 1931 failure of the Austrian bank the Credit Anstalt is widely identified as a key development that led a deterioration of the international financial crisis. What word would you use to describe that event? My approach would be to set a price level target, which the Fed has not done and then say we will do whatever it takes to meet the target, so I think the Fed has it backwards. I didn’t say that QE doesn’t have inflationary potential. As you know, I am in favor of inflation and supported QE because it would generate inflation. I don’t think that we got enough inflation and therefore didn’t get a significant boost in output and employment.

    Bill, I actually think that you can’t get the result you are looking for without currency, because as Tobin taught us deposits are not a hot potato so that there is a market mechanism that is either adding to or taking away deposits in response to excess demand or supplies of money. So in that model it is hard to see why whatever disturbance you start with you get an excess demand or supply of money that affects NGDP. You need gold or currency in the model to get the effect on NGDP that you are looking for.

    Morgan, you sound way too trusting of these surveys. I would have expected you to show a little bit more skepticism about the self-serving
    responses invited by such surveys.

    Herman, Thanks for confirming my intuition (and memory) about complete markets. The problem is in a way similar to the issue discussed by Hayek in his wonderful paper Economics and Knowledge which is that a full intertemporal equilibrium requires that individual expectations about future prices be brought into agreement otherwise someone’s plans will necessarily be disappointed, a disappointment incompatible with intertemporal equilibrium. He then pointed out that there is no market mechanism for bringing about the agreement among individuals about future price expectations, which was his intuitive recognition of the incompleteness problem, and suggested that the only basis for assuming that we ever come close to intertemporal equilibrium is the empirical observation that real world economies actually do function most of the time, not the most powerful of arguments (especially not in 1937).

    W. Peden, I don’t believe that I was aware of such an interview. I did once see that Hawtrey’s papers are housed at Cambridge and looked through listing of the contents, perhaps I saw that there was such an interview listed and forgot. At any rate, I would be very grateful if you could share your notes with me. When does “next year” start. Best of luck to you.


  19. 20 David Glasner September 1, 2011 at 11:13 am

    The first reference was to Williamson’s own comment responding to a comment on the paper mentioned in the second link. The previous sentence is probably difficult to understand, but I have tried to edit my post to it clearer what is being referenced and linked. Thanks for being such a careful reader.


  20. 21 Jason September 1, 2011 at 11:52 am

    There will always be taxes and regulation. We don’t want companies dumping in the river or paying employees $2 per hour. A company with a good business model can be profitable despite taxes and regulation as long as there is demand.


  21. 22 Morgan Warstler (@morganwarstler) September 1, 2011 at 11:54 am

    Good Jesus – David passive-aggressive much? If you are going to take the time to type, just take the time to answer.

    WHAT would it take for you to say think the larger issue is structural? Forget Monetary, I want to know what evidence of over regulation and taxation would convince you – if the answer is nothing, say nothing.

    Another thing I’m trying to understand about your assumptions: say we ended Worker’s Comp, Minimum Wage, and UI – do you think that reduces unemployment and do you think it would be say more than say 2%?

    I don’t care what you think is politically reasonable, I want to know how you estimate any potential drag from these things.


    thanks for that. But it doesn’t quite get where I was going… I think I caught the fact as sentence from a weekly standard article or something….

    You first one shows a bit why I don’t pay attention much to how you guys talk.

    I read 42% hired fewer than needed, and 62% of those are having a hard time finding the right employee, and 51% of those are worried about healthcare, I stop worrying about your claims of “not enough demand”

    To me, if we fix that AND THEN IF we still have a problem, we talk about printing money.

    Those are HORRIBLE STATS, that means we have a bunch of SMBs who want us to overturn Obamacare, establish a Guaranteed Income system (like I propose), and remake education to train workers for jobs… to teach students.

    Those are our marching orders! The three commandments.

    How you guys all pretend the SMBs owners are not the boss of everything is the problem.

    For data that makes better sense here’s this:

    Click to access 2011-04-sb-outlook-survey-results.pdf


  22. 23 W. Peden September 1, 2011 at 12:24 pm

    David Glasner,

    I’ll be in Cambridge from early October.

    Churchill College really do have a lot of great stuff- they also have Margaret Thatcher’s private papers.


  23. 24 Greg Ransom September 1, 2011 at 3:45 pm

    There are more than a hundreds miles of mothballed lumber hauling rail cars on unused rail spurs around the country.

    You can see them. You can drive past them for hours.

    This is MASSIVE evidence of a VERY SPECIFIC failure of coordination / production.

    What competent but 4th string mathematicians like Williamson cannot do is create math constructs which do much of anything to isomorphically map this phenomena, where systematic production misdirections caused by false price signals create masses of what are now non-economic goods.

    So BOTH of Willamson’s premises are bogus.


  24. 25 Wonks Anonymous September 1, 2011 at 4:37 pm

    “I think I caught the fact as sentence from a weekly standard article or something”
    A bunch of socialists in conservative sheepskin, best known for their habitual lying to conservatives on behalf of National Greatness boondoggles.

    There’s a phrase sometimes used at The Monkey Cage, “Me, the people”. There are a variety of reforms you favor, and they may in fact be very good ideas. But you can’t leap to claiming a whole bunch of other people favor those specific reforms without evidence.

    “How you guys all pretend the SMBs owners are not the boss of everything is the problem”
    SMB owners are the bosses of SMBs. Many of them will stay small (family owned businesses in particular), others will grow to become big businesses. We could assign weight to them based on headcount, profit, total revenue or growth (measures off the top of my head). What is your metric for concluding their importance?

    “WHAT would it take for you to say think the larger issue is structural?”
    I don’t know about David, but Scott Sumner says in the U.K the problem is clearly structural. Cameron is going to have to do real reforms, but in the meantime unofficial NGDP targeting eases the transition.


  25. 26 Bill Woolsey September 1, 2011 at 7:06 pm


    I am quite confident that an excess supply of deposits has a “hot potato” effect little different than that of currency.

    As long as merchants accept checks (or electronic payments) in exchange for their goods, without checking with their own bank to determine that the yield their bank is paying is sufficient to convince them to hold additional money balances, then it is really no different than currency in that regard.

    Sure, the interest rate paid on deposits that serve as money impacts the demand to hold them. And it would be wonderful if, in fact, the interest rates on deposits always adjusted so that people would hold the existing quantity. In such a world, there would never be a problem with nominal expenditure deviating from productive capacity. But in the real world, the opposite occurs. Yields on deposits frequently move the wrong way.

    For example, suppose there is an excess demand for money. People sell bonds. The receive checks which they deposit and increase checkable deposits. The sale of bonds lowers their prices and raises their yields. Banks, able to earn more on bonds, offer higher interest rates on deposits. And so, even though the demand for deposits has increased, and banks could pay lower interest rates on deposits and still have the same quantity demanded, they actually pay higher interest on deposits.

    If you assume deposit rates are sticky, then the higher yield on bonds raises the opportuntity cost of holding money, and so the quantity of money demanded falls, clearing up the excess demand. Interest rates are too high to coordinate saving and investment. In other words, by assuming interest rates on deposits are sticky, you are more or less in the world of currency, where the zero yield on currency is assumed to be exactly stuck.

    But if interest rates on deposits aren’t sticky, the higher yields on bonds results in higher yields on deposits, which raises the demand for money. More exactly, the opportunity cost of money remains unchanged and so the excess demand for money continues despite higher interest rates.

    Only if you assume there is a walrasian auctioneer, who calls out interest rates on deposits to clear them, does the interest rate on deposits fall, and so clear the excess demand for money.

    And in such a world, the walrasian auctioneer could keep nominal expenditure equal to the productive capacity of the economy too. Unfortunately, we don’t live in that world.

    We live in a world where deposits used as money are fully subject to monetary disequilibrium.

    But, maybe I didn’t understand Tobin.


  26. 27 Morgan Warstler (@morganwarstler) September 2, 2011 at 9:34 am

    WOOT! (Does a happy dance)

    Obama halts $90B smog regulation from EPA.

    Waiting to do QE3, has real benefits.


    Wonks, I gave you another source. Chamber of Commerce.

    Look man, I’m not coming here with an opinion, I mean yes I do have such an opinion..

    I’m coming here with a theory, meant to be poked prodded attacked.

    My theory is that in the US “Democracy” we have three viable powers in convention bi-polar thinking:

    1. The A power: Tea Party / SMB owners / The millionaire next door- all those who will in their earning lifetime spend at least a couple years earning in the top 90%, and many of those who reach the top 80%.

    The A power is a HUGE group. 30-40M and they OWN stuff, they have savings, they own all the guns, and they vote all the time. They earn a significant chunk of US wealth each year.

    2. The B power: the oligarchs. They have $, no votes.

    3. The C power: everybody else. The have votes, no $.


    I am just hoping you get that the best strategy for C is to play A and B against each other. If not, let me know.

    If you look at the past 30+ years, we started off in A, B, C position, and then in the past 15 years or so, we saw C spend far too much time supporting the corporatism and Big Business / Big Government that promoted the B power against the A power.

    And the economy has seized up. The A power is like the body’s poophole (David, I still think poophole is far more disgusting, but whatever), and when it goes shut, the whole rest of the body goes into recession.

    Stats all back this up. You like stats. Look what has happened to SMBs – and newco formation.

    Stats also back up my point about the strength of the A power: Even while the B power oligarchs have gained, and C has gotten crushed, the A power hasn’t lost anything.

    My point is actually PRO C POWER. I want to see the guys with no $, and and votes, just re-align with the SMBs – this will drive $ out of the oligarchs.

    This is my theory.

    PLEASE hit me with whatever data you think proves this is not correct.


  27. 29 David Glasner September 2, 2011 at 11:51 am

    Morgan, I don’t take survey responses as evidence of anything. Aside from that, it’s not as if we have a well-defined model here that I can derive a clear-cut implication from. Sorry, but this discussion so far is too vague for me to tell you if I had such and such evidence I would change my mind. And I don’t reject a priori the existence of structural issues (raising the minimum wage in the middle of a downturn was not a good move, but I am unable to estimate the magnitude of the effect on employment). But 10 million workers generally don’t lose their jobs within a year for structural reasons.

    Greg, we might interpret the causes of all those idle railroad cars differently, but I agree that they are compelling evidence of something other than an efficient response to a negative productivity shock.

    Bill, Then I think we have a basic disagreement about the mechanism of deposit creation. Well, if you are not sure if you understand Tobin, go back and re-read his “Commercial Banks as Creators of Money” one of the greatest monetary theory papers ever written.

    Morgan, I try to stay away from those kinds of analogies, regardless of which term is used.


  28. 30 Morgan Warstler (@morganwarstler) September 2, 2011 at 12:44 pm

    “But 10 million workers generally don’t lose their jobs within a year for structural reasons.”

    David, who said they do?

    10M people lose their jobs in a year because from 2001-2008, they were all supposed to be finding other jobs.

    And they DIDN’T. They weren’t forced too.

    Why do you think those railroad cars are mothballed? Because those railroad cars aren’t supposed to exist.

    Imagine a teenager driving around Vegas with his father, pointing at things and saying, “that, never should have been here!” “that over there, never should have been here!” “You dad, never should have been here!”

    Look, if you can’t start from a precept that GIANT mis-allocations or caital, resources, and labor occurred after the tech crash…


    You are arguing with people who KNOW that stuff never should have been here, and now that it is here….

    It has to sell to the guys with dry powder for pennies on the dollar.

    Until the guy who owns the railroad cars, has to sell them for scrap, banks have to take the losses on the houses…

    You just aren’t being real.


  29. 31 Morgan Warstler (@morganwarstler) September 2, 2011 at 12:45 pm

    And isn’t it great that the Fed just forced Obama to shut down the EPA?


  30. 32 Jason September 2, 2011 at 1:29 pm

    I think it’s sad when the President bends to political pressure instead of doing the right thing. But I guess we’ll be alright as long as some entrepreneur comes up with a way for humans to breath something other than oxygen. Free market to the rescue!


  31. 33 gregransom September 2, 2011 at 3:36 pm

    No doubt there are multiple contributing & overlapping causes explaining this striking observable phenomena — but to get at most all of them we have to imagine rival & imperfect constantly evolving judgments of changing local conditions and relative prices, which goods unexpectedly changing in relative value across time, including goods going into and out of economic status.

    None of this can be stipulated as a “given” or as “data” or as a formal function in one of Stephen Williamson’s math constructions.

    We have causal over determination. We don’t have a math formula which can possibly limn the kind of causal explanatory phenomena — changing rival judgments in unique circumstances — which is causally efficacious here.

    David writes,

    “Greg, we might interpret the causes of all those idle railroad cars differently, but I agree that they are compelling evidence of something other than an efficient response to a negative productivity shock.”


  32. 34 Bill Woolsey September 3, 2011 at 5:34 am

    I think Yeager’s reponse to Tobin, in “What are Banks?” was telling.

    However, much of my dissertation (so many years ago) involved an analysis of payments systems without currency, and showing how they are subject to monetary disequilibirum.

    The point was that some sort of redeemability requirement is necessary to pin down nominal values. But it doesn’t have to involve zero-interest currency.

    If you recollect, my interest was in indirect redeemability–redeemability in securities of equal market value to a broad bundle of goods.

    Like others, I later shifted over to index futures redeemability, with the index defined on a growth path for NGDP. Your approach was similar.

    Anyway, the more modest reform I have described has each bank’s deposits redeemable in reserve balances at the Fed. Those reserve balances do pay interest. The interest rate on reserve balances is pegged below T-bill rates.

    Even if the interest rate paid on reserve balances were fixed, the Fed doesn’t have to raise the interest rate it pays on reserve balances so that banks are willing to hold the existing quantity of reserves. It could, but it shouldn’t if the goal is to create a quantity of reserves consistent with money expenditures returning to target.f

    So, it would be possible for the Fed to do sufficent quantitative easing to get NGDP back to target, even if it insists on paying .25% interest on reserves.

    To the degree that asset purchases by the Fed lowers interest rates on other finacial assets, (like T-bills) what I propose is that the Fed lowers the interest rate it pays on reserve balances. So rather than imagining that the Fed automatically raises the interest rate it pays to prevent the increase in the quantity of reserves generating an excess supply, the interest rate falls.

    Really, what is happening is that any decrease in the yield on earning assets is not reducing the opportunity cost of holding reserves. Nor, for that matter, is it reducing the “profits” of the Fed, though that isn’t important. (Maximizing central bank profits isn’t part of the proposal.)

    Of course, with the system described above, households and nonbanking firms don’t hold reserve balances, they hold bank deposits. But the banks are only contrained to keep the deposits they issue redeemable in reserve balances. Imagining that each must pay interest on deposits so that the competitive deposit rate causes people to want to hold the existing quantity of money is wrong.

    If interest rate paid on reserve balances is held constant, then the interest rate banks pay on deposits may be unchanged. It is possible that banks will respon to quantitative easing by holding increased excess reserves, but at some point, even if banks solely hold reserve balances, quantitative easing can create an excess supply of deposits.

    But, I favor having the Fed lower the interest rate it pays on reserve balances, and that will result in a lower interest rate on deposits. And so, their isn’t a tendency for the margin that banks earn to fall and so an incentive to increase excess reserves.

    Now, if you get really fancy and get rid of the Fed altogether, and have a system of private banks without any kind of base money, the explanation is a bit more complicated. But it doesn’t require zero interest currency.

    Where did Tobin go wrong? Equilibrium always?

    Read his article again.


  33. 35 Morgan Warstler September 3, 2011 at 5:23 pm

    Bill, I have a question for you: what is the purpose of interest / loans?

    Imagine a monetary system where there are no loans.

    Every time money is purchased, equity is traded for it. You can only invest savings in profit seeking ventures.

    Now yes, you could agree in the future to be able to buy out someone’s equity for less than it is worth IF you hit your valuation marks (stock price), but generally speaking, whats the problem with a system (not a Islam thing) that forces all people with savings / capital to FIGURE OUT DIRECT RISK?


  34. 36 Bill Woolsey September 4, 2011 at 5:38 am

    I think the reason for debt finance is to shift risk.

    The debt holder bear less risk and the equity investors bear more.

    Mutual fund shares should be an equity form of money, and if they
    are aren’t “money market” mutual funds, but rather stock mutual funds,
    there is no debt involved.

    However, I don’t believe that such a monetary order is at all consistent with people carefully assessing risk each time they sell a good or service.

    The result is a system where people can “buy” shares of a portfolio of stocks by restricting ordinary expenditures on output. Or, they can “sell” them by simply making purchases.

    People who want less risk that is provided by the mutual funds used as money can purchase shares of less risky stock (or shares in portfolios of less risky stock.) But the logic of this is the logic of the transactions demand for money. You can only go so low.

    In such a world, saving equals financial investment in equity. People who don’t want to accumulate more stock must either purchase consumer goods or services or else work less.

    I don’t favor imposing such a regime. Risk sharing is a good thing. And, I think that hand-to-hand currency is convenient for many purposes. It is debt. I just think it should be privately issued debt rather than government debt, and certainly oppose using it as the basis for the entire financial system.


  35. 37 Morgan Warstler (@morganwarstler) September 4, 2011 at 11:49 am

    What about a system that more heavily taxed profits from debt / loans vs. profits from equity / dividends / gains?

    The larger question isn’t just risk, but forcing a sense of “the boats have been burned”

    Because in many regards that is what we have right now, it is incredibly hard fro anyone to find safe returns. And I see some upside from this.


  36. 38 David Glasner September 6, 2011 at 12:09 pm

    Morgan, There can be all kinds of structural adjustments going on in an economy without nearly three years of unemployment at or near 10% and virtually no growth. We can’t tell if resources are idle now because they are truly worthless (which I find really implausible), or because there is deficient aggregate demand (or stated differently because real (inflation) interest rates are above the expected profit on investment. If there were greater private investment demand, there would be a much greater derived demand for the resources that you think are worthless.

    Jason, I don’t think it’s quite as simple a call as you suggest. Unemployment is also bad for people’s health.

    Greg, Yup, it’s complicated, but raising the price level would not prevent relative prices from adjusting to reallocate resources across industries and sectors.

    Bill, Tobin actually didn’t quite grasp the significance of his article, and that’s why I think Yeager may not have understood what Tobin accomplished. Tobin thought that he was making an argument that because banks supply just the amount of deposits demand by the public, so that there is monetary equilibrium, the price level was indeterminate because the money multiplier simply changes to offset any change in high-powered money, making the quantity theory, in a Friedmanian Monetarist framework, useless as a policy tool. That was correct. What Tobin didn’t see was that the price level could be determined simply in terms of the demand for and supply of currency or the monetary base. The demand for and supply of deposits determine the structure of yields on different types of deposits which are largely interchangeable depending on the preferences of depositors and the costs of banks in providing alternative deposits. I have to go back and look at Yeager’s article, but I suspect that that is where the confusion lies.


  1. 1 Macro Theory: The Spirit of R.G. Hawtrey Walks… | FavStocks Trackback on September 9, 2011 at 8:00 am
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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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