Aggregate Demand and Coordination Failures

Regular readers of this blog may have noticed that I have been writing less about monetary policy and more about theory and methodology than when I started blogging a little over three years ago. Now one reason for that is that I’ve already said what I want to say about policy, and, since I get bored easily, I look for new things to write about. Another reason is that, at least in the US, the economy seems to have reached a sustainable growth path that seems likely to continue for the near to intermediate term. I think that monetary policy could be doing more to promote recovery, and I wish that it would, but unfortunately, the policy is what it is, and it will continue more or less in the way that Janet Yellen has been saying it will. Falling oil prices, because of increasing US oil output, suggest that growth may speed up slightly even as inflation stays low, possibly even falling to one percent or less. At least in the short-term, the fall in inflation does not seem like a cause for concern. A third reason for writing less about monetary policy is that I have been giving a lot of thought to what it is that I dislike about the current state of macroeconomics, and as I have been thinking about it, I have been writing about it.

In thinking about what I think is wrong with modern macroeconomics, I have been coming back again and again, though usually without explicit attribution, to an idea that was impressed upon me as an undergrad and grad student by Axel Leijonhufvud: that the main concern of macroeconomics ought to be with failures of coordination. A Swede, trained in the tradition of the Wicksellian Stockholm School, Leijonhufvud immersed himself in the study of the economics of Keynes and Keynesian economics, while also mastering the Austrian literature, and becoming an admirer of Hayek, especially Hayek’s seminal 1937 paper, “Economics and Knowledge.”

In discussing Keynes, Leijonhufvud focused on two kinds of coordination failures.

First, there is a problem in the labor market. If there is unemployment because the real wage is too high, an individual worker can’t solve the problem by offering to accept a reduced nominal wage. Suppose the price of output is $1 a unit and the wage is $10 a day, but the real wage consistent with full employment is $9 a day, meaning that producers choose to produce less output than they would produce if the real wage were lower, thus hiring fewer workers than they would if the real wage were lower than it is. If an individual worker offers to accept a wage of $9 a day, but other workers continue to hold out for $10 a day, it’s not clear that an employer would want to hire the worker who offers to work for $9 a day. If employers are not hiring additional workers because they can’t cover the cost of the additional output produced with the incremental revenue generated by the added output, the willingness of one worker to work for $9 a day is not likely to make a difference to the employer’s output and hiring decisions. It is not obvious what sequence of transactions would result in an increase in output and employment when the real wage is above the equilibrium level. There are complex feedback effects from a change, so that the net effect of making those changes in a piecemeal fashion is unpredictable, even though there is a possible full-employment equilibrium with a real wage of $9 a day. If the problem is that real wages in general are too high for full employment, the willingness of an individual worker to accept a reduced wage from a single employer does not fix the problem.

In the standard competitive model, there is a perfect market for every commodity in which every transactor is assumed to be able to buy and sell as much as he wants. But the standard competitive model has very little to say about the process by which those equilibrium prices are arrived at. And a typical worker is never faced with that kind of choice posited in the competitive model: an impersonal uniform wage at which he can decide how many hours a day or week or year he wants to work at that uniform wage. Under those circumstances, Keynes argued that the willingness of some workers to accept wage cuts in order to gain employment would not significantly increase employment, and might actually have destabilizing side-effects. Keynes tried to make this argument in the framework of an equilibrium model, though the nature of the argument, as Don Patinkin among others observed, was really better suited to a disequilibrium framework. Unfortunately, Keynes’s argument was subsequently dumbed down to a simple assertion that wages and prices are sticky (especially downward).

Second, there is an intertemporal problem, because the interest rate may be stuck at a rate too high to allow enough current investment to generate the full-employment level of spending given the current level of the money wage. In this scenario, unemployment isn’t caused by a real wage that is too high, so trying to fix it by wage adjustment would be a mistake. Since the source of the problem is the rate of interest, the way to fix the problem would be to reduce the rate of interest. But depending on the circumstances, there may be a coordination failure: bear speculators, expecting the rate of interest to rise when it falls to abnormally low levels, prevent the rate of interest from falling enough to induce enough investment to support full employment. Keynes put too much weight on bear speculators as the source of the intertemporal problem; Hawtrey’s notion of a credit deadlock would actually have been a better way to go, and nowadays, when people speak about a Keynesian liquidity trap, what they really have in mind is something closer to Hawtreyan credit deadlock than to the Keynesian liquidity trap.

Keynes surely deserves credit for identifying and explaining two possible sources of coordination failures, failures affecting the macroeconomy, because interest rates and wages, though they actually come in many different shapes and sizes, affect all markets and are true macroeconomic variables. But Keynes’s analysis of those coordination failures was far from being fully satisfactory, which is not surprising; a theoretical pioneer rarely provides a fully satisfactory analysis, leaving lots of work for successors.

But I think that Keynes’s theoretical paradigm actually did lead macroeconomics in the wrong direction, in the direction of a highly aggregated model with a single output, a bond, a medium of exchange, and a labor market, with no explicit characterization of the production technology. (I.e., is there one factor or two, and if two how is the price of the second factor determined? See, here, here, here, and here my discussion of Earl Thompson’s “A Reformulation of Macroeconomic Theory,” which I hope at some point to revisit and continue.)

Why was it the wrong direction? Because, the Keynesian model (both Keynes’s own version and the Hicksian IS-LM version of his model) ruled out the sort of coordination problems that might arise in a multi-product, multi-factor, intertemporal model in which total output depends in a meaningful way on the meshing of the interdependent plans, independently formulated by decentralized decision-makers, contingent on possibly inconsistent expectations of the future. In the over-simplified and over-aggregated Keynesian model, the essence of the coordination problem has been assumed away, leaving only a residue of the actual problem to be addressed by the model. The focus of the model is on aggregate expenditure, income, and output flows, with no attention paid to the truly daunting task of achieving sufficient coordination among the independent decision makers to allow total output and income to closely approximate the maximum sustainable output and income that the system could generate in a perfectly coordinated state, aka full intertemporal equilibrium.

This way of thinking about macroeconomics led to the merging of macroeconomics with neoclassical growth theory and to the routine and unthinking incorporation of aggregate production functions in macroeconomic models, a practice that is strictly justified only in a single-output, two-factor model in which the value of capital is independent of the rate of interest, so that the havoc-producing effects of reswitching and capital-reversal can be avoided. Eventually, these models were taken over by modern real-business-cycle theorists, who dogmatically rule out any consideration of coordination problems, while attributing all observed output and employment fluctuations to random productivity shocks. If one thinks of macroeconomics as an attempt to understand coordination failures, the RBC explanation of output and employment fluctuations is totally backwards; productivity fluctuations, like fluctuations in output and employment, are the not the results of unexplained random disturbances, they are the symptoms of coordination failures. That’s it, eureka! Solve the problem by assuming that it does not exist.

If you are thinking that this seems like an Austrian critique of the Keynesian model or the Keynesian approach, you are right; it is an Austrian critique. But it has nothing to do with stereotypical Austrian policy negativism; it is a critique of the oversimplified structure of the Keynesian model, which foreshadowed the reduction ad absurdum or modern real-business-cycle theory, which has nearly banished the idea of coordination failures from modern macroeconomics. The critique is not about the lack of a roundabout capital structure; it is about the narrow scope for inconsistencies in production and consumption plans.

I think that Leijonhufvud almost 40 years ago was getting at this point when he wrote the following paragraph near toward end of his book on Keynes.

The unclear mix of statics and dynamics [in the General Theory] would seem to be main reason for later muddles. One cannot assume that what went wrong was simply that Keynes slipped up here and there in his adaptation of standard tools, and that consequently, if we go back and tinker a little more with the Marshallian toolbox his purposes will be realized. What is required, I believe, is a systematic investigation from the standpoint of the information problems stressed in this study, of what elements of the static theory of resource allocation can without further ado be utilized in the analysis of dynamic and historical systems. This, of course, would be merely a first step: the gap yawns very wide between the systematic and rigorous modern analysis of the stability of simple, “featureless,” pure exchange systems and Keynes’ inspired sketch of the income-constrained process in a monetary exchange-cum production system. But even for such a first step, the prescription cannot be to “go back to Keynes.” If one must retrace some step of past developments in order to get on the right track – and that is probably advisable – my own preference is to go back to Hayek. Hayek’s Gestalt-conception of what happens during business cycles, it has been generally agreed, was much less sound that Keynes’. As an unhappy consequence, his far superior work on the fundamentals of the problem has not received the attention it deserves. (pp. 401-02)

I don’t think that we actually need to go back to Hayek, though “Economics and Knowledge” should certainly be read by every macroeconomist, but we do need to get a clearer understanding of the potential for breakdowns in economic activity to be caused by inconsistent expectations, especially when expectations are themselves mutually dependent and reinforcing. Because expectations are mutually interdependent, they are highly susceptible to network effects. Network effects produce tipping points, tipping points can lead to catastrophic outcomes. Just wanted to share that with you. Have a nice day.

14 Responses to “Aggregate Demand and Coordination Failures”


  1. 1 Lars Christensen October 8, 2014 at 10:16 am

    Excellent post David!

    I have a dream that Axel Leijonhufvud, David Laidler and Leland Yeager will be awarded the Nobel Prize in Economics together…my stupid dreams…

  2. 2 (Luis) Miguel Navascués October 8, 2014 at 11:48 am

    Splendid, David, indeed. I adhere to the Lars’ dream.

  3. 3 Diego Espinosa October 8, 2014 at 5:15 pm

    David,
    Great post. You had me at “complex” and “feedback” in the same sentence.

    The world has come a long way since the Austrians. I don’t mean the economics world. I mean information theory, network science, ecology, cognitive science, neuroscience, and others. Yes, Hayek himself was an early complexity theorist (“Theory of Complex Phenomena” — see link below). But why go back to the Austrian tradition on this when Herbert Simon, Brian Arthur and others have taken the thinking much further? In any case, I am continually impressed by your intellectual adaptability. Would that we all had it.

    http://www.ucss.ge/publication/Week%2004.pdf

  4. 4 Benjamin Cole October 8, 2014 at 7:51 pm

    Well, I admire all of David Glasner’s blogging. But I wish that once a week he would take a roundhouse punch at the coprolitic Federal Reserve and its tight money policies.

  5. 5 Michael Byrnes October 9, 2014 at 3:43 am

    “If one thinks of macroeconomics as an attempt to understand coordination failures, the RBC explanation of output and employment fluctuations is totally backwards; productivity fluctuations, like fluctuations in output and employment, are the not the results of unexplained random disturbances, they are the symptoms of coordination failures. That’s it, eureka! Solve the problem by assuming that it does not exist.”

    Should that be “…are not the symptoms of coordination failures, they are the results of unexplained random disturbances.”? It’s not clear (at least to me) from the text whether this sentence is meant to describe the RBC explanation or critique it.

    OT: BTW, have you looked back at your correlation between inflation and the S&P 500? I am curious whether that has continued.

  6. 6 djb October 9, 2014 at 4:06 am

    “Unfortunately, Keynes’s argument was subsequently dumbed down to a simple assertion that wages and prices are sticky (especially downward).”

    I think he said that in reality people resist changes in money wage…and thank god because if not this could lead to bizarre situations in which wages change rapidly…radically…

    And the idea that whereas one industry or company could decrease wages… a nd sell more….if the whole economy reduces wages then demand goes down and no more is sold so no more people get hired

  7. 7 dan October 9, 2014 at 5:30 am

    What happened to the invisible hand? I thought all coordination problems in economics were solved by mixing free-markets and self-interest?

    Is there any room at all for the notion of a coordination failure?

    Wouldn’t acknowledging a coordination failure essentially topple all of economics?

    I think this is the issue in economics.

    If there are coordination failures who should be the coordinating agent?

    Its ironic that you identify Keynes as having put macro on the coordination denial path. Keynes in a sentence: Sayes was wrong, there are coordination failures.

    Econ is damn difficult, fortunately one difference between physics and economics; without physics we don’t have a space shuttle, without economists we still have an economy…

    It is frustrating and fantastic at the same time just how deep and rich the econ tradition is. There are amazing people who have thought deeply about all of these issues, at the same time the core of macro seems somehow to have grasped shallow simplification from the depths of such a rich intellectual tradition.
    I am reminded by the fine Mark Thoma line that the best new economics is found in old textbooks.
    So I’ll add my vote for the nobel to go to these guys, why not Kalecki and Polanyi as well?

  8. 8 Roman P. October 9, 2014 at 6:32 am

    Alas, it seems that while we can discuss how coordination failures can theoretically wreck the economy, to move beyond that will require sophisticated models that describe the flow of real resources and money with some (great) accuracy. Essentially, something like dynamic Sraffian ‘commodities producing commodities’ model, and on an international scale (since modern industries are international). Even making a very crude prototype of such model will be quite an undertaking. It is also not really close to what modern economists do, though perhaps central planners of Gosplan and other twentieth century institutions did something similar.

    It is curious that over years you seem to be drifting towards more heterodox positions. Post-Keynesians will agree with much of your reasoning, though I think they’d reject the notions that the sources of coordination problems are wages and interest rates either on theoretical or empirical grounds. The current consensus among them seems to be that financial failures directly disrupt the expansion of debt, which wrecks the economy.

  9. 9 Frank Restly October 9, 2014 at 1:29 pm

    Dan,

    What I think you mean is:

    “Econ is damn difficult, fortunately one difference between physics and economics; without physicists we don’t have a space shuttle, without economists we still have an economy…”

    Applied versus theoretical physics begins splitting at the undergraduate level in most universities (applied physicists being called engineers).

    Not sure there is a collegiate discipline called applied economics (finance is the closest I can come). The finance guys and the economic theory guys don’t play very nice – you see this difficulty in any discipline including physics.

    Applied private finance is pretty straightforward – maximize income – expenditures or assets – liabilities within legal means. Individuals tend to be more concerned with income statements. Companies tend to focus on balance sheets.

    Applied public finance is the hard part – what role should government play in an economy and how should government pay for its commitments?

    The problem with economics is that the laws governing it are written by the people operating under it. With physics laws there is uniformity across space and time – what is true in the U. S. today should be true anywhere at any point in time – hence the scientific method is born.

    Man made laws are written, interpreted, re-written, and disgarded on a regular basis – that is why economics is hard – the rules change all of the time and the rule changes are often made by economists.

    Imagine Newton having the ability to change the gravitational constant on a whim. Sure he would sell a lot of new edition textbooks, but he would also frustrate a lot of physicists trying to learn the trade.

  10. 10 dan October 9, 2014 at 3:06 pm

    you are right, I meant to say physicists – I regret having added that to my comment, it was an unnecessary distraction. I meant it as a dig at the cottage industry that has sprung up criticizing Economists while not taking the time to do the hard work.

  11. 11 Frank Restly October 9, 2014 at 4:10 pm

    Dan,

    No problem. Economists bear some of the blame themselves. No one is forcing guys like Paul Krugman to write regular articles in the New York Times or appear on weekend talk shows. Granted, Paul’s opinions are his own and may not reflect even half of what other economists are thinking and writing, but with high profile comes a high level of scrutiny.

    The central bank used to be one of the most secretive organizations in the United States. Congressional oversight did not begin until the Humphrey Hawkins Act was passed in 1978. This for an organization that had been around since 1913. Ask someone 40 years ago who the federal reserve chairman is and maybe 1 in 10 could tell you (if that).

    Does this ring any bells?

    http://content.time.com/time/covers/0,16641,19990215,00.html

  12. 12 Frank Restly October 9, 2014 at 5:10 pm

    Dan,

    In a related vein, Time magazine has a sortable list of all of it’s cover stories going back to 1924 here:

    http://search.time.com/results.html?cmd=tags&Ne=13&internalid=endeca_dimension&Ntx=mode+matchallpartial%2bsnip%2bp_body%3a25&N=46&Ns=p_date_range|1

    Number of covers featuring economics related issues: 273
    Number of covers featuring a physics related issue: 1

    The physics related issue:

    http://content.time.com/time/covers/0,16641,20140217,00.html

    Date: Feb 17, 2014

    Which is pretty astounding when you think of all of the discoveries since 1924.

  13. 13 David Glasner October 12, 2014 at 12:29 pm

    Lars, Thanks. Same as mine minus one.

    Luis, Thanks. To each his own.

    Diego, Thanks to you to as well. And I agree we don’t have to go all the way back to Hayek, there are other intellectual resources available now, but we can still learn something from the way he approached the problem.

    Benjamin, Thanks. Maybe I have a too much of a soft spot in my heart for Janet. I don’t think that I could possibly say anything even remotely hostile about her.

    Michael, I did mean to say is that output and employment and productivity fluctuations are all the results of coordination failures. Random fluctuations may have something to do with the occurrence of coordination failures, but not in the way that they are modeled in RBC theory, where the adjustment to random fluctuations is optimal, meaning that coordination failures don’t exist. One has to have theory of how random fluctuations can cause coordination failures. Not only does RBC not have such a theory, it denies that such a theory would be useful.

    I haven’t redone the econometrics as I had intended to do, but from looking at the recent data, I think it is clear that the high correlation between inflation expectations and stock prices is no longer very close. There are two possible interpretations. One is that we have transitioned into a more normal situation; the other is that movements in inflation expectations are now being driven not by changes in monetary policy or expectations of monetary policy, but by supply-side factors in which case there would be no reason to see the positive correlation between inflation expectations and stock prices that I found for the 2008 to 2011 period. I think the correlation began to disappear sometime in 2012 after QE3 was well under way.

    djb, I think I agree with what you are saying about Keynes. My point is that he said a lot about wage and price stickiness and whether nominal wage cuts could increase unemployment. So just to say that Keynes suddenly figured out that wages are sticky is a gross oversimplification and distortion of what Keynes was saying.

    dan, Well, it turns out that what you thought is often true, but there are many situations in which it is not or may not be true, and economists differ about the relative frequency of the cases in which the invisible hand can relied on to do its work and the cases in which it can’t. Acknowledging that coordination failures can exists doesn’t topple economics; it make economics interesting and important, at least creates the possibility that it is interesting and important.

    Sorry, but dead guys aren’t eligible for the Nobel.

    Roman, Actually, in most respects I am a pretty orthodox, neoclassical economist. I just think that we have to be more eclectic in recognizing and accepting alternative ways of doing economics, and more open to the implications of our own models when we don’t make convenient assumptions about how the models work.


  1. 1 Aggregate Demand and Coordination Failures – Uneasy Money | Marty Investor Trackback on October 9, 2014 at 4:22 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.

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