Everyone is fretting about how severe the downturn that is now starting and causing the worst plunge in the stock market since the 1929 crash is going to be. Much of the discussion has turned on whether the cause of the downturn is a supply shock or a demand shock. Some, perhaps many, seem to think that if the shock is a supply, rather than a demand, shock, then there is no role for a countercyclical policy response designed to increase demand. In other words, if the downturn is caused by people getting sick from a highly contagious virus, making it dangerous for people to gather together to work, then output will necessarily fall. Because the cutback in the supply of labor necessarily will cause a reduction in output, trying to counteract supply shock by increasing demand, as if an increase in demand could prevent the reduction of output associated with a reduced labor force after the onset of the virus, seems like an exercise in futility.
The problem with that reasoning is that reductions in supply are themselves effectively reductions in demand. The follow-on reductions in demand constitute a secondary contractionary shock on top of the primary supply shock, thereby setting in motion a cumulative process of further reductions in supply and demand. From that aggregate perspective, whether the initial contractionary shock is a shock to supply or to demand is of less importance than ensuring that the cumulative process is short-circuited by placing a floor under aggregate demand (total spending) so that the contraction caused by the initial supply shock does not become self-amplifying.
The interconnectedness of the entire economy, and the inability of any individual to avoid the consequences of a social or economic breakdown by making different (better) choices — e.g., accepting a cut in wages to retain employment — was recognized by the most orthodox of all Cambridge University economists, Frederick Lavington, in his short book The Trade Cycle published in 1922 in the wake of the horrendous 1921-22 depression from which the profound observation that serves as the title of this post is taken.
It’s now 60 years since John Nash defined an equilibrium as a situation in which “each player’s mixed strategy maximizes his payoff if the strategies of the others are held fixed. Thus each player’s strategy is optimal against those of the others.” If the expectations of other agents on which other agents are conditioning their strategies (plans) are sufficiently pessimistic, then an unemployed worker may not be able to find employment at any wage, even if it is only a small fraction of the wage earned when last employed. That situation is not the result of a diminution in the productivity of the worker, but of the worsening expectations underlying the strategies (plans) of other agents.
To call unemployment “voluntary” under such circumstances is like calling the reduced speed of drivers in a traffic jam “voluntary.” To suppose that the intersection of a supply-demand diagram provides a relevant analysis of the problem of unemployment under circumstances in which there are massive layoffs of workers from their jobs is absurd. Nevertheless, modern macroeconomics for the most part proceeds as if the possibility of an inefficient Nash equilibrium is irrelevant to the problems with which it is concerned.
There are only two ways to prevent that cumulative decline from taking hold. The first is to ensure that there is an immediate readjustment of all relative prices to a new equilibrium at which all agents are able to simultaneously formulate and execute optimal plans by buying and selling at market-clearing equilibrium prices. Such an immediate readjustment of relative prices to a new equilibrium price vector is, for a multitude of reasons which I have described in my recent paper “Hayek, Hicks, Radner and Four Equilibrium Concepts,” an extremely implausible outcome.
If an immediate adjustment to an unexpected supply shock that would return a complex economy back to the neighborhood of equilibrium is not even remotely likely, then the only way to ensure against a cumulative decline of aggregate output and employment is to prevent total spending from declining. And if total spending is kept from declining in the face of a decline in total output due to a supply shock, then it follows, as a matter of simple arithmetic, that the prices at which the reduced output will be sold are going to be correspondingly higher than they would have been had output not fallen.
In the face of an adverse supply shock, a spell of inflation lasting as long as the downturn is therefore to be welcomed as benign and salutary, not resisted as evil and destructive. The time for a decline in, or reversal of, inflation ought to be postpone till the recovery is under way.
Uneasy Money 
One of the most irresponsible pieces i’ve ever read. Burden people with inflation while they are going through a pandemic? This is a recipe for the central bank to lose independence almost overnight via the electorat.
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Good post. We never hear much about Lavington, but I remember Patinkin teaching him to us briefly.
“Nevertheless, modern macroeconomics for the most part proceeds as if the possibility of an inefficient Nash equilibrium is irrelevant to the problems with which it is concerned.”
Dunno. That’s not true for New Keynesian macro, for example, for all its flaws. It’s an inefficient Nash Equilibrium even at the natural rate (due to monopolistic competition), which gets worse if the CB sets r>r* so we get a recession.
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Well perhaps so, but your reasoning is not very persuasive. My point isn’t that inflation is always and everywhere a good thing, but that under some circumstances, it may be better to have inflation than to allow output to fall precipitously and unemployment to soar. I provided a reason why that might be true, but you don’t address the argument, you just dismiss it out of hand. If it is the case that an increase in inflation via increased total spending may raise output and employment or prevent it from falling as much as it otherwise would (a point explicitly conceded by Hayek), then you have to consider whether it is worth accepting higher inflation to cushion the increase in unemployment.
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Thanks, Nick. You’re right I was a bit sloppy in my use of the concept of a Nash equilibrium. I meant only to indicate that there could be bad high-unemployment equilibria, as Roger Farmer argues. I actually don’t think it’s correct to regard most episodes of high unemployment as Nash equilibria. I was just making the point that it’s not useful to adopt standard micro reasoning as a benchmark for analyzing how a macro-equilibrium is achieved.
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Of course, great post.
As I see it, we have collapsed the global economy and financial system to save elderly smokers. Yes, I exaggerate…but by much? How much?
Hysteria as public policy married to orthodox monetary policy…well, two poisons do not make an elixir.
By government ukase, people and businesses cannot work. Some people are proposing debt-bondage as the solution. Let people borrow money!
If this was just one nation committing suicide, one could leave that nation. But this is global, and nearby planets are not habitable.
The 1967-8 Asian flu pandemic raced through the US, killed 116,000. About the equivalent of 200,000, in terms of today’s population. Hospitals were clogged. No one blinked an eye, economically speaking. Herd immunity was gained, the virus faded.
If the US gives up $9 trillion in GDP the next three years and we “save” 90,000 lives…well, that is about $100 million per life.
Go ahead, play with my math. Double the lives “saved” (including elderly smokers) Cut my GDP losses in half.
This is nuts.
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Ben,
“Hysteria as public policy married to orthodox monetary policy…well, two poisons do not make an elixir.”
Well said.
I would add that what David doesn’t mention is that the collapse in supply AND demand came about from the government mandated closure / shuttering of businesses.
“Some, perhaps many, seem to think that if the shock is a supply, rather than a demand, shock, then there is no role for a countercyclical policy response designed to increase demand.”
Sure there is a role for countercyclical policy response – to events independent of policy maker actions. It was policy makers that decided which businesses should close and which workers should be sent home. Now the very same policy makers should decide who gets a paycheck to continue living and who doesn’t?
This has gone beyond the realm of good intention policy making and has become just plain cronyism.
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David,
Before deciding that risk should be borne by all via inflation, you should ask whether risk should be voluntarily borne by each individual’s choice.
Your flaw is in thinking about “policy makers” as some homogenous group of well intentioned individuals with a mountain of knowledge, no lobbyist / political interests, and perfect forecasting ability. That one single group does not exist. Instead we have a variety of policy making groups, each with it’s own powers, responsibilities, areas of knowledge and influence, and goals.
The best outcome attainable is when the goals of each policy making group can be achieved independently of the goals of other policy making groups – see the Impossible Trinity that you mention in a prior post.
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What I find amazing is how many people are so much more afraid of inflation than of a potentially lethal or debilitating disease. Clearly, the threat of having to pay an extra dollar for a hamburger out of one’s recent twenty five cents an hour wage increase is much more to be dreaded than gasping for air, suffering a stroke or losing the use of one’s kidneys.
We’ve intentionally stifled the economy for four decades now to appease our irrational fear of an inflation that has yet to appear. Maybe it’s time to worry a bit about hundreds of thousands of deaths – serious people glibly shrug off the millions of deaths it would take to achieve herd immunity – and a major public health problem with many times more, and not just old people, with major hits to their bodily function.
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