Sunday, September 11, 2011

A Walrasian Solution to Our Current Economic Predicament

In the perfectly competitive economy of the textbooks, firms can sell as much as they want at prevailing prices. This premise is especially out of place at the moment. Many firms would be happy to sell more at prevailing prices if only there were buyers. Let's start with an oversimplified model of our current predicament.

Imagine a two-firm economy in which the wages paid out by firm X are spent on the output of firm Y, and vice versa. If X believes Y will be hiring additional labor, then X will expand its output, and if Y believes the same about X, Y will expand, and the result will be a high-output equilibrium. If both X and Y expect the other to reduce output, then you’ve got a low-output equilibrium.

There are, of course, more than two firms in the real-world economy, but can we modify our simple model easily enough. Let's keep our original firm X, but call it General Electric. But now let Y represent not a single firm, but the other 499 firms in the S&P 500. Since the "S&P 499" comprises a large share of economy, it's not implausible to suppose that General Electric's sales revenue will depend on the hiring decisions of the "S&P 499."

And, we may add, that all the firms in the S&P 500 face General Electric's predicament, which is to say that their sales will also depend on the hiring decisions of the S&P 499. The trouble, of course, is that each of the S&P 500 firms is uncertain about the hiring plans of the S&P 499. So, what is to be done?

First, we can hook up all S&P 500 firms via a computer network (alternatively a wider range of firms could be included). Second, the "auctioneer" at the center of this network asks each firm how many additional employees it would hire in the U.S. if total hiring by other S&P 500 firms in the U.S. increased by X%. This pooling of conditional intentions would continue until a consistent set of intentions is found. If firms fail to meet their hiring "commitments," they are subject to a tax, and some portion of the revenues from this tax would be transferred to the firms which kept their commitments.

By this method, we can transform a coordination game, which has both high- and low-output equilibria, into an assurance game in which a high-output outcome is more likely than a low-output equilibrium.

Sunday, May 2, 2010

Critical Note on the Austrian View of the Financial Crisis

A Critical Note on the Austrian View of the Financial Crisis

Austrian economist Roger Garrison writes that “a true-to-Hayek nutshell version of the Austrian theory is not difficult to produce. . . The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through.”

Garrison goes on to cite Mises’s master builder parable, “the whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan . . . [that cannot be fully executed because] the means at his disposal are not sufficient. He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.”

Reading this, I can only conclude that Mises’s “master builder” must be rather dim-witted. Why wouldn’t the Austrian master builder recognize that the Fed had pushed the interest rate below the “natural rate,” that the supply of artificially cheap credit couldn’t last, and that the rational course of action would be to avoid undertaking too many “roundabout” projects? Alternatively, when interest rates were artificially low, why wouldn’t the master builder borrow heavily at fixed interest rates (selling long-term bonds) and then hold onto the borrowed funds to assure he had “the material [funds] needed for the completion of the structure” after credit tightened?

It’s interesting to note that if firms took this last course of action, prices wouldn’t rise with the credit expansion because of the increase in hoarding. In fact, holding money as a store-of-value is precisely the aspect of a money economy that Piero Sraffa pointed to in explaining why Hayek's account of saving and investment was only relevant to a barter economy.

Keynes was once asked about his low opinion of the average business intellect, “If businessmen are so stupid, how do they get rich?” To which Keynes replied, “By competing against other businessmen.” I think Mises’s parable, and the whole Austrian theory of the boom-and-bust cycle, only work if Keynes’s quip is on the mark. Otherwise, they could discern when interest rates were below "the natural rate" and either circumscribe their investment plans or lock-in the prevailing low interest rates by selling lots of bonds.

Of course, the Austrians could argue that no one knows whether prevailing interest rates are above or below the natural rate. But, in this case, it's hard to criticize central banks for pushing interest rates below a natural rate the level of which no one knows.

Sunday, March 29, 2009

Barro, Keynes, and Macro Market Failure

The most popular paper on The Economists' Voice is Robert Barro's "Demand Side Voodoo Economics," which can be found at

Barro insists that Obama's stimulus plan will only work if "the government is better than the private market at marshaling idle resources to produce useful stuff." This proposition being false from Barro's vantage point, he wants to know how resources can remain unemployed when wages and prices are flexible.

By all means, let us give Professor Barro his answer. Even price-taking firms can’t sell all they’d like to at prevailing prices. The reason being that the demand for any individual firm’s output depends on the hiring decisions of other firms, just as the volume of deposits at any individual bank depends on the lending of other banks. Put the other way around, there are, in many circumstances, positive externalities generated by a firm’s hiring and by a bank’s lending. These externalities comprise the “market failure” Barro is looking for. And government, insofar as it can induce a preponderance of firms and banks to advance together, provides the solution to an “assurance game” in which hiring and lending are the best respective strategies for individual firms and banks provided they are confident others will do likewise.