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.