Arnold Kling  

Lectures on Macroeconomics, No. 14

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This lecture looks at a recession as an information problem. It is a synthesis of a number of the ideas mentioned in previous lectures.

The market solves a complex information problem. The economist who emphasizes this the most is Hayek. He (and Mises) made the point that no central planner can acquire the information needed to adjust resources to meet economic needs.

The information problem includes making sure that your grocery store has enough milk but not too much. However, it also includes allocating long-term investment between, say, pharmaceutical research and new microbreweries.

As a follower of Hayek, I believe that government will do a poor job at solving this information problem. However, that does not mean that I think that markets will do a perfect job of solving this information problem. A tiresome rhetorical tactic of anti-free-market economists is to say that when markets fail to solve information problems this discredits markets.

Instead, recall what I wrote.


Masonomics says, "Markets fail. Use markets."

My view is that markets fail all the time at solving information problems. By the same token, market innovation seeks to arrive at better solutions. Thirty years ago, large inventory buildups could occur at retail stores without other participants in the supply chain being aware of the problem. It took months to unwind these unwanted inventory buildups. Today, thanks to market innovation, such information problems are less severe.

I also reject what I call the naive Austrian view, which is that the only information problem that markets cannot solve is that of seeing through the distortions caused by government money. Yes, the monetary authorities can mess things up. But there are also many naturally-occurring information problems that markets have difficulty solving. I do not believe that markets would work perfectly if only there were no government.

On the other hand, I do not believe that government intervention is called for whenever the market trips over an information problem. Government does not have an automatic advantage in solving information problems. On the contrary, the Hayekian view suggests that government is at a disadvantage in solving information problems.

I view a recession as a special case of an information problem. A recession arises because individuals, investors, and entrepreneurs realize that they have committed resources to unprofitable projects. Currently in the United States, too many resources were committed to housing and mortgage securitization. Perhaps this information error was caused in part by monetary policy. Perhaps it was caused in part by other government distortions. Perhaps it was mostly a naturally-occurring information failure caused by speculative fever and poor judgment. It does not matter to me whether the cause was government or the market. There was an information failure, and now the economy needs to make a sudden, sharp adjustment. We have unnecessary resources in the construction and finance sectors.

The problem is to figure out where the resources should go. Which other sectors have the greatest marginal use for these resources? This problem eventually will be solved by the market. However, in the short run, the problem is so severe that the market is overwhelmed. Many of the adjustments that are taking place, rather than absorbing unemployed resources, are generating reductions in economic activity in other sectors. This is the problem that Leijonhufvud describes. The market may solve information problems quite well near full employment, but it staggers and stutters when there is a crisis.

Government can promote the use of unemployed resources in a recession. The government can borrow money from savers and give it to spenders, whose purchases will lead firms to absorb unemployed resources. The spenders could be individual consumers, or they could be government technocrats managing programs.

However, it is misleading to suppose that a government transfer from savers to spenders necessarily puts the economy on a better path. Instead, such a transfer may keep resources from getting to where they need to go in the long run.

If the spenders make decisions that are compatible with the long-run path for the economy, then this fiscal stimulus will be helpful. However, if the spenders cause resources to be committed to projects that ultimately are unsustainable, then any relief is only temporary.

Politically, the temptation is to try to fight the signals that the market is sending. If the housing market is headed down, the political impetus is to prop it up. If there is too much capacity in automobile manufacturing or financial services, the political impetus is to try to prop up those industries. To the extent that spending is focused on these political goals, it will be counterproductive. Rather than helping the market find its way to sustainable full employment, the prop-up strategy instead serves to impede the necessary adjustment.

Another way that government can cause harm is by creating uncertainty. In recent months, policymakers have contributed to uncertainty in many ways. Alarmist rhetoric that leaders used to motivate Congress to pass major legislation. Sudden, unpredictable changes in tactics for handling financial institutions. Frequent revisions of the rules for mortgage borrowers and lenders. Many questions about the future financial condition of the U.S. government, given the new path of deficits.

It is true that markets have been overwhelmed by today's information problems, and consequently resources are unemployed. However, the ultimate solution of where resources belong is not known by government officials any more than it is known by private investors. A large "fiscal stimulus" is, ultimately, a major transfer of power away from the trial-and-error process of entrepreneurial markets and instead toward the bureaucratic planning process. It is not clear to me that technocrats have suddenly acquired the wisdom that would justify such a transfer. In fact, while they may have an air of certitude, they may know even less than usual about the best future direction for economic resources. It could be that, relative to central planning, private trial-and-error is as advantageous in a recession as in a boom.


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CATEGORIES: Macroeconomics



COMMENTS (6 to date)
MattYoung writes:

Wait a few months and even government will be trying the entrepreneurial trial and error method.

fundamentalist writes:

Nice summary of the information problem. As Dr. Kling points out, state efforts to reverse the economic decline are nothing but attempts to maintain an unsustainable status quo. The question is not “are markets perfect” but “do freer markets do a better job of allocating resources than does the state.” History and economics say absolutely yes.

I’m not sure who came up with the idea of perfect market. Austrians have never claimed the market was perfect, just that it was far better than the state at creating wealth and guiding the economy. Both Hayek and Mises used “perfect” markets as abstract teaching tools for illustrating the effects of change. They were similar to equilibrium analysis. They used them to highlight the fact that entrepreneurs make mistakes because the information they have is always incomplete and often wrong. Economic profits (profits above the interest rate) exist only because some entrepreneurs have better information or better insight than others.

The problem with explaining recessions is understanding why so many entrepreneurs make so many mistakes at the same time and cause a depression, when most of the time the majority of entrepreneurs make fewer mistakes and the economy grows. That’s where state intervention helps explain widespread entrepreneurial failure. Market failure is nothing but entrepreneurial failure.

Bill Woolsey writes:

Kling's lecture explains why interest rates are low. It doesn't explain why interest rates aren't low enough to clear markets.

People don't know which investments will be profitable yet. Everyone is waiting. So there is a demand for short term assets, that they plan to sell when the more profitable projects become clearer.

So, why doesn't the market clear? Why don't interest rates on short term assets drop enough?

Kling's summary of fiscal policy--transfering funds from savers to spenders, is instructive.

Generally, the nominal interest rate is a mechanism to transfer of funds from spenders to savers. With inflation, a sufficiently low nominal interest rate tranfers funds from savers to spenders. The problem is that the nominal interest rate cannot fall below zero. If market clearing requires that savers pay spenders, the only way to get the real interest rate sufficiently negative is inflation. However, deflation is the more direct consequence of an increased desire to save rather than spend. So, while the real interest rate needs to be negative, a zero interest rate plus deflation, makes it positive.

Now, in reality, most unemployed people want to sell their labor in order to purchase consumer goods. So, rather than this "waiting" causing people to stand idle until someone figures out their best employment, they should be put to work producing consumer goods they want now.

If there is a multliplier effect of reduced production in some sectors resulting in less spending on consumption and less employment in producing consumer goods, for the most part, more consumption spending is exactly what is needed. Once the economy recovers, people will be buying those consumer good anyway.

If there really are people who would rather enjoy leisure because they cannot think of a good way to invest their income--then that is fine. However, the notion that there are many unemployed people who don't mind being unemployed because there no good investment opportunities for the income they would earn--well, I doubt it.

Of course, in reality, it is the short term, low risk interest rates that are getting close to their lower bound. Longer term, higher risk interest rates remain well above zero.

What needs to happen is for the lower risk, short term interest rates to be negative. People who want to save can either purchase higher risk, longer term assets and continue to save. Or else, they can consume.

And, financial interemediation becomes more profitable if people are willing to pay for short term, lower risk assets. (If banks can charge people for holding insured deposits, then they can accept some risk of loss from higher risk, longer term assets from that higher margin.)

Of course, the entire financial system is based upon zero-interest currency. That is a low risk, short term asset and its nominal interest rate cannot be negative. And so, that creates a lower bound on other assets--T-bills, reserve deposits at the Fed, insured bank deposits, and the like.

Quantitative easing by the Fed seeks to solve this problem by having the Fed provide financial intermediation. The intermediation will increase the supply of the short term, lower risk assets and increase the demand for the longer term higher risk assets. If the market clearing interest rate on the short term, high risk assets was negative, this increase in their supply should raise that interest rate (bringing it closer to zero.) Once the market clearing interest rate gets to zero or slighly above, then the market clearing rate has reached the current rate. Hopefully, then, this will result in more investment.

The Fed is taking risk that profit maximizing financial intermediaries won't take.

I don't see how one can analyse "fiscal policy" without taking into account that the govenrment can finance its spending by selling T-bills-- short term, low risk bonds. That increase in the supply should also bring up the market clearing interest rate for short term, lower risk interest rates.

Of course, the outstanding national debt will still be there when this is all over. And I suppose that "savers" are more on the hook for those future taxes.

The "hard money" market solution is deflation. The traditional story is the Pigou effect. That is, a lower price level increases the real value of the monetary base. Under current conditions, it also raises the real value of the other lower risk, short term assets. This makes the holders so wealthy that they consume.

So, notice, that the market solution to this problem is more consumption and the production of more consumer goods. (If you want to work, offer to work at lower wages. Lower costs allow lower prices. So the extra output the labor produces can be sold. This works in aggregate through the Pigou effect, higher real money balances make people so wealthy they spend on consumer goods.)

Of course, the price level might fall below the expected price level, and result in expected inflation and so, negative real interest rates on the short term, low risk assets. And so a shift to investment and consumption--the effect that would be generated from negative nominal interest rates.

It is a bit interesting that the Pigou effect rewards those who wait through an increase in their real wealth, rather than charge them for the privilidge of earning income from selling current products while wanting for some undetermined time to spend on future production.

Regardless, the market solutions to this problem involve increased consumption expenditure. And the problem with the market is that the price level doesn't adjust smoothly to keep the real supply of the zero-interest currency equal to demand. Or, else, of course, that the market uses currency that cannot have a negative nominal yield.

We can come up with all sorts of possible explanations as to why the demand for base money might rise. And, I think that an explanation of people being unsure about what are the best long term investments now is a possible explanation. But the _problem_ is with the failure of that market to clear. The notion that the market system has to always operate so that there is never a shortage of base money--seems odd to me.

Suppose there was a shortage of gasoline. Most free market (and interventionist) economists would explain that prices have failed to rise enough to clear the market. Kling might say, no, the problem is that uncertainty about the patterns of gasoline demand has caused firms to fail to build enough refineries, and so gasoline production is low. And, he might be correct. Perhaps if firms had built more refineries, there would be no shortage at current prices. And, perhaps, uncertainty about the best locations is what caused them to fail to build the refineries. But still, the reason for the shortages is that the price failed to adjust.

The notion that the pattern of supply and demand has to be just right so that given prices coordinate--well, that seems backwards. Prices are "suppposed" to adjust so whatever patters of supply and demand develop are coordinated.

My view is that quantitative easing will solve the problem. Monetary policy based upon targeting the federal funds rate has broken down. That doesn't mean that monetary policy can't work at all. Stop paying interest on reserves, and purchase the lowest risk, shortest term assets still outstanding. I don't believe that the demand for money will passively rise (or
the income velocity of money will passively fall) so that total expenditure cannot return to whatever growth path desired before the Fed runs out of assets it can buy.

I think that the deflationary solution is a disaster. And I hold out little hope for fixing the zero-interest currency problem so that we get the negative nominal interest rates we need.

Ryan writes:

You'll become an Austrian yet Dr. Kling! I love your blog because you seem to speak and understand both the Keynesian and Austrian economic languages and can recognize the specific faults and shortcomings therein. Your perspective is always insightful and interesting. Thanks for writing.

Marc Resnick writes:

One problem with the market in the short term is the effects of culture. The US has become overly focused on consumption. The average person consumes more than his/her financial resources allow. This could be explained by an information problem in part because we see the cool things that our neighbors (and TV characters) buy, but we don't see their credit card bills. We assume that if they can afford it, so should we.

The increase in consumption has created a deficit in investment. The government may be able to overcome this problem by promoting a macro shift from consumption to investment. But it should not pick winners and losers within those two general areas. That is an information problem the market is much better at solving than the government is.

manuelg writes:

Thank you for writing this whole series.

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