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Frequently Asked Questions
The first installment was The Northwest Passage. An excerpt from the second installment, called General Equilibrium Theory:
The whole installment is below.
If you did not know that there was such a place as macroeconomics and you wanted to get there, you probably would start down the path of general equilibrium theory. That is because general equilibrium theory keeps track of everything. All income is allocated. When resources leave one sector, they go somewhere else.
It is tempting to say that macroeconomics can neither live with the theory of general equilibrium nor live without it. Macroeconomics cannot live with general equilibrium theory in the sense that the general equilibrium path usually leads in the direction of predicting full employment. However, macroeconomics cannot live without general equilibrium theory in the sense that partial equilibrium theories tend to leave troubling gaps of logic.
Suppose that an economy is presented with the invention of a low-cost, labor-saving machine for harvesting wheat. In a microeconomics class, a professor might ask:
1.What happens to the price of wheat and to the quantity of wheat consumed?
General equilibrium theory asks, "What else happens?" As consumers buy more wheat, do they buy less of something else? Their purchasing power has risen, and how do they choose to allocate the additional income? If the number of workers in wheat production changes, where do the displaced workers go to or come from?
Economists are particularly careful to ask "what else happens?" when we analyze international trade. Suppose that cheap Japanese televisions displace domestic American production. The general equilibrium theorist is trained to ask what the Japanese do with their American dollars and what happens to the capital and labor that leave the American television industry. In the simplest general equilibrium model, with only two countries, two goods, and no savings, the capital and labor shift to precisely the industry that produces the good on which the Japanese will spend their dollars.
If you do not think in general equilibrium terms, it is likely to seem obvious that the cheap Japanese televisions reduce the income of Americans. In the full general equilibrium story, the result is more likely to be the opposite.
Trade increases income. The more that people consume goods that they do not produce, the better off they are. Our measures of economic activity take this proposition to extremes. If I cook my dinner and you cook yours, then the value of our cooking does not count as GDP, and my work does not count as employment. However, if I pay for dinner in your restaurant and you pay for dinner in my restaurant, then our cooking does enter into GDP, and both of us are counted as employed.
In general, if I am employed in the market, the output produced during my work hours counts as economic activity. However, if I am not producing for a market, then none of my output counts as GDP. As fas as measured economic activity is concerned, when I am not doing market work it makes no difference whether I take a nap or repair my air conditioner. Neither use of my time counts.
If one wished to be contrary, one could argue that what we call a recession is merely an artifact of failing to properly count the value of leisure and household production. If people stay home, this line of thinking goes, then they are doing something more valuable than what they could produce in the market. However, they are no longer counted as employed and their leisure and home production are not included in GDP.
Most economists would say that it is wrong to go down this particular contrarian path. As Franco Modigliani once put it, was the Great Depression nothing but an outbreak of laziness? Instead, we believe that there is such a thing as involuntary unemployment. We believe that in a recession the market activity that people forego because they are unable to find employment is more valuable than the non-market activity in which they engage.
The Dishwasher Story
To press this point further, suppose that unemployment did not exist, but that instead there was a very low-value job (say, dishwashing) that is always available, at whatever wage will clear the market. In that case, we would always have full employment. However, I would argue that we could still observe recessions in such an economy. During good times, the only dishwashers would be people who have no other skills. During a recession, many skilled people would be working as dishwashers, and they would drive down the wages of dishwashers. Income would be much lower in a recession, even though there is full employment.
This dishwasher story is my argument against one commonly-held view about macroeconomics. That view says that recessions are a product of inflexible prices and wages. Or, to put it another way, a common view is that if wages were fully flexible, then the labor market would clear, and we would not have unemployment. In the dishwasher story, the labor market clears in the sense that everyone is employed, but the economy is generating a low level of output and income, and workers are not fully utilizing their skills. We see that simply increasing the willingness of workers to accept low wages is not a cure-all. Still, it may be that wage stickiness in high-skill labor markets might be the problem that lies in the background in the dishwasher story.
General equilibrium theory looks at economic activity as trading. We do not separate the act of supply from the act of demand. I produce because I want to consume. The theory of general overproduction, so intuitively plausible to laymen, violates general equilibrium.
For example, during the Great Depression, many experts argued that the problem was overproduction, due to supply outstripping demand. This view was held particularly strongly about agriculture, where it was suggested that as technology improved, the prices for crops fell, farmers tried to restore their incomes by producing more, driving prices down further, creating a vicious cycle of impoverishment.
From the standpoint of general equilibrium, the story of agricultural overproduction invites the question, "what else happens?" If productivity increases faster than demand in one industry, then it is necessarily the case that demand grows faster than productivity in some other industry. The general equilibrium result is for workers to shift from the former to the latter.
John Maynard Keynes addressed this challenge of reconciling general equilibrium with excess supply in at least two ways. First, he suggested that an increase in the desire to consume output in the future through saving could fail to cause an increase in the production of future output through capital investment. Second, he suggested that an increase in the demand for money, which is not produced, would result in a general shortfall in what Keynesians call aggregate demand.
According to Krugman, a problem arises if a lot of people want to accumulate coupons to obtain babysitting services in the future, but not many people want to use babysitting services in the near term. With every family hoping to accumulate coupons, none of them can obtain babysitting jobs, and economic activity comes to a halt, in the sense that no one babysits for anyone else.2
In a real-world economy, you can do something with output now in order to have output in the future. For example, you can plant and tend to a fruit tree, which yield fruit years from now. However, in the babysitting economy, there is nothing that can play the role of fruit trees. The only form of saving is money (coupons).
I find this babysitting coop story unsatisfying, because the imbalance between saving and investment is ensured by assuming away the existence of capital. If we were to make the babysitting economy a bit more realistic by adding fruit and fruit trees to the list of tradable commodities, perhaps the problem of excess saving would disappear.
Here is another simple fable of excess saving and liquidity preference:
In the fable of the GDP factory, consider what would happen if we took money out of the picture, and instead the factory paid Joe by giving him GDP. Once Joe (and everyone else) saves in the form of GDP, rather than in the form of money, there can never be excess supply of GDP. Joe would find that every week the factory can employ him full time.
These simple stories suggest that pure barter economies would work better than economies that include money. Money only mucks things up, by creating a disconnect between demand and supply. That leads us to the path of monetary theory, which we will explore soon.
These stories also show that in the absence of capital goods production, saving can be dysfunctional. The question is whether this carries over into a the world in which there is capital goods production. That leads us to the path of capital theory, which we also will explore.
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