Arnold Kling  

Rationing and Recalculation

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I offer a new insight into the Recalculation Story. It is inspired by this quote from p.66 of Leuchtenberg's The FDR Years, the essay on the way that many policy makers and pundits were calling on the government to mobilize as effectively to fight hard times as it had to win the first World War.


The task of determining priorities in a war economy, [economist John M.] Clark observed, could not be equated with that of reinvigorating sick industries. He concluded, "All the machinery for allocating limited supplies of essential resources among conflicting uses, which played so large a part in the wartime controls, had no application to the depression...the problem is essentially opposite to that of war."

The price system and the central planner play similar roles. They set priorities and ration scarce resources. In war, the task is to shift a lot of resources toward manning and provisioning an army. The price system can do that (as the volunteer army shows), but central planning also can do that.

The Recalculation problem is different. The challenge is to find new patterns of comparative advantage in a complex economy. Both the price system and central planning have a more difficult time doing this than they have with setting priorities and allocating resources in a fully-employed economy. The rationing problem works with known arrangements of production. The recalculation problem involves discovering what are now unknown arrangements of production.

Please do not say, "Excess demand for money, you fool!" I understand what you are saying, but I do not buy it, and pounding the table and yelling it louder is not going to convince me. Give me a while. Maybe I will change my mind. But I think that instead I can come up with a simple, reasonable illustration of the recalculation story.



COMMENTS (16 to date)
Nick Rowe writes:

OK. I expect I had better revise my unfinished reply which starts out: "It's excess demand for money, you silly person!"

(Actually, I was already revising it along those lines.)

You lost me a bit halfway down this post though.

How is the recalculation problem different from the problem faced by a central planner who must *change* plans in the face of some exogenous change in technology, resources, or goals?

Norman writes:

I've been trying to sort out what the missing link in the Recalculation Story is. I think I've finally sorted it out here. The gist of my concern is this: why is the information that we have excess supply in many, many markets so easily and passively obtained by everyone (this is what creates the unemployment in the story, after all), but information about where supply isn't keeping up with demand is so very hard for entrepreneurs to obtain actively?

Of course, it's possible I've misunderstood the argument on a more basic level, so feel free to correct me. But I can't really say whether the Recalculation Story is more convincing than the excess demand for money or safe assets stories until some of these issues are more clearly sorted out.

Simon K writes:

The financial sector should coordinate the appearance of a new pattern of specialization. Entrepreneurs have to experiment to find out how resources can be used, and savers should lend them resources to perform those experiments. Financial intermediaries should link one up with the other. Even if all of these experiments fail, the activity of finding that out should consume labor, and there are endless possibilities to try, so we should end up employing everyone in trying to find new production possibilities. Why is this not happening? We know there are savers, and there are always entrepreneurs, so why is money not getting from one to the other? The only answers I can think amount to the thing you've told us we're not allowed to say ...

I supposed you might answer that some or all of the unemployed have no skills that can be put to work at the current market price. But if that is true, again, why doesn't the financial sector sponsor the potential experiment and temporarily raise the demand for these jobs? If bankers know that (for instance) telephone santizers are no longer in demand, how is it the telephone santizers do not know this?

MernaMoose writes:

Norman,

...and make no mistake, if we don't have something holding entrepreneurs back, then recessions are just not possible.

This is a good line, I like your thinking here.

I don't buy the "excess demand for money" story line. If I understand it, this theory says that entrepreneurs can't get their hands on money to work with because nobody wants to take a risk.

So entrepreneurs are having a hard(er) time finding money to use on risky ventures? What's new? They're used to this. I'm hard pressed to believe this, by itself, is stopping them in their tracks.

I have to be a semi-entrepreneur as part of my job. I spend a lot of my time rubbing shoulders with live, on-the-hoof entrepreneur types who are scattered around the country, and I hear what they have to say. My sense is that at least three things are going on right now:

1) What you can get for products and services, from small to mid-sized companies as well as foreign suppliers, has evolved significantly over the past several years. In a number of areas where it was never this way before, I can now buy a lot of things (products and services) outside, for less than we can produce them in-house. This has two implications.

We've lost some of our business because small to mid-sized companies can now do it cheaper than we can. Some. Not a huge amount, but noticeable.

This gives the real prospect that we'll be able to produce new products for our customers at lower cost, once demand starts picking back up (it is still largely soft). But this comes with some risk. If I'm outsourcing more work, I have to knit together a more complex supply chain. It's not clear yet exactly how that's going to work, or how well we're going to be able to manage it.

We're definitely talking "more complex supply chain than ever before" here. But with recent advances in IT, I'm not sure that we won't be able to pull it off. There are new challenges to be solved though and that makes people want to play it safe.

2) Everywhere, it seems, the cost of doing business has gone up due to new waves of government rules, regulations, and requirements. I'm not sure but sometimes, I feel like the regulatory environment in this country almost favors smaller firms.

I believe the impact of this on the economy has been underestimated by almost everyone. I've come up with a number of interesting new, potential ventures in recent years that didn't get off the ground because -- margins have to be higher now before it makes business sense. The bar is definitely higher today than it was five years ago.

I'm convinced companies have fewer new business options open to them today, because margins have to be higher. I suspect this may be a bigger drag on the overall economy than anyone is currently aware of.

3) Given all of the above, I believe we're in an economic phase where the road forward is really hard to see. It's like in scientific research projects, at some phases of the project it's easy to see where the work needs to be done and other times, you're at a junction where you just aren't sure what you should try next because it's not obvious.

Economically I think the collective "we" aren't sure what to try next.


From my corner of the rock garden, Arnold's Recalculation Theory sure makes a lot more sense than the Excess Demand for Money theory. If I was going to criticize Arnold's theory, it would be that he hasn't given enough attention to the fact that governments have driven the cost of doing business up significantly. That's a potentially major part of the root cause that got us here.

Babinich writes:

Arnold,

Wasn't it the price system, implemented during WWII, that gave us employer based medical benefits?

Thomas DeMeo writes:

"Norman writes:

I've been trying to sort out what the missing link in the Recalculation Story is. I think I've finally sorted it out here. The gist of my concern is this: why is the information that we have excess supply in many, many markets so easily and passively obtained by everyone (this is what creates the unemployment in the story, after all), but information about where supply isn't keeping up with demand is so very hard for entrepreneurs to obtain actively?"

Excess supply is reflected in hard sales and inventory numbers.

It is easy enough to see excess demand today, but meeting demand means thinking forward through all the complexities of bringing supply to market at some future point. You must make an educated guess whether the demand will still be there and will remain there long enough for you to be profitable. You don't know what competitors are thinking, and what is in the pipeline already.

All of this is taking place in a world that has only been around for a brief time. We now live in a new modular electronic marketplace where companies can coalesce can in a fraction of the time they did before. When the tech bubble burst a decade ago, many of the components that made economic activity speed up were in their infancy. Now they are tested and widely available.

Google had 8 employees less than a dozen years ago. This is the first recession in the new super-fast economy. You can have a great opportunity at a given moment, and still be terrified someone else will run over you before you can establish yourself.

MernaMoose writes:

Well said Thomas, right along the same lines I've been thinking.

MernaMoose writes:

One last comment on the impact of growing government regulations etc driving up business costs.

There are things we might be doing right now, if the margin requirements were not as high as they now are. These are the proverbial "low hanging fruit" options. But when government drives the cost of business up, it basically destroys that low hanging fruit.

Low hanging fruit may not be "the next big thing". But if we could go after the low fruit, whilst working in background on what the next big thing is going to be -- it would generate economic activity that would put more people back to work.

I wonder how much of our current unemployment level is due to just this effect. There's probably some economic term for these lost opportunities but I'm not enough of an economist to know what it is.

On top of that, the little bit of money we made off the low hanging fruit, would provide money to invest in the next big thing, once we've figured out what that is.

So the economic drag hit is a compound effect.

jsalvatier writes:

@ MernaMoose "If I understand it, this theory says that entrepreneurs can't get their hands on money to work with because nobody wants to take a risk."

You don't understand it. See the following for some clarification:

http://goodmorningeconomics.wordpress.com/2010/12/01/559/ (his most recent 2 posts makes me think he now understands it a bit better)
http://goodmorningeconomics.wordpress.com/2010/12/05/the-logic-of-monetary-disequilibrium/

Lord writes:

People are misconstruing what excess demand for money means. All it means is low demand for, or excess supply of, nearly everything else, what small businesses rate as their largest problem. This can be due to panic and fear as it often is in the early stages of a financial crisis, and fear of being stepped on can be part of that. But it can also be the result of perceiving reduced wealth and seeing reduced opportunities so that debt liquidation and building of reserves is seen as more productive or risk reducing than any other investment due to lower demand, or even reduced desire for current consumption in favor of future perceived need. In a neutral environment, lower demand for some things will spur higher demand for others, but when there is low demand for nearly everything, it is due to money and the real rate on it being too high even if that rate is at zero. If everyone suddenly decided they needed to save more for retirement, which everyone cannot do simultaneously, a negative real rate could be required to balance saving and investment. Many more risks become worth taking when faced with a negative rate and more consumption becomes desirable than facing a loss.

MernaMoose writes:

jsalvatier,

Thanks for the info, I am not an economist and I appreciate being educated.

You said

When people hold less money than they would like, they try to increase their holdings of money in two ways: 1) try to reduce their spending 2) try to increase their income. The quantity of money is fixed, so if one person holds a higher nominal quantity of money than before, all others must hold a lower quantity of money than before in aggregate.

Hmm. The whole business of how the "money supply" really works, in this our grand electronic age, baffles my poor engineer's brain. I've always walked away from discussions of this subject feeling like somebody is playing "three cups and a pea".

If everybody is feeling poorer -- and they certainly are -- because their houses are no longer revolving ATMs, then where did all that "home value" go? When you say "the quantity of money is fixed", it seems to me that cannot be so. In fact if the quantity of money really was fixed, we should have found ourselves running out during the housing bubble -- ?

Nonetheless, when you say

The circle ends when people no longer want to cut their their spending to achieve higher money balances.

I believe you're right on, and this is a major "root cause of failure" economically. When people feel okay again about their financial circumstances, they will spend more.

Spending less is a combination of how much reserves they like to hold, and also their perception of future income potential. A major fraction of the population sees their future earnings potential as uncertain. But I probably don't have to explain all this to you, or the fact that this problem just has to work itself out, over whatever time frame.

But here is the point where my discussion above comes back into play. If there was more low hanging fruit available, people would being seeing more economic activity than they now do (and I believe unemployment would be lower). If they weren't getting filthy rich yet, because they haven't found "The Next big Thing" yet, they'd at least feel better because something is happening. The fact that it isn't happening, depresses their sense of future earnings potential and that keeps them in "build up the reserves" mode because, who knows.

What I gathered from your links, tells me there's a strong element of truth to the monetary disequilibrium theory (assuming my understanding is now at least improved). Yes people are spending less because blah blah yadda.

But at the same time, it remains true that a) I'm convinced based on personal experience, economic opportunities have been depressed due to government increasing the cost of doing business, and b) there is also a strong element of truth to be found in Arnold's Recalculation model -- assuming I understand (see my above posts) the gist of what he's arguing.

Simon K writes:

MernaMoose - Money is different from wealth. The home value people thought they had was wealth. Money is what I give you when I buy your house. After I give it to you, I no longer have it - I have a house instead. I may be assuming I can sell the house for the same amount of money, but it doesn't change the fact I don't have the money any more.

The classic monetarist world works like this - money is actual notes and coins. In order to buy anything you need notes and coins. Any other form of wealth you may have, needs to be sold for notes and coins before you can buy something with it. Money isn't a very desirable form of wealth because it earns no return. So people with money they don't need invest it by lending it to people who need money. This world isn't quite our world, because we have cases where you can use loans to other people directly as money (eg. your bank debit card), but its easiest to understand the monetarist (and neo-Keynesian) point of view if you think about this cash-only world.

In this world the amount of money determines the cash-value of transactions that can happen at any time. If the amount of money falls, the value of transactions has to fall, which means either prices fall or quantities sold fall. If people hold onto money instead of spending it, that's equivalent to a reduction in the amount of money. Since prices (especially wages) take some time to adapt, the fact there's less money circulating causes quantities sold to fall, especially quantities of labor. That's a recession, right there.

Now of course, you need to modify this story a bit for the world we actually live in. For a start, we don't use cash for most transactions, we use bank deposits which function as a kind of transferable debt. This means the amount of useable money is not really fixed. Most of the econo-world has settled on an either explicitly or implicitly sort-of-monetarist story in which while the Fed can't directly control the amount of money, it can influence it by requiring banks to limit their deposits based on their reserves. When we talk about people choosing to hold more money, we really mean that banks are choosing to hold more money on behalf of their depositors.

I'm afraid I don't buy regulatory uncertainty accounts of the current recession at all. I see onerous government regulation, sure. But I don't see what's so different now than in 2007 that it accounts for 10% unemployment. If you have some account of this that isn't just vague mumbling about healthcare and deficits. What exactly stops you from hiring that's the government's fault and was not also there in 2007? I tell you what stops us from hiring - no-one wants to buy anything, that's what.

MernaMoose writes:

Simon K,

Thanks for trying to explain the money situation but I still don't understand it. I'm not yet convinced that the currency and coin level is so constrained in today's world, that people "saving" it is causing any real slow down in the economy. If I got a mortgage to buy a house, the bank would do it electronically and there isn't going to be a "real" transfer of hundreds of thousands of dollars going on. So, this all works out precisely how, when people try harder to save more?

Admittedly, I could be wrong about this one. Maybe the money supply really is that constrained. But it doesn't jive with my impression of how today's world really works.


I'm afraid I don't buy regulatory uncertainty accounts of the current recession at all.

I didn't say the problem is regulatory uncertainty, that's somebody else's theory and I'm not even sure what that argument is. On contrare, I'm talking about regulatory certainty. The regulations that have already been imposed, that companies must now comply with.

Compliance costs money. !!!!! Is this not self evident? And that money has to come from somewhere.

But I didn't say this load of regulations we're carrying is the cause of the recession. I just said that it's making it decidedly harder for us to climb back out, and it's probably contributing to the current unemployment level.

I wouldn't attempt a guess at hard numbers, in terms of "contribution to unemployment" or "net drag on economic growth", I don't pretend to have that kind of perspective.

Nor am I in a position to give you detailed disclosures on the inner cost structures of specific companies. But there is a general trend that I do see first hand and it's real: the cost of having your business doors open has grown significantly over the past decade, due to the ever-growing pile of government regulations we've accumulated.

From your comments I presume you're economically literate enough that I don't have to hand-walk you down the path of what happens when the cost of having your business doors open, starts climbing like this?

When times are good, we can carry this economic dead weight and it's easy to dismiss its significance. When times aren't so good, we notice the impact a whole lot more.

jsalvatier writes:

@MernaMoose nothing says Recalculation and Monetary Disequilibrium are mutually exclusive.

I personally don't like Rowe's statement "recessions are always and everywhere a monetary phenomena" because it depends a lot on the definition of 'recession'.

Simon K writes:

MernaMoose - In the real world, the "monetary base" is cash plus bank reserves held with the Fed. The bank reserves held with the Fed are the base for electronic and checking transactions, so these are the really interesting part. In fact the supply of notes and coins is not controlled - its the supply of reserves thats controlled. When we use electronic money, ultimately there is a debit from one bank's reserve account and a credit to another's. Banks that are short of reserves at the end of the day borrow the difference from other banks overnight. The Fed lends new reserves into existence or borrows them out of existence in order to control the supply of reserves. The supply of reserves is analogous to the supply of notes and coins in simple monetarist world - it controls the cash value of transactions at any one time.

That's the theory anyway. I'll short-circuit the rest of this conversation and tell you the biggest problem with this. Its that banks can create money without needing to increase their reserve balances. Bank A can lend me money, which I use to pay you and which you then deposit with Bank B. Bank A is then short of reserves, but simply borrows them back from Bank B. You end up with a balance in your checking account that previously did not exist - its new money and Fed didn't have any control over its creation. This is why the Fed mainly worries about the price of reserves (the Fed funds rate) and not the supply of money.

But here's why the theory is still relevant: When the Fed funds rate is zero, it is still possible for the amount of money banks are prepared to lend into existence to be too small to utilize all resources, because banks and other actors are acting as money sinks, trying to repair their balance sheets, and because banks don't see enough good opportunities to invest in even when their own borrowing costs are almost zero.

Regarding regulation - I'm familiar with the accounts of a number of businesses over the last ten years and I don't see our compliance costs having grown. You will need to be more specific about what you're talking about - what you say may be true in some sectors, but it isn't in the ones I'm familiar with.

MernaMoose writes:

jsalvatier,

Interesting, I didn't appreciate the fact that it doesn't have to be either/or for economists. I'm an engineer you see, and in my world either Theory A or Theory B is right, but usually it's not going to be both at once.


Simon K,

Your description of why the money supply might be an issue, actually does (sort of) make sense to me now. Which is more than I had before.

As far as the compliance cost issue, I'm afraid it would take a lot of explaining. And I'd probably need to spend some time thinking to make it concise, but here's a quick one.

HazMat (Hazardous Materials) regs are utterly out of control in this country. They are written with no common sense, and they are written as if nobody on the planet has any common sense.

I lead R&D teams of scientists and engineers and we commonly need to make prototypes and mock-up test hardware. At this point, just about everything but jello is now a "HazMat" and there's an ever-growing mountain of rules and regs we have to follow.

I don't know if this shows up as a "compliance" cost in the accounting, but it sure slows my work down, and it has substantially drive up the real, end cost of getting things done. Anything I can't do with a computer model -- which is most things that matter -- costs a lot more and takes a lot longer than it did five years ago.

And five years ago, it assuredly did cost a lot more than it had five years before that.

And that's about the limit of my horizon, because that's about when I started managing project cost accounts.

I work with other companies scattered across the country and my counter-parts would all tell you the same story.

I have seen new product ideas die on the drawing board for the simple reason that we could not muster enough internal budget, to pay for the initial development phase. Because it costs more to get everything done now than it used to.

These are foregone economic opportunities, pure and simple.

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