Arnold Kling  

Real Adjustment Costs

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A Macro Play in Three Acts... Me and the Students for Libert...

I am disappointed by some of the reactions to my macro play. People are not being deliberately obtuse, but they are being obtuse. That is what happens when you are committed to one paradigm and someone tries to suggest something different.

One way to articulate the difference between the AS-AD paradigm and the PSST paradigm is in terms of the barriers to adjustment. In the AS-AD paradigm, the problem is price adjustment. If nominal wages and prices move quickly enough, you can never have a recession. But because they move slowly, you can have excess aggregate supply, which you can alleviate by printing more money to boost aggregate demand.

In the PSST paradigm, the adjustment costs are real. The problem that Leroy and Bao have is not that they have failed to adjust the price on their menu. The problem for Leroy and Bao is that their experiment in Tex-Vietnamese cooking is a lousy idea. But it takes time and effort for them to figure out that instead they should partner with Esteban and Marcel, respectively.

An intermediate case is the DMP story, which won the most recent Nobel Prize in economics. Diamond, Mortensen, and Pissarides describe a real cost of adjustment, in which workers and firms must search for matches. However, a lot of AS-AD types look at the DMP model and focus on how this search process arrives at the equilibrium nominal wage.

Moreover, the DMP model assumes that the jobs are just sitting there, waiting to be filled. In the PSST model, there are costs to figuring out the patterns of sustainable specialization and trade. There is trial and error. There are up-front investments. There is training (which is an up-front investment). Because of these real adjustment costs, appropriate prices are necessary but not sufficient for the economy to be able to reach full employment. In the PSST model, all the price signals can be correct, but entrepreneurs have not yet done the right experiments and invested in the right business models to create the patterns of trade that will result in full employment.

Go back and read the play without trying to ask what is going on with the real money supply. Read it for what it is. It is a story in which people try a configuration of activities and it is not profitable. Their marginal products in that configuration are so low that the characters end up not engaged in market activity (unemployed, in other words). Then they figure out a configuration in which their marginal products are high.


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CATEGORIES: Macroeconomics



COMMENTS (22 to date)
Artturi Björk writes:
It is a story in which people try a configuration of activities and it is not profitable. Their marginal products in that configuration are so low that the characters end up not engaged in market activity

yes, but why?

Is it because sustainable patterns of specialization and trade are made unsustainable by the reduction in the medium of exchange or is it because people value their free time more than the products?

Why do you think that the patterns are independent from money in the short run?

Dan Carroll writes:

My issue with the PSST model is that I have not found a convincing argument why this adjustment is different now than five years ago. In a healthy economy, jobs and professions are always being destroyed, while others are being created. Overinvestment is common and results from lack of real time information about real end demand; more recently in the housing boom this problem was made worse by loose credit (primarily a monetary and regulatory problem), which created false demand.

In other words, I don't see anything "new" about technology or patterns of trade that wasn't also true 5, 10, or 15 years ago. We didn't suddenly discover China, or the Internet, or the cell phone. These changes have been evolving for years.

Therefore, for this to work, one must make some kind of tipping point argument. I generally argue that deflationary pressures have been building for over a decade, primarily because of our special relationship with China (though technology played a part), but these pressures were largely below the radar until 2008. This fed the housing boom, though lower real interest rates and higher perceived income, which then ultimately went bust.

david writes:

In the PSST model, all the price signals can be correct, but entrepreneurs have not yet done the right experiments and invested in the right business models to create the patterns of trade that will result in full employment.

So... AS/AD with sticky quantities (i.e., with new unexplored "right business models" stuck at zero?)? Is that a fair characterization?

david writes:

Incidentally, you may be interested in Mankiw's work on sticky information (i.e., slow dissemination of economic information). It sounds relevant.

Nick Rowe writes:

There is nothing logically wrong with your macro play, Arnold. The story makes sense.

As *measured*, if all 4 players are hard at work *investing* in setting up 2 new restaurants in scene 1. That investment will be valued at cost. So it counts towards RGDP. But in reality, as we learn with hindsight, in scene 2, that investment is worthless. So all 4 players were simply wasting their time. (Although, you could argue that it was a valuable investment in information -- in learning whether or not it was a PSST -- because sometimes the only way to find out is to try it and see if it works in the market).

It's a malinvestment story. And that story is being played out every day somewhere in the economy. As a *micro* play it's fine. (Though, why does Act 2 take more than a few seconds? Why doesn't the play go straight from Act One to Act Three? What are they waiting for?)

But, empirically, why should those malinvestments be correlated across the economy, so it shows up in macro data? How does it work as a *macro* play?

The old Austrian story is that the central bank sets the real rate below the natural rate, so a lot of people malinvest at once.

jsalvatier writes:

What does it mean to talk about NGDP without talking about the money supply? Nothing, it's meaningless. If you had just talked about unemployed resources, that would have been fine.

david writes:

I think Kling's point is that Act Two does take a long time.

But it seems to conflict, as it stands, with existing theories of search/matching. Plus, there is the uncomfortable result that PSST would imply a search for patterns suitable for a high-unemployment economy (e.g., investment in more bulletproof glass and burglar alarms factories), thus slowing movement toward lower unemployment in the absence of stabilization policy. Cue Sumner charging in yelling "NGDP!"

david writes:

Incidentally, it is possible to argue that such micro plays are in fact macroeconomically significant, especially as an account of real shocks (that then go on to spawn AD shortfalls that exacerbate the problem).

Lord writes:

It is easy to make up stories but it is difficult to make them consistent.

1) What were they doing before in Act Zero? Were they working across the street at Chuck and Bill's burger stand? Were the restaurants new or were they left over from some previous attempt? Was the boom in Act One due to labor or investment, or was their no boom at all?

2) One assumes they exist in a larger economy for if they didn't they couldn't possibly have failed. Instead they simply end up cooking for themselves rather than each other. There may be a measurement problem due to lack of exchange but no difference in production otherwise.

3) Chuck and Bob may have lost a little business that they regain when they close so why don't they go back to working there? If dedicated to their own concept then when they succeed Chuck and Bob have lost some business and they have gained an income, but there is no net change.

4) Rather than specialization this is more a tale of tastes. Some tastes may be more enduring than others but change over time and popularity waxes and wanes. If production changes, Chuck and Bob must not have had all the business before so what actually causes the change in eating out? Previous boredom and satiation with burgers? Excitement over new options? A change of mood or taste?

Various writes:

I read your play and I think it is excellent. I think I understand completely what you are saying. Keep in mind that there is a certain selection bias in the comments. Many folks who are on board with your concept simply won't comment because they have nothing to say other than "good job".

One general comment is that I think the research in macro and finance in the last few decades has tended towards the empirical and mathematical. Your theory doesn't lean that way, and thus probably garners more skepticism than it otherwise would.

Yancey Ward writes:

I think people might need to define what they mean by "full employment".

Nick Rowe writes:

Various: "Keep in mind that there is a certain selection bias in the comments. Many folks who are on board with your concept simply won't comment because they have nothing to say other than "good job"."

Good comment.

fundamentalist writes:

David Laidler has some good comments on the fetish with sticky wages/prices in “The Monetary Economy and the Economic Crisis” http://hayekcenter.org/?p=4122

Now "a general anxiety to sell" is a central characteristic of what our anonymous cartoonist called "convulsion", and Mill was here exploring the economy's transition from this state to one of "stagnation". But he did not complete this task, either in (1844) or in the parallel passages dealing with the cycle in his (1848) Principles. In (1879), however, Alfred and Mary Paley Marshall paraphrased Mill's by then quite standard account, noted that "the connexion (sic!) between a fall of prices and a suspension of industry remains to be worked out" (Marshall and Marshall 1879, p. 155), and proceeded to fill in this gap by examining the consequences of the fact that ". . . when prices are falling, the fall in the price of a finished commodity is generally more rapid than that in the price of the raw material, always more rapid than that in the price of labour " (p. 156, italics added). Thereafter, and for more than half a century before the publication of the General Theory, nominal wage stickiness was the standard "Classical" explanation of unemployment in a monetary economy, and today's practice of making it the defining postulate of "New-Keynesian" macroeconomics is simply another symptom of how badly our discipline's history is misunderstood by its practitioners.11

11 I discussed the evolution of ideas about wage and price stickiness in my 1991 Henry Thornton Lecture "Wage and price stickiness in macroeconomics: an historical perspective" (Laidler 2004, Ch.12) Wage stickiness had made a brief appearance in Henry Thornton's (1802) Paper Credit but only found a central place in the mainstream literature after the Marshalls' deployment of it. Their analysis, and that of their immediate successors, not least Pigou (e.g.1913), went on to emphasize the effects on real wages and hence on the demand for labour of interactions between sticky wages and more flexible prices, thus deploying a not quite satisfactory application of partial equilibrium labour market analysis to the economy as a whole to explain the emergence of unemployment. In (1913), however, Ralph Hawtrey began to argue that the real significance of wage stickiness arose because, by way of markup mechanisms, it created stickiness in money prices too, thus inhibiting the price level adjustments needed to
eliminate the excess demand for money and associated excess supplies of output and labour that developed during the transition from "convulsion" to "stagnation".

fundamentalist writes:

Here's another good quote from Laidler:

Keynes did, to be sure, concede that the forces leading to and sustaining stagnation could in principle be counteracted by lower levels of money wages and hence prices, but he was extremely skeptical about the practical significance of these mechanisms. To begin with, the route whereby they had to work was indirect. It ran through money wage adjustments in labour markets to price adjustments in output markets, and thence to the supply and demand for money, in order finally to relieve pressures in another market altogether, that in which savings and investment decisions were linked by the interest rate. Second, and more important, though downward wage and price flexibility was required for these indirect mechanisms to work at all, the fact of falling wages and prices was likely to have effects on the dynamics of the adjustment process, particularly by way of extrapolative deflationary expectations, that might make the attainment of equilibrium impossible. Hence Keynes's conclusion that wage flexibility could and should not be counted on either to prevent real stagnation emerging in a monetary economy, or of relieving it once it had .become established.
fundamentalist writes:

PS, the quote above won't make much sense until the previous post is posted.

fundamentalist writes:

Nick:

But, empirically, why should those malinvestments be correlated across the economy, so it shows up in macro data? How does it work as a *macro* play?

The old Austrian story is that the central bank sets the real rate below the natural rate, so a lot of people malinvest at once.

Exactly! And what is wrong with the old Austrian story? If business people make decisions based on prices, and therefore profits, how is it possible that so many get things wrong at the same time and often in the same industries? Prices must be wrong somewhere, as Laidler points out. People are trading on wrong price information.

david writes:

Yes, the old Austrian story has prices wrong before the recession. Keynesian/New Keynesian/monetarist stories have prices or wages wrong during the recession. Pretty much only RBC insists that prices are generally right. Happily, we can all agree to reject RBC, yes?

(conveniently, this comparison should highlight the Austrian problem of curiously myopic and/or gullible investors, who could hedge but don't. Better "change happens, and we have trouble adjusting to keep up" than "y'all were pricing things wrong")

wintercow20 writes:

All that keeps coming to my mind are the many current and former students I've had that regularly tell me, "I have no idea what I want to do with my life."

Indeed, isn't that the case for many of us anyway?

Daublin writes:

To the people asking how this effect can take effect economy wide, it goes like this.

Act I. A million people are building houses, and new houses are selling for X dollars per year.

Act II. Houses now sell for X/2 dollars per year. Many of those million are unemployed.

Keith Eubanks writes:

Very good piece.

All things take time. A fact often ignored.

fundamentalist writes:

Daublin, nice and succinct!

Laidler points out that Mill never interpreted Says law as dealing with a money economy, but with barter. In barter there can be no unemployment, but as Mill wrote a money economy makes unemployment possible. That's why I don't understand how people can wonder about why unemployment takes place. Here's what Mill wrote:

But those who have, at periods such as we have described, affirmed that there was an excess of all commodities, never pretended that money was one of those commodities; they held that there was not an excess but a deficiency of the circulating medium. What they called a general super-abundance, was not a super-abundance of commodities relative to commodities, but a superabundance of all commodities relatively to money" (Mill 1844, pp. 69-71)

A demand to hold more money creates a shortage of money relative to goods/services and thereby unemployment. That should be obvious. The real question, though, is why do people suddenly demand more money at the same time? And why do businesses stop investing at the same time?

If they did so randomly (not at the same time) then there would be no cycle but just random clusters of people suddenly deciding to hold more money for no reason at all. But I'm not convinced that people do anything for no reason at all. If they're rational, they have a reason for wanting to hold more cash. Keynesian and RBC and purely monetary theories of crises fail utterly to answer that most important question.

david writes:

New Keynesian (and other monetary) theories don't postulate a sudden surge in liquidity preference. The agents involve maintain the same structural preferences throughout the cycle, facing instead a combination of real and nominal adjustment costs. You should know what the theories actually say before you criticize them.

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