Fisman and Miguel, Economic Gangsters
The Regional Pattern of the Recession

General Glut Wins the Day!

Tyler Cowen rediscovers the general glut and Keynesian economics:

Marginal Revolution: The economic crisis, the calculation debate, and stability theory: Is the financial crisis -- which is rapidly becoming the "real economy" crisis -- somehow the "dual" of the socialist calculation problem? 

A'la Hayek, say the price of copper goes up.  Markets will make many adjustments and the proper adjustments usually cannot be foreseen by a central planner.  Nonetheless there is some iterative process by which those adjustments get made and, I am sad to say, our understanding of that process involves a good deal of hand waving.  It's fine to talk about entrepreneurship but the net effect need not be equilibrating.  The relationship between local adjustment, where we have decent Marshallian theories, and global adjustment, about which we know little, remains tricky.

General equilibrium stability theory used to assume gross substitutability to derive the convergence to a new equilibrium but in fact convergence did not usually come easily in the models.  (I take gross substitutability as meaning that a decline in the price of one good will, on the whole, lead to increased expenditures on other goods, but here are some alternate specifications.)  Most of the time we hope that the proper local adjustments get made and the whole pinwheel turns and mutates in the proper directions over time. 

Are there conditions, however rare, under which market adjustment and convergence does not occur?  If a few of the vertices get stuck, can it become impossible for the economy to fulfill its mutating pinwheel program of change and adaptation?...

The Keynesian answer (the monetarist answer to) is that Say's Law is not true in theory--that if the economy does eventually grope its way to a new full-employment equilibrium, it is not guaranteed to get there in a timely fashion. When actual real money holdings are less than desired real money holdings, the tatonnement process involves a fall in nominal prices--but in a world of nominal debt contracts and fixed money wages, et cetera, that fall in nominal prices (a) may not occur and (b) may do more damage in the short and medium run than it can do help. The Keynesian (and the monetarist) answer is to find specific limited government interventions in key markets so that even though Say's Law is not true in theory we can make it true enough in practice. Or at least get close enough for government work.

The way I think of it is that all of a sudden the economy demands shorter duration and less risky assets in its portfolio, the economy cannot respond--cannot liquidate the real capital stock that backs the portfolio--and the resulting adjustments in nominal prices that are triggered either do not happen or do not help. But it is not clear to me that that is the best way to think about these issues.

And yes, they are in some metaphorical sense dual to the socialist calculation problem: socialism cannot assemble the information and provide the right incentives; the unaided free market cannot always pass price signals from finance to the real economy that are helpful.