Memo Question for February 8, 2012: Slavery and Serfdom
David Glasner: Hawtrey, Cassel, Hayek and the Great Depression

DeLong Smackdown Watch: James Wimberly Enters the List, Armed Cap-a-Pie...

In our defense, I would say that we have five kinds of equilibrium:

  • Market day equilibrium, in which quantity supplied cannot change but quantity demanded (and sometimes prices) can.

  • Short run equilibrium, in which labor supplied, quantity demanded (and sometimes prices) can change, but capital stocks, technology, and the number of firms cannot.

  • Medium run equilibrium, in which labor supplied, quantity demanded, prices, and firm capital stocks can change but technology and the number of firms cannot.

  • Long run equilibrium, in which labor supplied, quantity demanded, prices, the number of firms, and firm capital stocks can change but technology cannot.

  • Very long run equilibrium, in which everything can change.

So we are not quite a metaphysical as James thinks…

James Wimberly:

In which I challenge famous ghosts: Not sure if anybody will read to the end of this, but here goes.

Brad deLong recently (my italics):

It turns out in economics to be remarkably hard for lots of people to distinguish between:

  • behavioral relationships–things that tell you how people will change their behavior to respond to changes in the economic environment and economic policy;
  • equilibrium conditions–things that tell you what configurations of the economic environment are consistent and are not rapidly-changing out-of-equilibrium phenomena seen for an eyeblink of time, if that long;
  • and accounting identities–things true by the metaphysical necessity of the definitions that are devoid of interesting substantive implications.

Hum. The doctrine of instantaneous equilibrium looks suspiciously like an analytical convenience that has got metaphysical notions above its station. It seems remote from real life. Getting information and taking decisions take time and effort. We run out of time before we optimise and then things change.

Just for fun, let’s build a toy qualitative model that reflects these facts, and see where it takes us…. Walras’ image is of a peaceful Swiss Bronze Age mountain village, a picture postcard without the chocolate. On market day all the farmers and shepherds bring their produce in kind: sacks of grain, baskets of parsnips, jugs of milk, goats and chickens. Each seller wants to go home with a different bundle of goods than he (it’s presumably a patriarchy) arrives with. The relative prices are established by multilateral haggling, in the famous process of tâtonnement – groping. Eventually everybody is Pareto-happy and the prices and quantities are frozen. Bingo, general equilibrium. In the absence of money and money prices, it’s general equilibrium or chaos. Also, it’s unclear whether the individuals are subject to a hard budget constraint in their initial haggling. If they are, how does the tâtonnement get started? But it applies fully at the end.

We’ll fast-forward 3000 years from Walras-la-Vallée to Keyneston, 1935.

Keyneston is an autarkic city-state, with factories run by industrialists, shops, wage-earning workers, a government, bonds, and money. The week is divided into three periods. Monday morning is market time, when contracts are negotiated to fix all the activities carried out in the second period from Monday noon to Saturday. On Sunday everybody reviews how things went in the week, taking account of information about others, and draws up plans for the Monday trading session. These plans are internally consistent, but not as a rule compatible.

Now here’s the crucial tweak. There is imperfect information and high search costs for everything, and a strict time limit to trading. The initial offers of participants are not random but good guesses based on previous experience – what happens is strongly path-dependent. The bell rings at noon, trading stops, and all participants must abide by their last offers, whether to buy or sell. Since there is money, the hard budget constraint on each is the income they expect to receive under the last offer for their labour or goods for sale, plus their holding of money. Money acts as a short-term cushion against trading uncertainty.

In this universe, everybody starts the week with a portfolio of contracts to buy and sell, and an invisible portfolio of regrets about what went wrong….

[H]ere’s the thing, In a world when no individual is ever in subjective equilibrium except by a fluke, still less entire markets or the whole economy, the accounting identities still hold in full as long as there any transactions at all: including Say’s Identity (total supply = total demand), and Keynes’ Lemma (savings = investment).

The impact of a bond-financed government stimulus cannot possibly be inferred from these identities. For this, you have to look at the behavioural responses embedded in the regret portfolios and revised bidding strategies. It’s very plausible, via Keynes’ propensity to consume, that there will be a positive multiplier in succeeding cycles. It’s plausible too that this will be counteracted to some extent by crowding-out of private investment as interest rates rise…