Mark Thoma asks
But do people really think that all would be fine right now if prices – and they must have housing prices in mind when they think about sticky prices as an explanation for the current episode – had only adjusted faster? If housing prices had dropped even faster than they have already, all would be well in the world?
I don’t know if all would be well in the world but we probably wouldn’t have a recession, at least not in the current sense of the word.
I line up pretty strongly with Brad Delong and Paul Krugman when in comes to Purists vs. Pragmatists. I think the profession went off the rails a little bit when it came to faith in some of the models as an accurate representation of reality rather than a tool to think through problems and conduct thought experiments.
I was going to write a post entitled: Real Business Cycle Models and Other Exercises in Cranial-Rectal Inversion, but though better about it before getting too far. The fact is Kydland, Prescott and the rest did make some serious contributions even if they went a little crazy about the implications.
That having been said, much of the problem in business cycle theory is that markets do not clear. Price does not move to equilibrate supply and demand. If it did, it would be hard to imagine why there would cyclical unemployment. If it did, it would be hard to imagine why there would be an output gap.
As for the current environment, a collapse in housing prices would be really bad for homeowners, but it shouldn’t introduce the kind of paralysis that it did. For one, it wouldn’t have much of an effect on homebuilding and the durable goods market that depends on homebuilding.
Prices would immediately collapse to their long run path and at that point those lenders who were still in business would have no reason not to lend. Buyers would have no reason not buy. Those whose wealth was devastated would have reason to save but those who saw houses suddenly more affordable would have reason to spend. In short, the world would work the way a surprising – well surprising to me anyway – number of economists seem to think it works.
But, that’s not the way the world works. In the real world houses drift down in price and no one knows where the bottom is and no one knows which lenders are really in trouble and few people want to buy a house when they are only getting cheaper every month.
In the real world the price of the land, materials and labor necessary to build a new factory don’t collapse so fast that in a recession building a factory is a no brainer. In the real world inventories do pile up. Companies do find it easier to layoff workers rather than give everyone a pay cut. Real wages decline because inflation isn’t squeezed out of the system as fast as output.
All of these happen because markets don’t always clear. Prices don’t always equilibrate supply and demand. At the deepest level this is the problem of business cycles and this is why we need models that can try to ferret out all the possible things that can go wrong when prices it happens. Its that second part – figuring all the possible things that could wrong — that’s really hard.
UPDATE: Free Exchange Responds. My reply
UPDATE II: I realized that I quoted Thoma poorly and that may have lead some people to believe I was thinking only of house prices being flexible. Here is the rest of the quote that gives a fuller context.
Okay, so maybe they don’t have housing prices in mind. Still, do we really think that sluggish price adjustment is the main mechanism at work in the present crisis? If not, then what use is the evidence from those models? Why do we keep hearing about theoretical simulations that give values for the multiplier that are small, large, zero, less than one, whatever? Do we really think that sluggish price adjustment captures the essence of the factors driving the present crisis? I don’t.[Emphasis Mine]

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Wednesday ~ July 22nd, 2009 at 11:12 am
Nominal Price Rigidities – The Economist Responds « Modeled Behavior
[...] ~ July 22nd, 2009 in Economics In response to my response to Thoma, Free Exchange writes Even if we assume that the there is no net negative effect from the [...]
Wednesday ~ July 22nd, 2009 at 12:06 pm
ao
Karl,
For someone who supposedly lines up with the pragmatists against the purists I think you’re missing some other significant impacts of asset deflation that occur when you stop assuming a frictionless world and enter reality. Namely, there are real costs to bank failures and consumer defaults when capital markets are not perfect. As Bernanke pointed out in his seminal 1982 paper “Nonmonetary Effects of Financial Crisis in the Propagation of the Great Depression” widespread consumer defaults and bank failures raise the cost of credit intermediation, essentially making it harder to tell between good borrowers and bad, and thus drying up the supply of credit.
A lack of instantly market clearing prices is necessary for monetary causes of recessions/depressions, but not non-monetary effects. If you think the Great Depression was a completely monetary phenomenon, then perhaps you are more on the purists side than you think.
Wednesday ~ July 22nd, 2009 at 12:29 pm
Karl Smith
Ao,
The question, I think is two fold:
1) Would bank consumer defaults and bank failure proceed at the rate they did in a world of perfectly flexible wages and prices? To some extent I think that depends on whether or not you are in the vicinity of the zero lower bound.
2) Would the result be a recession. It would be a technoligical shock but could a shock turn into a recession, in the sense of involuntary unemployment.
I try to work through these points somewhat here:
http://modeledbehavior.com/2009/07/22/nominal-price-rigidities-the-economist-responds/
Wednesday ~ July 22nd, 2009 at 1:13 pm
ao
Karl,
You don’t need defaults and bank failures at the same rate, you just need some of one or the other. As long as there are real costs to financial intermediation, a technical shock to the financial sector that causes some bank failures can lead to a recession even in the face of the perfectly adjustable prices described here and in your other post.
When the cost of credit intermediation go up it means that borrows who are able to productively use a loan cannot get the loan from lenders who would be happy to loan to them if only they could tell they were a good borrower. This means that some resources would be idle, and output would remain below potential GDP.
Picture this: An rural entrepreneur has a profitable business plan, but his community bank, which could tell he was a good borrower at little cost, just went out of business. The city bank cannot differentiate between good and bad rural borrowers without a cost that is significant enough that it is not profitable to lend to him. His next best option is below his reservation wage, and so he consumes leisure instead. Output is below potential GDP.
This is a recession with perfectly flexible prices.
Wednesday ~ July 22nd, 2009 at 2:39 pm
Karl Smith
The city bank cannot differentiate between good and bad rural borrowers without a cost that is significant enough that it is not profitable to lend to him. His next best option is below his reservation wage, and so he consumes leisure instead.
This story is good up until the last sentence above. If wages and prices are flexible then the next best opportunity is paying its marginal product. The farmer is consuming leisure because the marginal product of work exceeds the marginal cost in terms of forgone leisure.
Now, yes of course the loss of banks is a technological shock and can exacerbate a recession in the presence of wage a price rigidities. Just as oil shock can or a terrorist attack.
However, if we mean by recession that “a technology shock such that drives down productivity until people no longer want to work” then it can count. This is why I tried to say “recession . . . in the current sense of the word”
I think there is a real difference here because in your example without undoing the technoligical shock the farmer cannot be employed in a product way. That is, a stimulus project that would not pass a cost-benefit test would be a net negative if it employed the farmer.
Wednesday ~ July 22nd, 2009 at 3:15 pm
ao
I don’t want to get into quibbling about the technical definition of a recession. But I agree with you that what is meant by recession is important here, and that Keynesian stimulus aimed at simply employing the farmer would not pass cost benefit. However, much of the Fed/Treasury stimulus aimed at making sure that credit continues to flow to worthy borrowers would pass cost benefit. This is especially true if the negative financial shock has the potential to set off a cascade of bank failures and debt default, which I think is the case.
I believe the overall question you posed is, absent wage and price rigidity, is it possible to experience large and protracted periods of negative growth? And similarly, can there be real negative consequences of asset deflation absent nominal rigidities? I that the mechanism of an increase in the cost of credit intermediation provides a “yes” to both.
Wednesday ~ July 22nd, 2009 at 4:24 pm
Karl Smith
I believe the overall question you posed is, absent wage and price rigidity, is it possible to experience large and protracted periods of negative growth? And similarly, can there be real negative consequences of asset deflation absent nominal rigidities? I that the mechanism of an increase in the cost of credit intermediation provides a “yes” to both.
I think that’s correct and the more I think about the more I see that since a specific policy response could elevate a protracted downturn in growth there is no reason to separate out this phenomenon as “not a recession”
Its clearly different than an RBC type situation where declines in employment are optimal.