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 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]