My New Keynesian Bona Fides

Arnold Kling offers this quiz

Which of the following impediments to economic adjustment do you believe to be the most important?

a) the cost of establishing a new enterprise
b) the cost of integrating new workers and equipment into an existing enterprise
c) the cost of adapting physical and human capital to new circumstances
d) the cost of whiting out an old price list (menu) and updating it with new prices

If you answered (d), then congratulations–you have shown your New Keynesian bona fides. If you answered anything else, then congratulations–you have shown common sense.

Indeed, I did answer (d) and so I suppose its incumbent upon me to convince readers that I have some sense, even if its not common.

The key part of the question is “impediments to economic adjustment” which is moving from one state of economic affairs to another. To practice with Arnold’s paradigm, to establishing new economy wide patterns of trade.

There are a few issues here.

One, the first three costs are very large to individual businesses attempting to establish new trade patterns. So, from a business owners perspective its natural to see them as a big deal.

However, in the background of the economy new patterns are being created and destroyed all constantly. As noted before this happens in the best economy and in the worst.

So, when we think about the economy wide pattern disruption the question isn’t so much what makes it difficult to start new sustainable patterns or end unsustainable ones. The question is, what would create even a moderate degree of covariance in the creation or destruction of patterns.

Because the churn of the economy is so tumultuous it only takes a slight shift in the tendency of patterns to open up or the tendency of patterns to close in order for us to experience what we would call a painful recession.

A related phenomenon for the broader audience is this. At the beginning of the recession I was warning friends and family as well as officials to batten down the hatches.

An in-law of mine was puzzled. How, she asked, can a huge recession be heading our way when she goes to the malls everyday and there are still plenty of people there. It seemed people were still buying things to her.

I answered, that for her particular mall – which was in a rapidly growing section of a rapidly growing city – to suddenly empty out, would not indicate a simple recession but the likely end of Western Civilization. I genuinely meant that. An event powerful enough to collapse all major patterns of trade in that area, in that short of a time period, would be a potentially civilization ending event.

The issue is not, of course, that the mall is keystone of humanity. It is that abandoning existing patterns of trade is costly. In order to suddenly convince everyone at the same time to do it, something really bad must happen.

To bring us full circle, the thing about changing the price lists is not that it’s a big deal for any pattern. Its that its highly correlated between patterns. For there to be no disruption each pattern must change in co-ordination with all other patterns.

That’s the first thing that makes price changes important for patterns of trade.

The second is that price is the language in which patterns communicate to one another. Lets think of a single pattern as similar to a neuron in a giant brain that is our economy. Prices are like the signals the neurons send to one another.

Because of the, on the scale of things small, cost of changing prices one of our neurons is slow in relaying its signals forward. This will affect the communication with the neighboring neurons which our neuron experiences as bad business.

However, more importantly for the entire economy, it will disrupt every signal traveling through that neuron. Some of those signals are incredibly distant to the neuron in question and have no direct business relationship. Yet, the entire network will suffer.

Now, lets suppose that all at once 30% or 40% of the neurons become slow in transmitting signals. The entire communication process of the net becomes impaired. Not destroyed. Signals get through eventually and communication does happen. However, there is noticeable widespread impairment.

This is how I would think of a recession.

There is a churn happening in the patterns of trade. Small highly correlated adjustments to that pattern cause widespread impairment. This impairment leads to a slightly faster destruction of patterns and slightly slower creation. The net result is that the number of people left without a pattern rises and we experience cyclical unemployment.