September 22, 2009

Rational Expectations in a Recession

Paul Krugman wrote a (bit self-serving) post about the differences of viewpoints between the "saltwater" and "freshwater" economists in the US.

In this article there is one bit of economic orthodoxy that I don't quite get:

Think about the story of unemployment I’ve just described. It’s a story in which a contraction in the money supply can produce a recession – but only as long as people don’t know that there’s a recession! You see, if people do know that there’s a recession, they know that the low prices they’re being offered reflect low overall demand, not specifically low demand for their products.

I'd say that en expectation of a smooth change in the overall price level in a recession is certainly not what anybody would expect in a recession.

When the general population hears the word "recession" they think of an economic disturbance. This disturbance manifests itself as a shock-wave. In this wave, most of the people quite rationally anticipate a possible loss of income, which can be passed on to expenses only with a considerable delay.

This anticipation causes people to cut down on spending, which just reinforces the initial drop in demand. It's the prisoner's dilemma with millions of participants. Betting against the shock-wave would not be too rational.

This phenomenon is not that different from a "traffic wave" that can bring a whole highway to a complete standstill even if there is no apparent reason whatsoever. However, it is quite rational to expect congestion in dense traffic, because it happens.

These kinds of issues make the economic models that assume perfection for human beings quite dangerous. As can be seen in the video of traffic waves below, even small human errors accumulate to drastic disturbances in a tightly coupled system.

To mitigate these problems, "shock-absorbers" should be built into the economy. These absorbers would eat some of the efficiency of the system. On the other hand, so do shock absorbers in vehicle suspension, if the focus is on the short term. (Shock absorbers actually do increase the initial impact of a pothole.) We really have to reach a better trade-off between efficiency and reliability in the financial system.

These economic shock absorbers could take the form of increased transaction costs, or possibly taxation of capital gains that would discourage short-term gains.

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