If we can't eliminate friction, we need a stimulus

Synthesising the whole stimulus debate into a few lines, there seem to be a small number of messages:
  1. Stimulus is good because it gets idle resources producing something
  2. Stimulus is bad because it moves productive resources into less productive use
  3. Stimulus is bad because its cost has to be paid back, reducing future efficiency
  4. Stimulus won't work because rational consumers will save as much as the government spends
  5. Stimulus is good/bad because government spending is efficient/inefficient
These messages are not necessarily contradictory - some of them are orthogonal. The truth of each assertion all depends on your model of how the economy works - and especially on one big factor: how much friction is there?

In an economy without friction, much of the argument would disappear. Idle resources would be immediately reallocated to some other use, since there is always somebody with savings that they could switch to consumption. Prices would adjust. Resources would always go to the most productive application.

Even the efficacy of the rescue of the banking system is substantially dependent on this friction question - if the government nationalises and shuts down a bank, how quickly will its assets (if any) and the capital of its depositors return to productive use? How quickly are savings redistributed as investment? In short, what is the velocity of money?

If all friction disappeared, our only debate about stimulus would be the argument about how efficient government spending is, which really comes down to (as Lynne Kiesling says) the knowledge problem versus the collective action problem. Even that question would get a lot easier with the help of the immediate feedback that a frictionless economy would provide.

So why is the economy so frictional? There are several reasons and none of them are going away soon.

One cause is the existence of contracts. Contracts are there to give people predictability - perhaps they don't trust in the efficiency of the market, so they want to provide some security of income. Normally a seller reduces its price (or an employee reduces potential wages) in return for this security. The buyer is generally happy to accept this and absorb some risk.

We can see a transition very clearly in some commodity markets which have moved over time from contract to spot trading. The gas market in the UK is one - once a liquid market was created, suppliers and buyers were willing to move from the contract structure and trust the spot market. This increases economic efficiency and thus both parties should benefit (at least in the long run).

However, many markets are not like this - including most employment markets and many markets for the provision of intermediate goods and services in business-to-business sectors. So, contracts create friction.

Another cause is anchoring. This is a psychological effect which, again, is likely to have evolved to increase predictability and also to reduce cognitive load. We learn that a particular object in the world has a particular value - for example bread or petrol may have a particular price - and we make certain decisions about it. In order to save time in future, we look at the price and remember our last decision. If the price changes, we need to make the decisions all over again - therefore prices are likely to stay the same.

As an aside, this is one reason for price discrimination between new and existing customers. Existing customers have already made the decision to buy at the old price. Therefore sellers want to get the benefit of the customer's memory of the decision they already made. Non-customers, on the other hand, if they have seen the price before, have made a decision not to buy at that price. Therefore you need to get them to make their choice anew - and thus, give them a new price so they have to reconsider.

Related to anchoring is loss aversion or a closely related phenomenon, the endowment effect. This means we overvalue what we own in comparison to what we don't; making us less likely to trade. We may be unwilling to sell a house which has fallen in value, even though the new house we want to buy is also cheaper. It means we may not leave a job that we're unhappy with, because we have an attachment to it which is not, strictly speaking, rational.

A fourth cause is information lags. It takes time for information to disseminate around a population. If the price of a product is reduced or a new service becomes available, it won't immediately have an effect because the people who might buy it won't know about it right away. Technologies like the Internet naturally act to combat this, but they are far from perfect.

A special case of the above is negotiation time. When products (and particularly services) do not have a published price, it often takes time for two parties to reach an agreement. This also occurs when a service is not of a standardised kind, in which case the nature of the service has to be negotiated as well as the price.

The final cause, and the one most handled in the economics literature, is the generic category of transaction costs. Some of these are the physical cost of consuming something - for example the effort of moving house, or the delivery cost of a book from Amazon. Others include taxation (stamp duty on shares or houses), costs of telecommunications or postage, or time spent queueing to buy something.

So next time someone says a stimulus isn't necessary, or that the market will sort itself out, or that we should just close down all the insolvent banks and let new ones start up, ask them how they plan to eliminate friction from the economy.

If they don't know, then they better be ready for a three-year depression while people and companies form a whole network of new relationships, figure out the right prices for services and products, the appropriate savings rate for them, and how much to trust each other's and the government's promises. This is no small undertaking and I really don't want to waste three years of my life on it. Do you?


Don said…
This was a good post. I haven't got around to commenting on it, but I wanted to let you know.

Don the libertarian Democrat

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