Saturday, December 31, 2011

A Quasi-Keynesian Solution to the Great Recession

In the perfectly competitive economy of the textbooks, firms can sell as much as they want at prevailing prices. This premise is especially out of place at the moment. Many firms would be happy to sell more at prevailing prices if only there were buyers. Let's start with an oversimplified model of our current predicament.

Imagine a two-firm economy in which the wages paid out by firm X are spent on the output of firm Y, and vice versa. If X believes Y will be hiring additional labor, then X will expand its output, and if Y believes the same about X, Y will expand, and the result will be a high-output equilibrium. If both X and Y expect the other to reduce output, then you’ve got a low-output equilibrium.

There are, of course, more than two firms in the real-world economy, but can we modify our simple model easily enough. Let's keep our original firm X, but call it General Electric. But now let Y represent not a single firm, but the other 499 firms in the S&P 500. Since the "S&P 499" comprises a large share of economy, it's not implausible to suppose that General Electric's sales revenue will depend on the hiring decisions of the "S&P 499." 

And, we may add, that all the firms in the S&P 500 face General Electric's predicament, which is to say that their sales will also depend on the hiring decisions of the S&P 499. The trouble, of course, is that each of the S&P 500 firms is uncertain about the hiring plans of the S&P 499. So, what is to be done?

First, we can hook up all S&P 500 firms via a computer network (alternatively a wider range of firms could be included). Second, the "auctioneer" at the center of this network asks each firm how many additional employees it would hire in the U.S. if total hiring by other S&P 500 firms in the U.S. increased by X%. This pooling of conditional intentions would continue until a consistent set of intentions is found. If firms fail to meet their hiring "commitments," they are subject to a tax, and some portion of the revenues from this tax would be transferred to the firms which kept their commitments.

By this method, we can transform a coordination game, which has both high- and low-output equilibria, into an assurance game in which a high-output outcome is more likely than a low-output equilibrium.