Wednesday, September 5, 2012

How to Solve Our Massive Macroeconomic Coordination Failure

Robert J. Barro asked me here to identify the market failure that would justify the American Recovery and Reinvestment Act (aka “the stimulus”).  My answer, in brief, is that the market failure which permits sustained high unemployment is the lack of a truly comprehensive market in which workers with excess leisure, and firms with excess capacity, could make conditional commitments of the following kind, “if you’ll hire me at the going wage, I’ll promise to purchase goods from firms A, B, and C, whose new hires, in turn, will promise to buy goods from you.”

In the absence of such a market, a firm’s decision to expand employment will give rise to a positive externality insofar as the new hires buy the output of other firms.  (I assume the new hires were unemployed, and that prices exceed marginal costs, so aggregate demand rises, and firms profit from additional sales.)  Since firms don’t take account of this positive externality in their hiring decisions, total employment will be less than optimal.

At first glance, persistent unemployment looks like a coordination problem.  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.  The trick, in this case, is to get X and Y to coordinate on the high-output equilibrium.

Laurence Kotlikoff has suggested that coordinating around high employment could be accomplished if President Obama urged the largest 1,000 firms to hire additional employees, then urged the next largest 1,000 firms to expand employment, and so on.   

I don't believe this approach will work for the following reason: in game-theoretic jargon, this is really a Prisoner's Dilemma Game in which each firm's dominant strategy is to wait for other firms to start hiring.  It's too risky to expand employment unless you can be assured that other firms will do likewise.  By waiting, a firm avoids the risk of expanding employment without an increase in demand.  And the losses in this scenario would certainly be greater than the profits that would be foregone "by coming late to the party," i.e., hiring after the recovery has gained momentum.  So President Obama urging thousands of firms to expand employment can only be successful if a) Obama inspires an awful lot of confidence and/or b) firms have some altruistic component in their decision-making objectives.  These are both unreasonable expectations in my view.

Nevertheless, Professor Kotlikoff is onto something.  Our current unemployment problem is a coordination problem.  But you can't solve it without converting it into an Assurance Game in which each firm is assured that, if it hires, others will also hire.  In an earlier post, I suggested that large firms submit “offers” to a central auctioneer of the following kind: I’ll increase employment at my firm by X% if the total increase in employment promised by all other firms amounts to at least Y%.  This Walrasian process of t√Ętonnement would continue until the greatest increase in total employment commitments were achieved.  These hiring pledges, in turn, would be enforced by levying tax penalties on firms that failed to meet their commitments, and transferring revenue from these payments to firms that met their hiring commitments.

One drawback of this process is that firms would “low ball” their hiring commitments, understating the employment commitments they would really be willing to make.  To address this problem, the government could offer tax subsidies to those firms whose employment commitments exceeded the median employment commitment, measured by (say) the percentage increase over a firm’s actual employment in the previous year.   Alternatively, you could replace the median threshold with (say) the top quartile, etc.  Finally, the government could stipulate that it would only impose the tax penalties and transfer revenues if (say) 80% of the firms made hiring commitments.


  1. This promise of hiring and purchasing may impinge on competitiveness. Though this is desirable and may generate desirable results, it may also bring about monopoly.

  2. Jessie,

    Thanks for your comment. My proposal probably does favor larger firms since the transaction costs of organizing a multilateral contract among a large number of small firms would probably be too high. But smaller firms would also benefit, and without taking any risks.

    p.s. there are no commitments to purchase any volume of goods from anyone.

  3. Greg,

    "To address this problem, the government could offer tax subsidies.."

    To address this problem, the government could SELL tax subsidies. The distinction is crucial. When a government gives something away, the incentives of the new owner are unchanged. When the government sells something, the buyer must put capital at risk.

  4. Frank,

    The aim of the tax subsidies is to prompt firms to do something they'd rather not do in the absence of a subsidy, i.e., incur the risks involved in hiring more labor. I'm not sure what it means to "sell tax subsidies," but it sounds like it would be an added cost for the firm, further reducing their incentives to hire more rather than fewer workers. But maybe I've misunderstood your point.

  5. What business should anticipate every time they start a business is the possibility of incurring debts more than they can pay. Entrepreneurs usually come to a business with their capital and a plan of some sort to grow their business. But there is no contingency plan as to what they should do when the "walls fall down" so they say.

    1. Gwen,

      You make an interesting and too often overlooked point about business planning. It's a bit far from my macroeconomic concerns, but here's a thought. Suppose demand for a firm's product depends on two things: 1) the quality of the product in comparison to similar products in the markets where the firm competes; and 2) the strength of "the economy as a whole." Assume the latter is reasonably captured in GDP growth in the last year. If a firm wanted to hedge its bets, and if there were a market in "GDP futures," then the firm could short the GDP futures contract, so that if GDP growth were lower than expected, the firm would profit from its short position, which, in turn, would offset some of the firm's losses in its primary business.

      Thanks for taking the time to comment, Greg