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Terence Tao - 2011-8-18 - Buzz
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In a perfect free market, the only economic transactions conducted are those that benefit all parties involved, and so the self-interest of each individual leads to a benefit (in the sense of increased efficiency) of the economy as a whole, a phenomenon popularly known as the "invisible hand".
There is however a major caveat to this phenomenon, though, and that is when transactions carry externalities - costs that are unwillingly borne by third parties (or benefits unwillingly granted to third parties) as a consequence of an economic decision. A typical example is that of pollution; in the absence of laws or other mechanisms to penalise an individual from polluting, self-interest would induce individuals or corporations to inflict costs on the wider community in exchange for a self-benefit. Generally speaking, government intervention (e.g. through regulation) can improve upon the outcome of a free market when there are significant externalities, but when externalities are negligible, a mature and healthy free market is most efficient (in the sense of coming closest to Pareto-optimality) with minimal government intervention (beyond such basic governmental functions such as preventing fraud and theft, of course). [EDIT: this does not preclude the need for other, non-market, interventions to improve efficiency, or to obtain other societal objectives such as increased equality or increased allocative efficiency (which is stronger than Pareto efficiency). In some cases, it is worth reducing the efficiency of an externality-free market (e.g through taxation) in order to improve the efficiency of an externality-laden one, or to improve equality through redistributive policies.]
I was recently puzzled, though, by how this reasoning would apply to Keynesian economics, particularly with regard to the need for government intervention to fight recessions. At first glance, there was no obvious externalities in a recession that would prevent a free market from correcting a recession automatically. I did finally figure out that there was in fact such an externality, though, which explains the need for government intervention.
To oversimplify, the economic activity of an individual person or company in a free market can be broadly divided into three categories:
* Production. Using labour (or other inputs) to produce goods and services, which one exchanges for money (either directly through a market, or indirectly through a salaried contract).
* Spending. Using money to exchange for goods and services produced by others.
* Saving. This is the difference between production and spending; it is positive if one earns more than one spends, and is negative if one spends more than on earns.
A self-interested individual would, generally speaking, prefer to work (i.e. produce) as little as possible, spend as much as possible, and save as much as possible. Of course, these three objectives are mutually inconsistent, due to the constraint
Saving = Production - Spending (*)
and so one has to optimise one's production, spending, and saving subject to the constraint (*).
Each individual (or corporation) would have a different preferred allocation of production, spending, and saving. For instance, individuals typically plan to have positive savings through their working years, and negative saving through retirement. Conversely, companies often have negative savings when starting out and positive savings once they become profitable. One of the main reasons we use money at all is in order to allow individual savings to be positive or negative as the need requires. However, there is a fundamental collective constraint on savings, caused by the equation
Total production = Total spending (**)
or equivalently
Total saving = 0 (***).
This simply reflects the fact that in order for one individual to buy a good or service, some other individual has to produce that good or service. (This assumes that one is in a closed economy; the situation is more complicated once one allows imports and exports, but let me ignore this aspect for simplicity.)
In view of (***), we see that the economy is in equilibrium when the participants in the economy who are trying to have positive saving are balanced out by the participants who have negative saving. However, for a variety of reasons (e.g. external economic shocks), the economy can end out of equilibrium, and in particular in a situation in which there is a net desire for saving: roughly speaking, more participants in the economy are trying to save money than to spend it.
Thanks to (*), there are only two ways to increase savings: either increase production, or decrease spending. In many cases (e.g. with salaried workers), the former option is not available or is insufficient to meet one's savings goals, and so what happens is that many individuals choose to cut spending. But here is where the externality occurs: due to (**), every time an individual reduces his or her spending, somebody somewhere loses the business (and hence, the profit) that would have otherwise been obtained from that spending. That individual, in order to maintain his or her own savings goals, must now either make up that lost production, or else also cut spending. Again, a significant fraction of the time, spending will again be cut, and the cycle continues. When this process becomes widespread, a recession occurs. Ironically, in the early stages of a recession, the free market often makes the problem worse; once it becomes apparent that the economy is in recession, it is natural for individuals to save even more to ride out the recession, which only serves to exacerbate the problem (the "paradox of thrift").
The usual regulatory methods of dealing with externalities do not work here; one can penalise someone for polluting, but in a capitalist system, one cannot penalise someone for failing to buy something from someone else. Instead, there are two major types of government intervention to deal with recessions:
* Fiscal policy. By stimulating demand through countercyclical spending (or tax reductions), one can allow individuals to meet their savings goals through increased production, rather than reduced spending; if the stimulus is large enough, this can arrest the recession cycle. (To balance things out, of course, the government should also be engaged in deficit reduction (and tax increases) during boom times, when the private sector has an excess of spending rather than of saving.)
* Monetary policy. By reducing interest rates, one can make saving less attractive (and spending more attractive, thanks to the more favourable terms of credit), returning individual savings preferences closer to balance (***). (In an open economy, devaluation of currency can also be effective, though at a global level this method suffers from a similar externality problem, as it basically exports the recession to other countries.) Another option is to increase the money supply (e.g. by quantitative easing) to meet the demand for savings, although the effectiveness of this method is still in dispute.
What happens in the absence of government intervention? Interest rates still exist in a free market, so in some cases a recession can correct itself through a free-market fall in interest rates. However, there are circumstances in which interest rates will not fall on their own, for instance if the currency is pegged to an external reference point (e.g. the euro, or gold). Also if interest rates are already close to zero, then this self-correcting mechanism becomes unavailable (this is arguably the situation that much of the West is currently in). In that case, the free-market will still self-correct, but in a much more painful way: by reducing both total production and total spending in real terms until individuals are forced to abandon their excess savings goals because they cannot afford them any more (and must instead use all their earned income for subsistence spending). This process is often also accompanied by deflation, as individuals and companies cut prices and wages in an attempt to boost demand, but ironically deflation can exacerbate the situation by making saving more attractive (and, in the case of debtors, more urgent).
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