Tuesday, April 21, 2009

Thoughts on the Economic Crisis, II

In my previous post, I concluded that given the complexity of the problem associated with the high degree of specialization of labor that prevails today, one might expect chaos to rule. Yet, it does not. In fact, when the economic environment becomes relatively more uncertain and chaotic, it is called a crisis.

Anyone who has had a basic economics course can recognize that we do not have persistent chaos because the market system functions well most of the time. The prices of goods reflect relative scarcities of goods and services. If people want more pencils than they had previously, the price of pencils increases indicating that pencils are now relatively more scarce. The higher price is a signal to pencil producers to find additional resources and produce more pencils. By doing so, their profits increase. The higher profits, if large enough and sustained enough, may even induce an entrepreneur to enter the industry and begin production of pencils. A natural disaster such as a hurricane that destroys homes and businesses creates a need for resources to be reallocated so that the area that was destroyed can be rebuilt. Again, price changes can provide the signals needed to induce people in other parts of the country to reduce consumption of materials and to induce building supply companies to increase production of lumber, shingles, and so on.

The term "invisible hand" is used to represent the process by which markets operate in an orderly manner. Another term sometimes used to describe markets and some other systems is spontaneous order. That is, order is arrived at spontaneously and not as the result of deliberate and planned actions of a group of people. The order achieved evolves over time through the development and evolution of institutions such as contracts, firms, non-profit organizations, co-ops, courts, government agencies, and so on.

But what about times of economic crisis? The market system would seem to take care of equilibrating quantities of demand and supply in most markets for goods and services. Price changes that signal changes in relative scarcity provide the correct information and signal. A natural disaster--hurricane, drought--can cause a problem for awhile, but the system should adjust over time. So, crises can be related to supply shocks to the economy. The bigger the shock the bigger the problem. Yet, if we just look at the real economy, the markets should correct themselves given some time. So, what else is needed to have a serious economic crisis?

Money is a complicating factor. The price signals mentioned above refer to "real prices" or to "relative prices." If the price of lumber increases, we mean to say that the price of lumber increases relative to the prices of other goods. But if there is money in the economy, then it is possible to have price inflation or deflation. If the inflation is anticiapted and if all prices go up by the same percentage, inflation should not add to the problem. However, that is not the way inflation works. Instead, some prices go up by more than others and the price changes come at different times and with different frequencies. Now if the nominal price of lumber increases 5 percent, it could be associated with a real price increase of 5 percent, or more than 5 percent or less than 5 percent. In fact, it could actually be a price decrease in real terms if all other prices are going up by more than 5 percent. The signal used in a market economy to indicate changes in relative scarcities is less informative in the case of inflation. People are more likely to make incorrect decisions because they interpret a 5 percent increase in the price of lumber as indicating that lumber is now relatively more scarce and should be economized more, when in actual fact it may be relatively less scarce. The more variable the inflation rate the more difficult it is for people to know what is going on in the marketplace.

We see then that an economic crisis can be related to incorrect monetary policy. This is not the end of the story though. We still need to consider the effect of time on the stability of a market economy, and this will be the topic of my next post.

No comments:

Post a Comment