I made some comments on Noah Smith’s blog about wage flexibility but as I thought about it all and how to explain it to others, it occurred to me that, in response to Noah’s position (that an economy must automatically return to health and/or full-employment sooner or later – 5 years? 20 years?), actually, there is a strong parallel between Spain and Greece’s problems (a currency outside their control and a lack of transfer payments to re-normalize the balance-of-payments problem – eg Spain is worse off than Florida) compared to tax jurisdictions experiencing “urban decay” and other forms of “economic stagnation.” These cases illustrate how and why economic stagnation can linger indefinitely. And they illustrate the chaotic nature of economies (that is, recovery is not predictable, despite the illusion of predictability when looking at recent history).
For instance, Detroit is a large example (larger than I prefer, but everyone is familiar with it now). The border of Detroit and surrounding municipalities is a stark contrast – with the primary cause of the difference being tax policy and the evolved needs of each community. Detroit was essentially sucked dry of sustaining capital of all kinds – including confidence in the community network, while adjacent communities are “healthy” simply because they haven’t been sucked dry (yet). So as Detroit needs to have a higher tax rate to sustain its decayed infrastructure and low-trust population, (and maintain its debts) that higher tax rate just amplifies the problem – discouraging anyone who has a choice from settling within Detroit city limits, and encouraging those already there to move, if they can. It is virtually identical to the pumps in (biology) cell walls that maintain the healthy mix of material within the cell – only in Detroit’s case, the situation within the cell has become pathological.
This analogy applies even to neighborhoods within cities (something I’m familiar with – south Phoenix is practically a hispanic ghetto) where the lack of some kind of transfer payments causes one area, large or small (nation or neighborhood) to fall into a sub-optimal stagnation that can routinely last for decades. By “transfer payments” I mean more than just financial capital. Money is important, but confidence in the community spirit of your neighbors is also crucial.
The big picture is a demonstration to people like Noah Smith that an optimal economy really is a “special case.” There is no time frame for recovery, necessarily. Just looking around at the economic landscape provides millions of cases for how economic stagnation can linger – systemically – and be continually amplified – for decades, and maybe even centuries. The “Dark Ages” in Europe weren’t quite so dark as many believe, but they certainly weren’t a case of economic vitality. They were punctuated by enormous income inequality and probably maintained by a strong debt-morality sentiment in the culture. That is, beyond just the economic debt serfs felt to their masters, the culture widely endorsed the notion that people are not created equal, and the wealth distribution allowed that view to be maintained, to the detriment of the entire society, for centuries.
The conclusion is that recovery virtually requires a firm kick, unless you want to just wait around for an indefinitely long time until some natural or external event provides the kick-start.
Update: I added links and need to add that a crucial part of the economic stagnation of an area is also strongly affected by the emigration situation. Freedom of movement, such as a resident of Detroit being free to move to a suburb, actually tends to amplify the problem. But closed borders are not a panacea, as seen in the Soviet bloc. If people cannot leave or do not want to leave, they will eventually resolve the bad economic situation. But the time frame until that happens (and their success at actually bringing in a better situation) is dependent on the level of suppression, the power (including wealth) inequality distribution between suppressed and suppressors, and the ability of the suppressed people to “imagine” a better way of life. This latter factor is affected by education, the availability of neighbor-regions to learn from, and the ability of the people to interact and develop their ideas. We have names for important aspects of these factors: freedom of speech, freedom of the press, freedom of assembly. But when too many people are leaving a stagnated area, causing the area to fall below the social, cultural, and economic mix necessary for a “critical mass” of sustainable communities, a kind of socio-economic “liquidity trap” arises where the likely “return on investment” for any one person’s attempt to move in or revitalize the community is perceived to be so small or so unlikely that it is dwarfed by the expected ongoing costs of any attempt.
This is, at bottom, what a “liquidity trap” is, only it need not (and should not) be merely a monetary concept. Lately, it has been expressed strictly in financial terms, but I’m saying it’s really a Game Theory concept, where the financial case is a special case of the general idea. I’ll do another post later once I come up with a decent, verbal definition of the general case. But in rudimentary terms, an economic liquidity trap is a case where the prevailing “natural rate of interest” is less than zero – which means that a central bank would need to charge a “negative rate of interest” on deposits to get banks back to confident lending. But what that would mean in the real world is the central bank just handing out cash. Not “loose money” loans, but actual cash – without obligation for pay back. And the problem is there would be no conditions for banks to constrain their “borrowing” from the central bank at a negative interest rate. They would simply take out an infinite amount of loans, if allowed. In practice, that means a race to take as much as the central bank will offer, and then a potentially irresponsible (or unfair) pattern of investment once they have the cash.
So what is a non-monetary, socio-politico-economic liquidity trap? Something like conditions that are really bad and no one wants to live in the bad neighborhood, but some central authority might offer an amazing amount of money, good will, and/or political power, for anyone that will move into the space. Eventually, someone does, and they get the pay-out. But the crucial factor that makes liquidity traps a problem is that the recipients are free – free to move out and take their winnings, or in the case of banks, take their new cash as executive bonuses. As a result, no “central authority” or even “interested parties” are willing to setup the “negative interest” incentive systems. And as a result, no resolution to the problems occur.
An obvious solution is to require people that “move-in” to stay for at least some amount of time. This is a viable (temporary) solution and allows us to see how common this situation is in the real world. But first, realize that this is not a panacea – even with some kind of requirements to stay, the stagnation may not be cured. It depends if a critical mass of all the socio-political-economic factors can become resolved within the required “stay” timeframe.
So here’s the fun part. What are examples of this kind of not-fully-monetary liquidity trap being cured via “stay” clauses?
- the 2008 first-time home buyer tax credit
- tax breaks to corporations to setup a local site
- minor laws (ie children are minors until 18 yrs of age)
I asked my wife for examples that came to her mind. Group projects. And my favorite non-monetary liquidity trap: Friends that abscond on doing their part when you help them with homework. This is especially interesting because the long-term desired “optimum” situation is simply that your friend will have learned something and somehow benefit. But if they are likely to “abscond” on doing their part, you are likely to refuse to help them much with their homework. The result? Some people fail to ever reach the envisioned educational optimum. They remain relatively stagnated, not receiving help that is fully available.
I can’t help but think this is a type of Game Theory equilibrium, but I don’t know the name. The key is that the pattern is all around us. And we know what the solution is. And we all know that these situations routinely do not resolve themselves (though there are many cases where they do – but often only as a result of someone else doing what it takes to bring resolution [preemptive help, despite risk of futility]).