Roger Farmer is an old grad skool buddy. We were in the same MA and PhD class at UWO in the late 1970's, though we have lost touch a bit over the decades. That's a sort of disclaimer. Roger preferred punk to disco; I think he was right on that score. But Peter Diamond's "A Search-Equilibrium Approach to the Micro Foundations of Macroeconomics" came out in 1982, and I think of it as a Saturday Night Fever model of the multiplicity of natural rates of unemployment.
Roger's publisher, Oxford University Press, has sent me an advance copy of his forthcoming book "How the Economy works: Confidence, Crashes, and Self-Fulfilling Prophecies". Roger actually has two books coming out at the same time. The one I got is aimed at the general reader. I haven't read his other book. That's probably as it should be. The version aimed at the general reader ought to be self-sufficient, so you can understand his argument without needing to read a lot of technical stuff.
There is a lot to like about Roger's book. The thumbnail sketches of economic thinkers and their ideas are alone worth the price of admission. And here's just one idea that is worthy of some serious consideration.
How can the central bank prop up the banking system in a crisis without at the same time creating moral hazard? Roger's solution is beautiful in its simplicity. The central bank should target and support an index of banks' share prices. Each individual bank can go bust, and will if it screws up worse than the other banks, (its share price can go to zero). But all banks together cannot go bust (because the central bank will buy as many shares of the index as is needed to capitalise the banking system). This solves the moral hazard problem, and also recognises (as I argued in this earlier post), that the problem is not "Too big to fail": it's "Too big a percentage to fail".
It's at the macro level, putting all the bits together, that I have difficulty understanding Roger's main thesis.
The main themes are clear enough: search theory of unemployment; multiplicity of equilibrium natural rates; and using monetary policy to target an index of share prices. And I'm sympathetic to all those themes. But I don't really understand how Roger is connecting them together. I'm going to take a guess below; but I could be totally wrong.
Here's the Saturday Night Fever search model. Boys are searching for a girl they like, and who likes them. Girls are searching for a boy they like, and who likes them. The bigger the numbers of boys and girls who meet at the same time and place, the better the chances of a good match. More boys will go to the disco if they think more girls will be there. More girls will go to the disco if they think more boys will be there. This is a model with positive feedback ("strategic complementarity").
If that strategic complementarity is strong enough (if positive feedback exceeds one over some range), it's possible to get multiple equilibria with such a model. Typically we get two stable equilibria that are locally stable, with a third equilibrium between them that is unstable. For example, if half the girls go to the disco, that might be just enough to persuade half the boys to go, and vice versa. So that's one equilibrium. But if a small temporary shock caused the number of girls going to increase by 1%, and if that caused the number of boys to increase by 2%, which in turn caused girls to increase by another 4%, etc., then that halfway equilibrium is unstable. There's a second equilibrium in which all boys and girls go to the disco, and a third equilibrium where no boys or girls go to the disco.
Saturday Night Fever can sometimes work for the labour market too. Lots of hi-tech workers go to Kanata, because there's lots of hi-tech firms. Lots of hi-tech firms go to Kanata because there's lots of hi-tech workers. You don't necessarily need anything exogenous, like climate, to explain why Kanata has a hi-tech industry and Wawa doesn't.
But I don't think it works for business cycles. If it did, we would get two natural rates of unemployment, and two Long Run Aggregate Supply curves. In theory it's fine, but numerically the feedbacks just don't seem big enough to make it work in practice. In recessions the workers don't look for jobs because there aren't any firms looking for workers; and the firms don't look for workers because there aren't any workers looking for jobs? No. It just doesn't sound plausible. Everything I hear tells me it's much easier for firms to find a suitable worker during a recession, when unemployment is high. Some workers may be discouraged, but many keep looking for jobs. Enough boys go to the disco regardless that it's even easier for girls to find a suitable boy on a quieter night.
OK, so looking at the labour market alone won't give us enough positive feedback to create multiple natural rates. Let's throw the output market into the mix.
The keynesian multiplier has its own positive feedback loop, with the marginal propensity to consume. The higher is employment and income, the higher is aggregate demand for output, and the higher is the demand for labour, and employment.
Asset prices create another positive feedback loop. The higher is output and employment, the higher are assets' earnings, the higher are asset prices, the higher is aggregate demand, and the higher is output and employment.
Yep. It wouldn't take much to persuade me that under some circumstances an economy might have two (or more) aggregate demand curves. But two AD curves won't be enough to give you two long run equilibrium levels of real output.
Suppose we had a model with two AD curves and two LRAS curves; something like this:
That would be a really neat model. A purely temporary shock could shift the economy from the red equilibrium to the blue equilibrium, and it would stay there indefinitely, even if all the exogenous variables returned to normal after the shock.
But I just can't believe it. It's those two LRAS curves that bother me. I can only see that happening if the labour supply curve were very elastic, so that a decline in job openings during a depression so discouraged workers that they gave up trying to find a job. So if firms tried to increase employment, they would face a labour shortage.
But it's quite possible, even very likely, that I have misunderstood what Roger is saying.