Theory of Recessions
by Paul Krugman
for a moment an economy that is chugging along at full employment. All
factories are working at full shifts, all workers have jobs. (In reality
this never happens, because there is always enough friction and uncertainty
in the world to ensure that some factories are closing and some workers
can't find jobs; but that isn't important at this stage of our story.)
Alongside the smoothly functioning "real" economy will be a smooth financial
flow, as firms earn money from their sales, pay out their earnings in
wages and dividends, and households spend these receipts on new purchases
from the firms.
suppose that for some reason each household and firm in this economy
decides that it would like to hold a little more cash. There are a number
of reasons, which we need not go into, why people hold some of their
funds in the form of currency or bank deposits backed by currency rather
than in other assets that yield higher returns. The important point
is that sometimes they decide that they would prefer to hold more cash
than they were holding a little while ago. Keynes argued, in particular,
that this happens when businessmen lose confidence and start to think
of potential investments as risky, leading them to hesitate and accumulate
cash instead; today we might add the problem of jittery households who
worry about their jobs and cut back on purchases of big-ticket consumer
items. Either way, each individual firm or household tries to increase
its holdings of cash by cutting its spending, so that its receipts exceed
Keynes pointed out, what works for an individual does not work for the
economy as a whole, because the amount of cash in the economy is fixed.
An individual can increase her cash holdings by spending less, but she
does so only by taking away cash that other people had been holding.
Obviously, not everyone can do this at the same time. So what happens
when everyone tries to accumulate cash simultaneously?
is that income falls along with spending. I try to accumulate cash by
reducing my purchases from you, and you try to accumulate cash by reducing
your purchases from me; the result is that both of our incomes fall
along with our spending, and neither of us succeeds in increasing our
If we remain
determined to hold more cash, we will react to this disappointment by
cutting our spending still further, with the same disappointing result;
and so on and so on. Looking at the economy as a whole, you will see
factories closing, workers laid off, stores empty, as firms and households
throughout the economy cut back on spending in a collectively vain effort
to accumulate more cash. The process only reaches a limit when incomes
are so shrunken that the demand for cash falls to equal the available
Keynes's story. It's pretty simple, yet it has caused an astonishing
amount of confusion; somehow even intelligent people seem to find it
difficult and abstract. As it happens, however, we can illustrate the
essence of Keynesianism with an example that is, literally, childishly
can hold a picture of the reality of the U.S. economy, with its hundreds
of thousands of firms and hundred million workers, in his or her head.
Inevitably we must rely on models-that is, some kind of simplified representation
that we hope gets at the essence of the question we are trying to answer.
Part of what distinguishes professors and policy entrepreneurs is the
kind of model that they prefer. Policy entrepreneurs generally prefer
their models in the form of metaphors: for example, they may describe
the U.S. economy as being like a corporation, competing in the world
marketplace. Professors generally prefer their models mathematical.
Each of these preferences has disadvantages: mathematical models can
be constricting, leading you to ignore what you haven't figured out
how to represent as an equation; metaphorical models can all too easily
create a false impression of understanding and sophistication, and those
who rely exclusively on metaphor often fail to notice that their fine
phrases are covering crude conceptual or factual mistakes.
physical and biological sciences, however, there is a third kind of
model: the experimental model. My personal favorite example is the work
of the great meteorological theorist Carl-Gustaf Rossby, who found that
the essential features of global weather can be simulated by placing
a pan filled with water on a slowly rotating turntable and gently heating
its rims. Experimental models can allow you to see, on a small scale,
the essence of events that occur in the vastly larger and more complex
experimental models are hard to come by in economics, for obvious practical
and moral reasons. There is a limited literature on experimental auctions
and other market mechanisms, some anti-poverty schemes have been tried
out with pilot projects, and so on; but how could you experimentally
produce recessions and recoveries?
turns out that a group of Washington D.C. professionals inadvertently
created a sort of experimental macroeconomy during the 1970s. Their
unhappy experiences are described in a whimsical article by Joan and
Richard Sweeney in the Journal of Money, Credit and Banking (February
1977), entitled "Monetary Theory and the Great Capitol Hill Baby-Sitting
the story. A group of young professional couples with children formed
a baby-sitting co-op: that is, they set up an arrangement to look after
each other's children. Any such arrangement requires some method to
make sure that the burden gets fairly allocated. What this co-op did
was introduce a self-regulating bookkeeping system, by issuing scrip:
coupons with one hour of baby-sitting. Every hour of baby-sitting would
involve a transfer of a coupon to the baby-sitters from the baby-sittees.
think about it a bit, you will realize that such a system requires that
there be a fair amount of scrip in circulation. Couples cannot predict
exactly when they will want to go out, or when they will be free to
baby-sit for others, so on an average they will want to keep a reserve
of coupons available in case they want or need to go out several times
before earning some more scrip by sitting for others.
co-op had been in existence for some time, it got into trouble. For
reasons that we needn't get into, the number of coupons in circulation
per couple became rather low. This had peculiar consequences.
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