The Cure for an Uncoordinated Economy: Laurence Kotlikoff

Nov. 30 (Bloomberg) -- If a deadly virus struck our country, scientists at the Centers for Disease Control and Prevention would diagnose the problem, inform the public, and then prescribe a cure. If only this were true for our economic illness.

Neither President Barack Obama nor the disloyal opposition has explained what really ails the economy. But this hasn’t stopped them from applying highly expensive and generally ineffective elixirs.

The Obama administration blames its predecessor, reasoning that President George W. Bush enabled the housing bubble to develop and stood by as Wall Street churned out trillions of dollars in deeply flawed investments. The resulting financial panic led to a huge, ongoing slump.

The Republicans say Obama had three years to fix the economy and failed. Had the government stopped taxing and regulating business, and eliminated the departments of X, Y and ?, the logic goes, the U.S. would be booming.

Finger-pointing is no substitute for an actual diagnosis. Instead, let’s examine the patient to see what’s wrong.

At first glance, our economy looks much the same as in 2007. The factories, equipment, houses and apartment buildings are all still here or have been replaced with newer versions. The same holds for our workforce, and our technology has improved.

So our economy hasn’t lost its productive capacity, its real wealth. We’re just not using it fully. In other words, potential supply exceeds effective demand, leaving 29 million Americans either out of work or working less than desired.

Missing Customers

Where are all the missing customers, whose demand could justify hiring these 29 million? The answer is these same 29 million Americans. They are the missing customers. If they were working full time, their demand could support their extra supply of goods and services.

So why aren’t these folks fully employed? After all, free markets shouldn’t let supply exceed demand. Prices and wages are supposed to adjust until everyone who wants to work is employed producing something others want to buy.

Unfortunately, real world markets don’t operate by the textbook. As Nobel laureate and Massachusetts Institute of Technology economist Peter Diamond has noted, in the real world, there are no fictional auctioneers to find just the right prices and quantities at which supply and demand meet. Buyers need to expend time and money locating suppliers, and suppliers must do the same finding buyers.

In bad times, people and companies lose their incentive to search. The perceived returns to looking for jobs or customers are too low, because everyone thinks no one is searching for them or their products. The result is the market failure we see, with 29 million people fully or partially out of work.

The sheer scale and rapidity of firings in the fall of 2008 and winter of 2009 support the view that the U.S. arrived at what economists call a bad equilibrium. “Times are bad” becomes an easy excuse for shedding hundreds of thousands of jobs a month.

Coordinating supply and demand is even tougher when it comes to investment, which, incidentally, is running at a postwar low. Investing entails spending money today to make and sell more and better products tomorrow. But there are very few markets in which producers and consumers can register their future supply and demand. Economists call this a case of missing markets.

When you look at all the economy’s coordination problems -- equating, without centralized market makers, supply and demand for hundreds of thousands of outputs and inputs -- you have to marvel that capitalism works at all.

Coordination Failures

Economists have spent decades studying coordination failures. The work gets little attention, partly because it doesn’t fit into the public battle between free marketeers, who say the government should do nothing and let the economy adjust, and Keynesians, who say printing money or boosting government spending will help demand meet supply.

President Herbert Hoover tried the free-market approach early in his administration. It didn’t work. Doing nothing failed to ignite what Keynes called our animal spirits and nudge our economy to a full-employment equilibrium.

Presidents Franklin Delano Roosevelt and Obama tried the Keynesian approach. It did better, but the activist fiscal and monetary policies may have reinforced the view that times were terrible and that waiting out the uncertainty was the best move.

What really worked in 1939 was Uncle Sam’s coordinating the labor market by demanding that millions of Americans start supplying their labor to the military, albeit at a very low wage.

We can do the same today, without war, by coordinating a collective increase in labor demand to meet the excess supply. In a recent column, I proposed five ways this can be done on the cheap, without scaring the public about the costs.

Here’s a sixth idea that’s less crazy than it sounds: Let’s have the government allocate 20 of its more than 10,000 square miles of public land to build a charter city. We can call it Romerton after New York University economist Paul Romer, who is organizing a charter city for Honduras.

With our country’s population slated to explode by more than 130 million (today’s population of Japan) by the middle of this century, we’ll need new cities to avoid horrific congestion in existing ones. Building Romerton can usefully employ 2 million out-of-work construction workers who won’t otherwise find jobs. And our remaining 27 million unemployed or underemployed people can readily find work with businesses that the new town will attract or the government can establish. Over time, the government would sell its ownership claims to the land, buildings and companies that it helped develop, and could even turn a profit.

Roosevelt was right that fear is our greatest enemy. We need bold, coordinated actions that restore faith in our economic future.

(Laurence Kotlikoff, a professor of economics at Boston University, is a Bloomberg View columnist. The opinions expressed are his own.)

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