Monday, January 26, 2009

This Recession's Coordination Failures

I've mentioned in class that recessions are largely about coordination failures: for a variety of reason, transactions aren't made that should make both parties better off.

Historically, these coordination failures have generally been between workers and employers: unemployed workers won't accept offers that come with lower wages, while employers can't offer higher wages until someone starts buying their products, which they aren't doing because they're worried about their wage falling.

Keynes' prescription for this problem is to pay workers something so they'll start buying (and then to get out of the way).

Alberto Alesina and Luigi Zingales point out in a January 21st piece in The Wall Street Journal entitled "Let's Stimulate Private Risk Taking" that we have a similar but different problem this time around:

But this particular recession is unique not in its dimensions, but in its sources. First, it is the result of a financial crisis that severely affected stock-market valuations. The bad equilibrium did not originate in the labor market, but in the credit market, where investors are reluctant to lend to risky firms. This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, further validating investors' fear. Thus, the problem is how to increase investors' willingness to take risk. ...

The bottom line is that we have to get lenders out of their investments in treasury bills (loans to the government) and back into commercial paper and corporate bonds (loans to firms).

There is no better way to encourage this than a temporary elimination of the capital-gains tax for all the investments begun during 2009 and held for at least two years.

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