Relative Prices Matter

28 March 2009 at 6:00 am 3 comments

| Peter Klein |

Hate to keep flogging a dead horse, and perhaps preaching to the choir, but the point can’t be made often enough: relative prices matter. The childish Keynesianism of people like DeLong and Krugman, like Bernanke and Geithner, understands only aggregate concepts like “national output,” “employment,” and “the price level.” A consistent theme of this blog’s rants is that resources are heterogeneous (1, 2) and, consequently, relative prices must be free to adjust to changes in demand, technology, market conditions, and so on. When government policy generates an artificial boom in a particular market, such as housing — drawing resources away from other parts of the economy — the key to recovery is to let resources flow out of that market and back to the sectors of the economy where those resources belong (i.e., to match the pattern of consumer demands). It’s quite simple: home prices should be falling, interest rates should be rising, savings rates should be going up, and debt levels should be going down. The Administration’s policies, like that of the last Administration, are designed to achieve exactly the opposite. Why? Because relative prices don’t matter, the allocation of resources across activities doesn’t matter, all that matters is to keep any sector from shrinking, any prices from falling, any firms from failing, any consumers from reducing their consumption. A child thinks only about what he can see. The unseen doesn’t exist.

Here are some excellent posts on the subject. Craig Pirrong notes that Sherwin Rosen had a colorful way of emphasizing relative price effects. Mario Rizzo (1, 2) points to data on the housing market and the Fed’s continuing attempt to keep resources from flowing out of this bloated sector. And here’s a snippet from Israel Kirzner’s short book on Mises explaining that insolvent financial institutions should be liquidated, not rescued. Good reading for grown-ups.

Entry filed under: - Klein -, Austrian Economics, Bailout / Financial Crisis, Myths and Realities, Public Policy / Political Economy.

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3 Comments Add your own

  • 1. paolo mariti  |  28 March 2009 at 7:03 am

    I entirely agree ,with the only possible exception where relative prices are too slow to adjust.

  • 2. srp  |  29 March 2009 at 4:04 am

    But Obama has very clear sectoral priorities–solar panels and windmills over nuclear and fossil, education and health care over manufacturing and entertainment. He reiterates these priorities of his industrial policy in every speech, speciously linking them to economic recovery and growth. So far I don’t think the public is paying much attention to this aspect of the budget and those who are don’t seem that enthused, judging from the poll numbers.

  • 3. Peter Klein  |  30 March 2009 at 8:48 am

    Right, I was referring only to the “stimulus” part of the budget, not the “long-term infrastructure” part. I agree, clearly the Administration has sectoral priorities for the latter. But even there one sees little recognition of trade-offs or the idea that the pattern of expenditures should somehow match the pattern of consumer wants. Indeed, the idea is clearly to substitute the preferences of policymakers for the preferences of market participants.

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