Fisher, Keynes, and the corridor of stability

American Journal of Economics and Sociology, The, Jan, 2005 by Robert W. Dimand

"[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable," observed John Maynard Keynes (1936: 249). In contrast to the Treatise on Money's parable of a thrift campaign in a banana plantation (in which cumulative contraction would continue until what Don Patinkin termed a "coroner solution" at zero ouput), Keynes's General Theory excluded such extreme instability. However, this particular insight of the General Theory has not been well captured in subsequent macroeconomic models. Many models, with a classical flavor at least in the long run, imply automatic restoration of full-employment equilibrium after any shock, no matter how large. Others, notably some in the post-Keynesian tradition, deny such an automatic readjustment mechanism but are unclear about a threshold of stability, with demand shocks smaller than the critical level being insufficiently large to cause a lasting disturbance. A promising way of analyzing such a threshold of stability draws on the pathbreaking work of Irving Fisher (1932, 1933) when he sought to explain why there was a long-lasting, severe depression after 1929 in contrast to the rapid recovery from the sharp recession of 1920-1921.

The issue to be addressed is showing how a large demand shock, such as that associated with the stock market crash of October 1929, can cause years of mass unemployment without automatic movement back to market-clearing equilibrium, even when there exist stabilizing forces able to correct automatically for smaller demand shocks. Axel Leijonhufvud ([1973] 1981: 112n) has suggested "the notion of 'the corridor' within which market forces, as they were traditionally conceived, are strong enough to override the disorganizing tendencies arising from 'trading at false prices', etc." Such a "corridor of stability" (which, Leijonhufvud states, "is not in Keynes") can provide another way of looking at Keynes's insight that the economy is not violently unstable. Leijonhufvud ([1973] 1981: 129) offered the idea of a corridor of stability as a sketch of a theory, an agenda for and invitation to modeling. This could provide a response to the problem that "[m]athematical general equilibrium theorists have at their command an impressive array of proven techniques for modeling systems that 'always work well.' Keynesian economists have experience with modeling systems that 'never work.' But, as yet, no one has the recipe for modeling systems that function pretty well most of the time but sometimes work very badly to coordinate economic activities. And the analytical devices and routines of neo-Walrasian general equilibrium theory and Keynesian theory will not 'mix'" (Leijonhufvud [1976] 1981: 340).

It is argued in this paper that an approach based on work by James Tobin (1975, 1980), drawing on insights of Maynard Keynes and Irving Fisher, contains such a corridor of stability. Keynes (1931a, 1931b) mentioned such debt-deflation effects briefly, while Fisher placed them at the heart of his Booms and Depressions (1932) and his "Debt-Deflation Theory of Great Depressions" (1933), which appeared in the first volume of Econometrica in lieu of a presidential address to the Econometric Society. The paper also argues that more of such an analysis can be found in the General Theory than Leijonhufvud suggested. The key point is that the effect of a lower price level on real aggregate effective demand is not the same as the effect of a falling price level or expectations of a falling price level. This point was stressed in a debate over whether faster price adjustment can be destabilizing (De Long and Summers 1986, 1988; Driskill and Sheffrin 1986; Chadha 1989), but, except for Groth (1993), the emphasis of this literature has been on systems that, given certain parameter values, are either everywhere stable or unstable, rather than having a corridor of stability.

A. C. Pigou (1941, 1943, 1947) and Gottfried Haberler (1941) (1) advanced the real balance effect as an argument for why lower prices and wages would suffice to restore output to its full-employment level, even if an increase in the real money supply could not cause any further reduction in nominal interest rates. Such a liquidity trap, in which deflation has lowered nominal interest rates nearly to zero, was invoked by Fischer Black (1987), with the new name "currency trap," to explain the failure of the automatic adjustment mechanism in the early 1930s. The Pigou-Haberler real balance effect of a lower price level is an increase in the real value of assets with a fixed nominal value, with a consequent wealth effect on consumption (in terms of the Harrod-Hicks-Meade framework: shifting the IS/LM intersection the right by moving the IS curve, even if the relevant portion of the LM curve is horizontal at or near zero). Pigou carefully distanced himself from the advocacy of deflation as a remedy for unemployment implied by his analysis: the final sentence of Pigou (1947: 251) warned that "the puzzles we have been considering in the last section are academic exercises, of some slight use perhaps for clarifying thought, but with very little chance of ever being posed on the chequer board of actual life." This inconsistency of theory and policy was in keeping with Pigou's position in the early 1930s, when he joined Keynes in supporting fiscal expansion in response to the Depression even though his Theory of Unemployment (Pigou 1933) implied that in theory an excess supply of labor could be eliminated by money wage cuts.