Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Monday, December 13, 2010

Deficient Demand: The Deflated Balloon Hypothesis

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Mark Twain.

At one level, it is easy to understand the popularity of the deficient demand hypothesis. First off, it's pretty much the first thing any undergrad learns in the way of macro theory. Second, they tend to learn it as a factual and self-evident explanation of the way the economy actually operates; not as an hypothesis or interpretation of the way an economy may work. Third, it is apparently easy to "see" evidence of deficient demand out there (much in the same way people can "see" the Phillips curve here?). They can "see," for example, that many firms cite a lack of product demand as a reason for holding back on making commitments to future capacity (including the addition of fulltime workers). The flip side of deficient demand is a "savings glut." People claim to see this as well; for example, in the form of low inflation and low Treasury yields. 

Well, heck...I can see these things too. But the question, surely, is not what we record in our measurements. The question is how these measurements are to be interpreted. Interpretation (or explanation) necessarily entails a theory. (I define theory as a set of assumptions leading to a set of conclusions through the use of deductive logic.) And it is frequently the case that a given phenomenon has more than one plausible (or no less plausible) interpretation.

Before I go on, I want to make something clear. I do not disapprove of the practice of asking people what motivates their behavior. I would, in fact, like to see more in the way of this type of field work; see here. Having said this, we need to be careful in interpreting any given survey response as supporting one or some other theory. This is especially true in macroeconomics, where general equilibrium (system wide feedback effects) are likely to be important. According to Krugman, this is what makes macroeconomics hard.

And he is right. Unlike partial equilibrium analysis, it is conceptually difficult to identify independent "supply" and "demand" schedules in a dynamic general equilibrium system--everything is interelated, after all. Consider, for example, a shock that contracts the supply of some object (oil, credit, etc.). The ensuing price rise may lead oil-intensive sectors to curtail not only their demand for oil, but also their demand for a variety of complementary intermediate inputs. To the suppliers of these inputs, this will look very much like a "lack of demand" for their products. They are obviously not wrong for saying this. But upon hearing such reports, it would be rather hasty to conclude that these reports necessarily imply that "aggregate demand is too low."

With that out of the way, let me now discuss the deficient demand hypothesis. Some people may have been led to think that I don't believe that there is a demand problem. That's not quite true. It seems clear enough to me that the aggregate demand for investment (broadly defined to include investment in recruiting activities) is depressed. I'm just not very sure of the source of this depression. Understanding what these "fundamentals" are is necessary, I think, if we want to identify an appropriate policy response (more generally, the properties of an optimal policy rule).

Let me try to formalize what I mean here by way of a simple model that is, I think, sufficiently flexible to accommodate a range of views. I describe the model in some detail here (it is an OLG model). The fundamental economic friction is limited commitment, leading to an asset shortage; see here. The asset shortage gives rise to role for government debt (or money). The model highlights a portfolio choice problem: people must decide how to allocate a given amount of savings between two available asset classes, money and capital.

The key parameter in the model is the expected return to capital investment. A shock that depresses this expectation leads wealth-maximizing agents to substitute out of capital and into money. There is a collapse in aggregate investment spending (leading to a decline in future GDP); and there is a corresponding "flight" into government securities (money). For a fixed stock of money, the price-level drops (reflecting the increase in the market value of money); that is, the shock is deflationary. In short, the model generates something that resembles what we experienced in the recent recession.

Now, let's imagine that these expectations remain stubbornly depressed. What are the policy implications? Would it help if I told you that this is a model where increasing government spending (on investment), or lowering the interest rate (on government securities), or increasing the inflation rate, all serve to stimulate real economic activity? (This is, in fact, a property of the model.) It's tempting, isn't it? The economy is depressed and you have the tools to "fix" it. But hold on a minute. Before proceeding with your government stimulus plan, shouldn't you first ask why expectations appear to be so stubbornly depressed?

At the risk of oversimplifying, imagine that there are two possible answers to this question. [1] agents are rationally pessimistic; they forecast low returns on their investments because the environment (including the likely evolution of future government policies) dictate such a view. [2] agents are irrationally pessimistic; they forecast low returns on their investments for psychological reasons (e.g., Keynes' animal spirits). 

Under interpretation [1], the decline in investment and flight to money is a rational response to an unfortunate  event that has altered the economic landscape. One might imagine a rather muted enthusiasm for government stimulus under this interpretation. Under interpretation [2], the depression is caused by a collectively irrational flight to government bonds (Brad DeLong) or money (Nick Rowe); see their debate here. Under this interpretation--which is what I think most people have in mind when they speak of deficient demand--there is a strong case to be made for government intervention. There is obviously room here for reasonable people to disagree.

I want to conclude now with what I think is a shortcoming of the deficient demand hypothesis. It seems to me that the hypothesis leads us to think of a recession the way we might view a deflated balloon. The fundamental structure of the balloon remains intact, even if it is deflated. All that is needed to get back things to normal is a puff of fresh air. And if the private sector seems unwilling or unable to blow, then let the government do it instead. What could be simpler and more obvious?

My own observations over the years have led me to view recessionary events more like Humpty Dumpty after his great fall. Hands up all of you who think that the financial crisis had a severe impact on the economy's "structure." What do I have in mind here? Think about the disruptions that must have occurred in the form of terminated relationships (firm/worker, creditor/debtor, supplier/retailer, etc.). Think about the disruptions created out of a growing realization that resources have been misallocated (i.e., investments that looked good ex ante, now look like a bad idea ex post).

The main point is that a crisis destroys capital, broadly defined to include relationship capital--the glue that keeps the structure of economic relationships intact and productive. Sure, a breach in this structure may lead to deflated expectations and deficient-demand-like phenomena. But do not confuse symptoms with causes. The process of reallocating resources and rebuidling relationships after a traumatic event like the recent financial crisis is likely to take some time. This would be true even if all the king's men knew how to put Humpty Dumpty back together again.

23 comments:

  1. This is going to show my ignorance, but...Why can't it be both? why can't the destruction of capital lead to deficient demand like phenomena and deficient demand lead to the destruction of capital etc.?

    Also, why can't people behave rationally and irrationally depending on their circumstances, leading to a blend of responses to the shock?
    Meaning you would be wrong whether you use interpretation [1] or [2] on there own.

    These aren't meant to be challenges to your points (i.e. I'm not trolling), just questions that came to me while reading your post.

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  2. Mike, I don't think your first point is wrong. It can be both. General equilibrium macroeconomics is rife with vicious cycles and feedback loops. But I think Dave's point is that deficient demand is generally never the original cause of hard times. It's a symptom. As such, perhaps it can be ameliorated to some extent with policy, but it's not going away until the original cause of the problem fixed (or has righted itself on its own).

    To use a pretty terrible analogy, consider a fever resulting from a viral infection. The fever itself causes you a lot of discomfort and it can dehydrate you, making your situation in general even worse. And while you can take some aspirin and rehydrate yourself to temporarily alleviate some of the discomfort, the fever isn't going away until your body fights off the virus.

    I've just realized that the choice of a viral infection analogy is probably polluted by my Minnesotan mind -- there's not much you can do about a virus other than wait it out. So if you don't like the implications of that one, think about a bacterial infection like strep throat. Your throat hurts a lot and lozenges help a bit, but it's not going away until you take antibiotics to fix the original problem.

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  3. Mike: I did not mean to imply that it had to be one or the other. My point is that it is difficult to distinguish between (for example) these two competing hypotheses. And if this is so, then it is puzzling to see how doggedly people like to attach themselves to a particular interpretation.

    And I'm fine with the concept of a "deficient demand shock" destroying broadly defined capital. But this is more like Humpty Dumpty and not a deflated balloon. An economywide increase in G is not going to put Humpty's pieces back together again.

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  4. David: This actually reminds me of Arnold Kling's theory of "recalculation". (It might be just because I am currently trying to think up a good reply to Arnold's post http://econlog.econlib.org/archives/2010/12/a_rant_against.html

    Off topic: It's strange, but I didn't see Mike's post as "trolling" at all. The whole concept of "trolling" somehow just seems not applicable to economics blogs? It's quite OK for people to comment and say "Your post is wrong!" (politely, preferably).

    By the way, I think Mike is basically right. A financial crisis is also a real shock, and will require a change in the pattern of resource employment, as well as, in my opinion, a deficient demand recession.

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  5. Nick:

    My post reminds you Kling's post? Gosh, I can hardly make heads or tails out of what he is saying! (I just realized that this might be your point...lol).

    At some point, expressing theoretical ideas in English has its limitations. Too many implicit assumptions, many of which I'm not even sure the expositor is aware of. It would be nice to see some of these arguments formalized mathematically, where the assumptions are laid bare, and where we can all easily verify the underlying logic.

    I will re-read Kling's post and look forward to your reply!

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  6. David:
    thank you for the response. I like the point you are trying to make.

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  7. David,

    I think Kling, while not an Austrian, practices a similar methodology.

    It's sort of funny - Austrians say the flip-side of the coin is the problem with mathematical economics. Namely, it's not as flexible as verbal logic and you can't make is sufficiently nuanced without inviting in boatloads of complexity that make it difficult for any but the highly technically oriented to understand.

    I also think it's really important to recognize that there are very few academic blogs for academics. This is one. Coordination Problem is another. I don't think Econlog counts since the guys who write there don't spend much time arguing carefully. At least, to me they don't.

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  8. If I might put in my own pet theory. While I think the economy has experienced a serious of shocks in the past few years (news, financial, and nominal), I think the biggest problem in late 2010 is a heightened sense of risk and a scarcity of sufficiently productive investment opportunities at the desired level of risk. This is why we are seeing a flood of people going into government bonds and money - not because of some irrationality. Financial intermediaries and people alike realized they screwed up their assessment of risk over the last decade and I think we are actually now seeing excessive risk aversion in the aggregate, though I believe it's individually rational due to dispersed information about investment and asset returns. Furthermore, there are certainty search costs associated with discovering new profitable investment opportunities and these are higher now since I believe people now desire more safe investments. So, since everyone seems to care about unemployment, why aren't we seeing hiring? I think it's a natural response of heightened risk aversion. What employer is going to engage in the non-trivial search costs associated with a risky investment (a new employee) with an uncertain pay-off. Also, I think we are underestimating the degree to which the long-term unemployed have become undesirable from a loss-of-skill perspective, creating a mismatch problem. Oh, and it goes without saying some of the problem is a loss of economic structure - like massive waves of consumer bankruptcies.

    In short, I think the housing bubble, financial crisis, and subsequent recession have caused a serious re-evaluation of our risk tolerance. To some extent, I think a risk heightening happens in every recession - but I think it's especially bad here because this was largely an investment boom-bust where the majority of people and financial institutions were extremely bad at assessing risk. This is why I think the best "stimulus" policy would be to introduce investment tax credits and reduce the corporate tax rate since it makes the returns higher on investment, making people more likely to take the risk, and they increase collateral values which will ease financial intermediaries fears about lending.

    Also, I don't think there is a strong-case to be made that just because there is an "irrational flight" to government bonds or money that stimulus or government intervention may be necessarily. In fact, let's say I am behaving somewhat irrationally. If I see the government start doing something like an $800 billion stimulus package, I might be inclined to think "oh god, this recession must even be worse than I thought!" and I run even more into government bonds / money (or even GOLD!). I don't think there is any reason to believe the government intervening would necessarily be a good thing if you are dealing with irrational agents prone to arbitrary revisions in expectations based largely on sentiment.

    Now, one note on the deficient demand hypothesis. I mean, OK, nominal spending fell so people were laid off. But then, spending increasing throughout 2010 coupled with a reduction in wages (assuming wages aren't excessively rigid) should have done something to the unemployment rate - which should lead to an increase in nominal spending - which reduces the unemployment rate and so on and so forth until you are back at 5%. And this money being spent, would increase investment along the way as well in a similar fashion. Why didn't this catch on if this was just a story about consumers not spending money? How is it possible to square this observation away with the demand story? Or do we now live in a mindless world of AS-AD models where everything is just explained by not enough "demand" It was there, but now it's gone. It's just magical.

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  9. Ted: It's good to get things off your chest like this, isn't it? :)

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  10. FYI, Edmund Phelps used similar analogy (skater who has badly fallen but remained uninjured vs skater who has broken some bones and needs real attention) in the following article: http://www.nytimes.com/2010/08/07/opinion/07phelps.html

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  11. himaginary: Thanks for the link to Phelps!

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  12. I think this is one of the problems with our econ profession. They insist that there is AN answer like to a physics problem and endlessly try to flesh out just what percentage of a current problem is deficient demand, what percentage is structural and in the mean time its decided that we need to fire teachers, policeman and day care workers (most of whom were doing their jobs). Why wasnt the same level of consideration given to figure if the jobs needed to be eliminated? It was an automatic decision when the credit crisis hit.

    People need incomes. They cant be participants, consumers, customers without it. Income IS effective demand.

    As we sit here trying to determine if we've just seen a quark or a muon, gravity is bringing a lot of stuff down..... hard.

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  13. Greg:

    Isn't a correct diagnosis important before administering a "cure?"

    I'm not sure I can speak to the consideration given to the choices agencies made with respect to their personnel. I like to keep my nose out of other peoples' business.

    Perhaps all people need is to be given a fair chance at earning a living; contributing to society, rather than burdening it with a collective sense of entitlement. Most people are free and willing contributors. Some need to be taught. And a small fraction just need our charity. Not sure what effective demand has to do with any of this.

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  14. David,

    "Isn't a correct diagnosis important before administering a "cure?"

    Glad you used a medical analogy because that is my area of expertise.

    The answer is yes and no. Plenty of palliative therapies are started way before a definitive cure is addressed. Sometimes there is NEVER a definitive cause (sounds more and more like our economy huh?)
    When I know someone is bleeding, I start blood (or other volume expanders). Before I even know where they are bleeding from exactly I use my monitors and knowledge of physiology to determine "This guy needs blood/volume"

    So how does this relate to the economic issues we are discussing? Just as its obvious to me when someone needs volume (after looking, listening, feeling and a couple fancy measurements with monitors) it seems obvious to me when an economy is lacking "demand". How you want to exactly categorize it is up to academics, but the facts are this as I see them.

    1) 8 million people who had jobs 2 years ago dont now. Yes many were construction workers (not even half I'll bet) but it has bled into many sectors for obvious reasons.
    2) Many others are working part and want full time work.
    3) There are way more current job applicants than job openings.

    So, this economy needs jobs. Theres plenty of work to do, I'm sure you'll agree but no one is paying to have it done currently.

    Can the private sector provide them? Not yet, obviously.

    Why? The private sector needs paying customers to make its enterprises worthwhile and there arent enough of them.

    Here's what we tried up to now.

    1) Reducing uncertainty (this is equivalent to me patting the bleeding patient on the head and saying "Ill take good care of you").

    2) Giving the "hirers" more money by cutting their taxes (and some of the potential consumers..... if they have a job and are paying taxes). This assumes that the hirers dont have enough money to hire, which is of course specious because hirers fund new jobs from customers coming through the door.

    3) Removed all obstructions to lending.(except the uncertainty.... damn that circular logic) Of course this requires the notion that the private sector wants/needs more debt which was at historically high levels pre crash. This is like filling the blood bank up with blood donors and telling that bleeding patient "Hey we've got plenty" Of course no one has started an IV yet they are still arguing over whether its the common femoral artery thats bleeding or the superficial femoral artery.


    I asked in a previous thread, what it would take for economists like you to say "Ok, we need a direct hiring program. 10$/hr job to anyone who'll take it doing all types of things that various communities decide on their own that they want done. Fully funded by the feds" Unemployment of 25%? 500 more bank closings? Would any crisis lead you to that conclusion? Is there any point you say "Ya know what, we just need to get people doing something, for an income, so they can be participants in our economy again.

    People are bleeding (as I'm sure my heart will be accused of, so be it, I'll actually consider that a win if thats what a critic responds with) and I really dont understand why more economic voices arent just calling for the bleeding to be stopped. Period. Communities are dying and much unnecessary hardship is being foisted upon people under the mistaken idea that "We dont have the money"

    I read your blog frequently and I know a lot of people do, you have a voice in this discussion.

    Thanks for allowing me to comment. Sorry if I sent everyone to the "Bummer trip tent at Woodstock"

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  15. Greg:

    It's thoughtful posts like yours that make it worth blogging.

    I think of the "science" of economics as currently being on par with how medicine was practiced in the middle ages, or before. (I once read--I'm not sure it's true--that prior to the invention of penicilllin, doctors killed more people than they cured).

    Aristotle thought that the body was made up of four humors (liquids): phlegm, blood, yellow bile and black bile. If a person had a fever he was thought to have too much blood. The treatment was to cut the patient and let him bleed. Medieval doctors were great believers in blood letting. Ill people were cut and allowed to bleed into a bowl. Evidently, people believed that regular bleeding would keep you healthy. So monks were given regular blood letting sessions.

    Now, if you were to ask doctors, and people in general at the time, they would have viewed all these things as "obvious." And, indeed, since patients frequently did not die after bleeding, the evidence could plausibly be interpreted as supporting these obvious notions.

    But having said this, I'm not against the idea of someone doing "something"--as a practical matter we cannot wait for some theoretically "correct" solution to a pressing problem. On the other hand, my interpretation of the what caused the Great Depression to last so long places some blame on FDR's "gumbo soup" approach to "fixing" the economy. One can claim that these policies helped the US get out of the depression, just like those middle age bleeders liked to claim credit for their interventions.

    I do not dispute your facts 1-3. I disagree with your conclusion as to what these facts imply; namely, that "the economy needs jobs." It is worthwhile to note that in most of recorded history, what people wanted (found lacking) was leisure, not work. It is easy to create work. This should not, in my view, be the goal of social policy.

    You ask what it would take for me to advocate a public hiring program that would pay anyone who wanted a job $10/hr doing whatever. I could imagine worse uses for my tax dollars, so count me on board. I would be more in favor of subsidies for education/vocational/retraining programs. Finance it all out of corporate welfare and other pork!

    Have a Merry Christmas!

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  16. David

    Thanks for the thoughtful response.

    You're correct that for many people 100 years ago a trip to the doctor was the lethal event (We still joke that "your problem was you went and saw a doctor!!)

    It seems you are characterizing demand side solutions as more archaic, similar to the wrong headed thinking of ancient humorists. I know there is still the great debate amongst economists as to actually what happened during the depression years and how it could have been managed better (or not "managed" at all) but is it your view that supply side concerns are modern medicine vs the "leeching" demand siders?

    Wasn't the traditional/classic view prior to the 20th century that keeping your money strong was the answer to economic problems? Wasnt it this view that drove the liquidationists of their time. By liquidating you made the price cheaper which increased buying power. Right? Wasn't the view of labor as a commodity a classic view? Workers were just another supply for production, a machine that bleeds and needs to be fed.
    Wasn't it Keynes who questioned this "common wisdom"? Maybe not first but most notably? It appears to me, a simple reader of economic blogs for two years now, that much of the monetarist/supply sider material is a rewrapping of the old classic view. Some new math to jazz it up but still strong appeals to Say and Ricardo, defending currency values and a push to cheap labor.

    I dont know why we cant have both/and in regards to direct hiring and education vocational training. The only way to know how many would prefer a salary ( I wont call it work in deference to those who object to calling such activity work) to training is to offer it.

    You are certainly correct about leisure but leisure is expensive these days. It didnt used to be as expensive. Most cant afford not to earn a salary.

    I must say that I have had to reconsider some of my ideas about work and production in light of things you've said and in light of this article here;

    http://www.interfluidity.com/v2/1004.html

    I'll quote the most enlightening (for me) part here


    "However, we do not measure prosperity in terms of how much work people are doing. That is a terrible error and the most vulgar form of Keynesianism. Make-work is not a path to prosperity, and effort is not production. Prosperity is a matter of the rate at which goods and services that are highly valued can be produced, whether the production is labor intensive or capital intensive, however much or little people are working. Employment is a more complicated issue than output. Under current (foolish) institutional and ideological arrangements, for most people, employment is our main source of claims on current or future production, and also a measure of our respectability and value as human beings. Holding institution and ideology constant, unemployment is harmful far beyond its effect on output. But let’s not confuse objectives. Employment and output are historically correlated, because it takes work to produce output, and also because the measured value of output is dollar weighted and there are few consumers to confer value without widespread employment. But the degree to which the production of any given thing is tethered to traditional employment is variable and technology dependent, and the ability to confer value through purchase could be distributed via means other than employment. Employment and prosperity are different things."


    The whole essay is worth reading and it really made me look at things a lot differently.


    YOU have a Merry Christmas too.

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  17. Greg:

    Hey, I'm impressed with your knowledge of the history of economic thought. You know more about this than most economists!

    My own view on this matter has been greatly influenced by the economic historian David Laidler; and in particular, his book "Fabricating the Keynesian Revolution."

    Laidler argues, persuasively in my view, that there was no "revolution." All of Keynes' contributions (General Theory) grew naturally out of steady progression and mixing of ideas that occurred in the early 20th century (and before). Laidler pays due respect to Keynes' many contributions. But if you were to name one, it would be easy to find someone who thought of it earlier. This idea that Keynes somehow challenged and overturned a prevailing orthodoxy was largely fabricated by some of his young followers.

    I do want to take a moment to clarify one thing, in case you have a mistaken impression. I did not mean to characterize demand side solutions as archaic. I meant to characterize our entire profession as archaic; and this includes myself! We have not advanced to the degree that, say, modern medicine has advanced. (In our defense, the profession is still relatively young).

    I pick on people who latch on to "demand side" ideas because it is these notions that appear to be so firmly embedded in their brains these days. My job, as I see it, is to make people question these preconceived notions (indeed, to question preconceived notions in general). I enjoy doing this, I think, because the reactions I get help me to question my own preconceived notions. I don't know any other way of learning things.

    Finally, thank you for the link to Steve Waldman. This guy certainly seems like someone worth following!

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  18. Your post is very interesting and thought provoking. Thinking of recessions as destruction in relationship capital does have important implications for fiscal policy. I was thinking if one could analyze the effect of government spending in developing countries like India using this criterion. The difference being there is no shock that is destroying capital but there is substantially lower relationship capital to start with. With liberalization and globalization, there indeed is some evidence of presence of economy wide business cycles in India, but a more prominent problem still is substantial poverty and lack of opportunities to improve one’s standard of living. Such a lack of opportunities could manifest as not having access to education, infrastructure, health care and other public goods. This not only affects the quality of human capital one has to start with but also limits the ability to enter into contracts or relationships that could improve standard of living significantly. Thus, in a way, I am interpreting continued existence of poverty as dearth of relationship capital. Does fiscal policy have any role to play in such situations? If yes, what kind of policies would work?

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  19. Parag: Thanks! It's always nice to hear that a post of mine gets someone thinking...

    It is an intriguing idea to the apply the concept to explaining development (or the lack thereof).

    You say that the more prominent problem is poverty and lack of opportunities to improve living standards. At the risk of sounding crass, I doubt that poverty has very much to do with it (since our ancestors managed to develop, and they started out poor). A lack of opportunites sounds like a more promising avenue to pursue.

    But what does this mean, exactly? Is it a communication problem? (I view match formation as building a communication channel between two or more parties). Is there something preventing the formation of potentially more productive relationships? Are these barriers, if they do exist, legal, cultural, or technological?

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  20. The causality that I had in mind was something like this: lack of opportunities leads to lack of relationship capital which in turn leads to persistence in current standard of living. So it is the dearth of relationship capital that leads to persistence of poverty. It may or may not cause it, though.

    Some of the barriers to profitable match formation are definitely cultural to start with. For example, land holding might be determined by which caste you are born in. This would affect what kind of education you would be able to afford and hence your human capital formation. Even if you are no more dependent on agriculture, the social group that you belong to does affect the outcomes for you and your children.

    I guess one could argue that may be it is not lack of opportunities but lack of the ability to profit from them is important. So profitable matches could be formed potentially but they are either destroyed quickly or do not form at all. Clearly, some kind of government intervention would definitely help in alleviation of the circumstances. One obvious choice is providing access to quality education and health care. But it is to general and may not address the context specificity of constraints on match formation.

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  21. Parag:

    Right. Makes sense.

    The caste culture immediately popped into my head, when I thought of India.

    You say that profitable matches are either destroyed quickly or not formed at all. I wonder why this might be the case?

    Primitive communities (small villages) are pretty good at match formation within the community (they are essentially coalitions). Might there be language or religious barriers that prevent fruitful relationships across these "islands?"

    As for quality education and basic healthcare, I'm all for it.

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  22. David:
    Thanks for your response.

    The reason why I said that matches are either destroyed quickly or they do not form at all is because the realized or expected match quality is low. This may be because of poor human capital formation or expectations about match quality are formed based on similar past experiences. For example, people from the city where I come from (Pune) would not hire a business major straight from school because past experience indicated poor skill formation and hence poor match quality.

    Small villages in India were indeed good at match formation and some of these matches were dictated by customs and traditions making matches transferable across generations. But with the emergence of modern methods of production and organization of commerce, a village is no more a viable economic unit. There is no alternative insurance mechanism available either. May be there is some scope for government provided unemployment insurance here.

    I will have to think more about your 'islands' idea though. There are certainly language barriers which might make difficult for an outsider to enter. But these may be not be that relevant for high skilled jobs requiring a common language like English.

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  23. Coincidently, I opened my email after posting the above comment and there was one with a review of Jackson's Social and Economic Networks in the latest JEL issue! Reading the article got me thinking and I realized that there indeed are islands even in modern cities of India. In fact, I have personally experienced these networks while working as a lecturer before I decided to go back to school again.

    These islands are based on caste, language, region, etc with some overlap at times. Often job matches are formed or destroyed based on whether you belong or not. The optimal response for an outsider, then, is to enter into a dominating position or credibly demonstrate willingness to assimilate in the dominant network or island. Both of these optimal responses assume certain kind of abilities which may be affected by your socio-economic background.

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