Tuesday, January 20, 2009

The Law of One Strange Price

Tyler Cowen at Marginal Revolution is rightly skeptical of macroeconomic explanation that rely on one strange price, including interest rates, tax rates, and the price of T-bills compared to cash. But it's only partly true. Yes, one screwy price is unlikely to mess with the whole economy (even for systematic prices such as interest rates and taxes). But it can if it's screwy enough. If the minimum wage was $100 an hour, there would be a major macroeconomic downturn thanks to that law alone.

The question becomes what is likely to be so out of whack. Interest rates and T-bills are traded on the market, checked and rechecked every day. If there is a systematic error, it's either short lived or relatively small. Taxes are checked as well (by voters), but that happens only every couple of years, if at all. They're also checked in a political process where the "right" tax is determined and spent by lawmakers acting on the voters behalf, instead the voters themselves. Most prices aren't so strange to mess up an economy by themselves. But if one is, I bet it's a tax.

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