I want to follow up on Krugman's column which takes a cue from an LA Times article by Peter Gosselin, who in turn cites recent Nobel prize winner Thomas Schelling:
On Their Own in Battered New Orleans, by Peter Gosselin, Los Angeles Times: ..."There is no market solution to New Orleans," said Thomas C. Schelling ... who won this year's Nobel Memorial Prize in Economic Sciences for his analysis of the complicated bargaining behavior... "It essentially is a problem of coordinating expectations," Schelling said of the task ... "If we all expect each other to come back, we will. If we don't, we won't. But achieving this coordination in the circumstances of New Orleans,'' he said, "seems impossible." ... "There are classes of problems that free markets simply do not deal with well," Schelling said. "If ever there was an example, the rebuilding of New Orleans is it."
Though microeconomists generally acknowledge coordination failure can be a problem in individual markets, its importance to the macroeconomy is a point of division among macroeconomists. Leigh Tesfatsion explains:
Nonwalrasian Equilibriun: Illustrative Examples: 1. Introduction In previous lectures it was seen that market clearing constitutes an essential part of the definition of a Walrasian equilibrium. ... But must markets clear in order for economies to be in equilibrium, in the sense of an unchanging situation (rest point)? In particular, can an economy become stuck at a point where positive “involuntary” unemployment persists? Or do ... decentralized market economies..., assuming flexible prices, and absent government intervention, ... tend to converge over time to points where all markets clear?
This issue is at the heart of the debate between ... economists; see King (1993) and Mankiw (1993). In general, [the alternative view is] that decentralized market economies are inherently stable, tending naturally towards an equilibrium state in the sense of Walras, whereas new Keynesian economists do not believe this to be the case. More precisely, new Keynesians believe that a decentralized market economy might or might not tend towards an equilibrium state depending on its supporting institutional structure and circumstances. Moreover, the meaning of “equilibrium state” does not presuppose any optimality or efficiency properties. ...
New Keynesians also stress that, in general, a given economy can have multiple possible equilibrium states, some more socially desirable than others. A key factor affecting the ability of macroeconomies to coordinate on a socially desirable equilibrium state is whether agents are credibly able to signal their intended actions to each other. For example, if other market participants fail to signal (communicate) to agent A in a credible (believable) way what actions they intend to take, how can agent A rationally take these intended actions into account in planning his own actions? And if agent A cannot take these intended actions into account in his planned actions, what guarantees that his actions will be coordinated with the actions of these other market participants? For example, if agent A is a producer, and consumers do not credibly signal to him today their intended future purchases of his goods, how can he take these intended purchases into account when planning today for future production? And if he cannot take these intended purchases into account, what ensures that future demand for his goods will equal future supply? In summary, new Keynesians identify two basic types of signalling problems that can give rise to coordination problems among economic agents: Problem 1: Incomplete Signalling ... Problem 2: Signalling Not Credible...
In New Orleans, the problem is that agents cannot signal each other in a compete and credible way what their intentions are through the market process. When that happens, the market can breakdown into a suboptimal equilibrium. The solution in such a case is for somebody to coordinate expectations. Would you show up, for example, at a pickup baseball game if you didn't think anyone else would show up? Usually such games require a coordinator to set them up. In the case of New Orleans, it is up to government to set expectations so that everyone believes everyone else will "show up for the game" and hence are willing to show up themselves. Expecting such "pickup games" to occur spontaneously through the market process is often wishful thinking.
That is not to say the private sector can never solve these problems, a tradition might develop where everyone simply shows up a particular field at a particular time each week to play baseball. These often take time to develop, and such implicit agreements tend to break down over time without some sort of coordinator. It is the belief that others will show up if you do, the coordination of expectations, that makes it work, and this often requires centralized credible signaling through government action and commitment. We want to avoid, if we can, situations where everyone would love to play baseball, but no game occurs because nobody knows if others will show up to play. And, as with New Orleans where people may decide to live elsewhere due to lack of faith in the rebuilding effort, if you wait too long to start the coordination process, people may have already committed to other less desirable, but unchangeable plans.
Update: Tim Haab at Environmental Economics has more on the need for credible coordination efforts:
Who would you believe?, by Tim Haab: For people to make rational economic decision they must have accurate information on the expected consequences of their decision. Many times, such information is tough to get. Take for example the decision to return to New Orleans. Who would you believe? From Reuters:
State and federal officials gave the "all-clear" to residents and tourists, saying recent alarming reports by environmentalists about toxic sediment are unfounded. In fact, the state's chief environmental officer said the deluge that covered 80 percent of the city was no more polluted than typical floodwater. [...]
In fact, McDaniel said neighboring Lake Pontchartrain's water quality is now "about as good as we've seen them," and is fit for swimming and harvesting seafood. Air quality actually is better than normal because of reduced industrial and vehicular activity, he said.
Environmentalists, led by the Natural Resources Defense Council, have released their own testing they said shows potentially dangerous levels of several contaminants in the dried sediment left behind by floodwaters. Environmental chemist Wilma Subra, working for the council and the Sierra Club said arsenic was a particular worry, but that sediment also contains chromium, lead, barium, cadmium, mercury and hydrocarbons. "The government has a legal obligation to begin the cleanup immediately," said Monique Hardin, co-director of the New Orleans-based Advocates for Environmental Human Rights. "People have a right to return to healthy homes and neighborhoods."
Government officials counter that residents can do so now. "We're not seeing anything out of the ordinary that we wouldn't normally see this time of year from the standpoint of upper respiratory illnesses," said Louisiana State Health Officer Dr. Jimmy Guidry. The two biggest health issues in post-Katrina New Orleans, Guidry said, are cleanup-related injuries and mold that has grown unabated in moist structures. "Mold is a major issue -- we do want people to be very careful with that," he said.
Now that you have the information, would you move back?