Arnold Kling suggests that business cycles are a real (non-monetary) phenomenon and that at the heart are errors about what goods or services to produce or what human of physical capital investments to undertake.
I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations. Digging out from these mistakes is going to take a long time. A lot of recalculation needs to get done, and the problem is really daunting.
I don’t think that fiscal and monetary policy solve this calculation problem. At best, they substitute the errors of fumbling central planner for the errors of fumbling individuals.
I am sensitive to this perspective. Its elegant and compelling to see real micro problems at the heart of macro fluctuations. There are several problems, however:
- How do you get to unemployment from here. If people are retooling I see a huge demand for retraining. Or them accepting very low wages in a new industry but why persistent unemployment. Why doesn’t the labor market clear.
- How you get from here to monetary induced contractions. Maybe there is still debate over whether the Fed can stop a recession or at what costs. However, how do you get from here to the Fed being able to start a recession. The experience of the early eighties seems to clearly show us that the Fed can.
- How do we get the Great Depression from here?
Ultimately these are the challenges that I think sink most attempts at a real macro theory.
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Monday ~ August 10th, 2009 at 8:39 pm
ao
I can think of a couple reason you’d get unemployment from here. With unemployment benefits people will have a reservation wage they won’t be willing to work for less than. This voluntary unemployment is larger the more uncertainty there is with future wages. I’m thinking of McCall’s search model. Also with a minimum wage they won’t be allowed to work for less.
In a world with adjustment costs you can have the new growth industries growing their capital base slowly, which could just be a standard RBC model with adjustment costs. This would explain why adjustment is protracted.
RBC people would probably say money appears to matter because it is an output from the banking industry, which contracts like all the other industries in response to shocks. Obviously that’s a terrible theory that nobody should beleive… but it is a theory.
Tuesday ~ August 11th, 2009 at 12:18 am
Karl Smith
The unemployment benefits as reservation is a good point. Though it makes a strong empirical prediction. Employment will be highly dependent on benefit levels and duration. Furthermore, we should be able to calculate a rough maximum on unemployment by looking at initial claims.
Tuesday ~ August 11th, 2009 at 9:06 am
ao
If the shock to the shrinking industry took the form of a Wile E. Coyote moment where firms instanlty knew their long run average cost was below the industry LRAC so that all shut downs were instantaneous, then I think you’d be correct about the max unemployment being equal to initial claims. But I think a more realistic story is that firms don’t know whether their LRAC is below industry LRAC, becuase both are changed by the shock. As the shock makes it’d way through the economy, unemployment would increase as firms discover that shut down is optimal.
I agree the empirical prediction is clear, and I think the literature on this says that unemployment is responsive to duration but not (or only slightly) to level of benefits. That does suggest, at the very least, a more complicated model. What that model looks like, I don’t know.
Tuesday ~ August 11th, 2009 at 3:36 pm
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[...] your father’s real business cycle theory.”) In response to this post Karl Smith asks: I am sensitive to this perspective. Its elegant and compelling to see real micro problems at the [...]
Wednesday ~ August 12th, 2009 at 2:54 am
Richard H. Serlin
“I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations.” — Arnold Kling
What was this huge cultural event that occurred in the last 18 months that caused this mass soul searching about what people majored in in college and what career they chose, that didn’t occur in the previous 18 months, or the 18 months before that, or before that. Did the last big mass career and major soul searching occur in the early 90s recession? How did I miss that?
Wednesday ~ August 12th, 2009 at 11:30 am
ao
Richard,
The event was the sudden and unexpected change in the expected long-run equilibrium size of the finance and real estate industries. Suddenly people realized there are going to be a lot less finance and realtor jobs for the foreseeable future. A change in expectations of that scale didn’t occur in the previous 18 months, or the 18 months before that. In addition I would point the the sudden and sever change in people’s wealth, which would affect career choices, both in terms of retirement decisions and in terms of trading off current consumption and leisure.
This does not need to explain every recession in order to be a good theory for this recession.
Wednesday ~ August 12th, 2009 at 4:45 pm
Richard H. Serlin
ao,
These factors just aren’t strong enough to explain most of what happens during recessions and depressions. The point I was trying to make in my earlier comment is that career and education decisions are long term, hard to change suddenly, and depend on many factors other than short term economic conditions.
Recessions and depressions just correlate very poorly with technological and structural changes in the economy relative to how well they correlate with changes in monetary policy and demand based factors. The logic and evidence for these factors being much greater is extremely strong.
To see a nice layout of this evidence I recommend Nobel Prize winning economist Paul Krugman’s book, “The Return of Depression Economics and the Crisis of 2008″.
Wednesday ~ August 12th, 2009 at 4:55 pm
Richard H. Serlin
I should add that my first comment meant to allude to the fact that the late 90s was a time of great technological and structural change, but we didn’t see a recession at all at that time due to people re-evaluating their educations and careers, and you can find many other times of great technological and structural change that didn’t lead to huge unemployment, that in fact had low unemployment. There’s just not a strong correlation.
Wednesday ~ August 12th, 2009 at 9:41 pm
ao
Richard,
You’re description of career and education decisions as long-term and hard to change suddenly is a good description of how individuals usually make career choices. However, in response to a massive shock to an industry, career changes behave nothing like you’ve described them. I don’t think the 26,000 employees of Lehman brothers made their career choices like that. Maybe deciding what their next career is will be a long-term and gradual decision, but in the meantime their “decision” not to be in finance has been made for them, and quickly so. Evidence of a fast structural shift is also seen in the fact that 40% of Harvard graduates entered into finance and consulting careers in 2008 and 20% did in 2009.
Regarding your comparison to the 90s, there is no reason to expect that labor markets would shift as quickly in response to a positive structural change as they would to negative structural change. We don’t expect a bubble to deflate as slowly as it inflated either.
And to whether or not structural changes correlate with the business cycle; like I said, I see no reason why a theory has to explain every recession in order to be a good theory for this recession.
Monday ~ August 17th, 2009 at 1:22 am
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[...] Karl Smith writes, If people are retooling I see a huge demand for retraining. Or them accepting very low wages in a new industry but why persistent unemployment. Why doesn’t the labor market clear. [...]