Bill Woosley asks

Are you just saying that the “balance sheet recession” involves requires a change in the allocation of resources, more structural unemployment and so a higher NAIRU?

How does higher inflation help avoid higher structural unemployment?

Yes, we could say that a Balance Sheet recession involves more structural unemployment. However, we want to differentiate between a change in structure that comes from technological change and is likely permanent; and a change in structure that comes from sudden credit constraints and is likely temporary.

So suppose that we have two representative agents Amanda and Ben. They are exactly the same accept Amanda is a safe saver and Ben is a risky investor.

Now to be clear neither Amanda nor Ben are directly involved in the building up of the capital stock. Ben is not a venture capitalist or a real estate developer. He merely owns the capital stock that is created in the background via the magic of the K-dot equation.

The there is a sudden collapse in asset values. Lets just say that someone thought there was a way to mitigate the risk involved in providing owner occupied homes to households with poor credit, but turned out be wrong and so the price of owner occupied housing collapsed. This example is purely hypothetical mind you.

Now the central bank is really good here, so any increase in liquidity demand was matched by appropriate monetary policy. There was no effective tightening and the economy did not spiral into a Great Recession.

However, unemployment still rose. Why? Because Ben now credit constrained and has to cut back on consumption across the board. Amanda faces roughly the same set of net constraints and so her consumption doesn’t change.

To make markets balance the economy must shift from consumption that was going to Ben to the accumulation of more capital. And, indeed the real interest rate has fallen to make that happen because we have great central bankers.

However, we also have workers that were skilled at consumption who now have to shift to capital. This is a structural readjustment that raises structural unemployment.

However, it is not forever. It is just until Ben is no longer credit constrained. Then he will resume his normal consumption behavior and workers must flow back into consumption industries from capital industries.

This process is brought more quickly to an end by an increase in the rate of inflation which burns down Ben’s debt and gets him out of the credit constraint trap.

So there is a temporary increase in structural unemployment as the economy is forced to reconfigure around Ben’s credit constrained status. However, it is not permanent as would be a shift in technology and it can be brought to an end more quickly with higher inflation. 

Advertisements