Arnold Kling  


A Good Explanation... The Fallacy of Time Diversific...

I spell out my current thinking on macroeconomics.

Over the past twenty years, Keynesian forecasters, such as Morgan Stanley's Stephen Roach, have predicted many phantom recessions--slumps that never took place. In order to remain attractive, the picture of Keynesian economics has to be heavily airbrushed.

My current view is that what we call "cyclical" unemployment is in fact a severe version of structural and/or frictional unemployment. During the Great Depression, many government policies, such as the National Recovery Administration, served mainly to create structural unemployment. There also was an unusually high level of frictional unemployment, as the spread of motorized road transport greatly altered the efficient structure of production.

Given this theoretical outlook, I would be inclined not to forecast a severe recession in 2008.

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CATEGORIES: Macroeconomics

COMMENTS (8 to date)
spencer writes:

your memories are a lot different than mine.

What I remember about the worries about the Reagan tax cuts is that they would generate crowding out,
not that they would be inflationary. I remember creating quite a stir at the NABE meeting by forecasting that the crowding out would work through the strong dollar rather then high rates.

Second, yes Roach is a perpetual bear,but I do not believe the consensus economic forecast has ever forecast a recession. Even if you check the current wall street journal consensus forecast I believe you will find it is not for a recession.

If Don is correct about the government taking resources from the private sector during a recession why does the Wall Street journal editorial page keep correctly pointing out that rising federal deficits are essentially always accompanied by falling interest rates.

Finally, why not compare the era of government counter-cyclical policies with the earlier era when the government did not try to dampen the cycle. According to the NBER from 1854 to 1918 when the government did not play a counter-cyclical role the economy was in a recession about 45% of the time. Since 1950 the US economy has only been in a recession some 15% of the time. Yes, many things contribute to that difference but federal counter-cyclical polies are clearly one of them.

Mike writes:

Very good summary of a number of issues many of which are logical candidates. I would like your or anyone else's thoughts on an alternative explanation that you didn't address.

Kydland and Prescott received the Nobel Prize in 2004 in part (in addition to their paper on time consistency) for their paper (time to build) which demonstrated that business cycles could be shown to be induced by normal inventory investment and building/construction lags and feedbacks initiated by shocks to the system.

They concentrated on productivity shocks but it could be argued that any kind of shock would have a similar effect. Some "shocking" candidates could include a sub-prime lending collapse causing a freeze up in credit markets, war spending, or even fear of a recession induced by artificial election year fear mongering.

We know business is risk averse and when confronted with information uncertainty - in this case the uncertainty of recession - they are going to pull back and wait for clarity in the marketplace. So it may just be that "all we have to fear, is fear itself."

Could the election year fear of recession be self-fullfilling?

Jim writes:
Given this theoretical outlook, I would be inclined not to forecast a severe recession in 2008

Hardly a maverick stance, as few economists seem to be forecasting a severe recession. Maybe if you defined 'severe' it would help us evaluate what you're really predicting.

As for the general point, I'm not sure why structural and frictional unemployment would follow the kind of 'cyclical' patterns we see, so the argument that there is no actual 'cyclical' element isn't all that convincing, especially since you appear to concede that there are cycles (peaks and troughs, at least) but that they aren't as large as the Great Depression. Of course as spencer says, this may be a point in favour of macroeconomic theory (and policies enacted on the basis of said theory) rather than against it.

Lastly, you don't exactly command respect when you casually lump Keynes in with Hitler and Stalin. Put the Jonah Goldberg book down, please.

PrestoPundit writes:

I might recommend some of the articles and interviews Auburn economist Roger Garrison has posted on his web site -- Garrison shows how a non-Keynesian model with a "structural" or "frictional" account of unemployment using a micro-economic foundation can account for the boom and bust cycle.

Gary Rogers writes:

Conventional wisdom always portrays recessions as a time when uncertainty causes consumers and businesses to hold on to their money resulting in a cycle of decreased spending. This did happen in the 1930s but we have since learned how to add money to the economy and stimulate consumer spending each time things get shaky. History shows that this works and I would venture to say that this is why so many recessions have been predicted but never take place.

Given this theoretical outlook, I would be inclined not to forecast a severe recession in 2008.

On the surface I would agree with this prediction. The Fed is providing plenty of liquidity, inventories are under control and consumers are still spending. All the signs are there to say we are going to avoid another recession.

But, don't miss what the symptoms are telling us. The sub-prime mess is not caused by consumers holding on to their money. It indicates the exact opposite! After years of stimulating consumer spending at each economic slowdown, the consumers have spent to their limit. Consumers are finding that they cannot live up to the desires of the politicians. After sub-prime mortgages we can expect problems with prime mortgages, car loans and credit card debt that are all in danger of becoming too much debt for an over-stretched populace. At some point consumers must quit borrowing and start saving. That should not be a scary thought, but given what we are accustomed to, it will be a real shock. Given the situation we should be thinking less about stimulating consumer spending and more about how to solve the real problem.

Bill Woolsey writes:

You believe prices (including wages) are sufficiently flexible so that the real supply of money adjusts to demand without any impact on aggregate output?

I think a recession with sufficient aggregate demand and structural unemployment would show a reduction in output and employment, yet we would observe sectors with shortages, rapid growth, growing employment, etc.

I don't think that universal price and wage floors causes what I would cause "structural" or "frictional" unemployment.

Rather than think of the thirties (where prices and wages did fall, and price and wage floors were imposed,) consider instead 1981-82. This was structural or frictional unemployment?

John V writes:

Great article. Very thoughtful though I'm not so sure you are totally fair to classical economics since marginalists, like the Austrians and Neo-classicals built on the classical ideas and made some newer discoveries.

But anyway,

I gave your article a plug at a new blog I created called "Dr. Economist"

But ironically, my first post is addressed to Ezra Klein....hardly an economist...or even a faux-economist.

Megan Rae writes:

I just went to a lecture talking about Milton Friedman, and how following Keynesian made the depression worst. Do you think following another method could of help reduce that affects of the depression?
"Stephen Roach, have predicted many phantom recessions--slumps that never took place. In order to remain attractive, the picture of Keynesian economics has to be heavily airbrushed." How is Keynesian airbrushed? Why is it still around if most of the predictions are wrong or never occur?

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