Arnold Kling  

Modern Recessions

Political Economy Lessons for ... Flight of the Red Balloon

Robert Hall writes,

One of the most important facts about the modern recession is at all sectors of the labor market slacken at the same time. . .Each of the seven major sectors—even including government—were recruiting to fill far fewer positions at the trough of the recession. The softening of the labor market was economy-wide, not restricted to recession-prone sectors such as durables. Abraham and Katz (1986) were the first to recognize the significance of this feature of the economy, which rules out theories of recession that rest on reallocation from shrinking to expanding sectors.

My late teacher Bernie Saffran used to say that every growing economy needs a leading sector. That theory may explain this fact fairly well. If there is no sector that is expanding, then nobody quits their job, and nobody posts openings. So, even if government employment is not pro-cyclical, government job openings will be pro-cyclical.

Another way to put this theory is that when one sector is expanding there will be lots of turnover in other sectors. So job turnover should be highly procyclical. When there is no leading sector, job mobility slows down, and openings decline across the board.

If this theory is true, a recession happens when a leading sector collapses. The tech sector in 2001, the housing sector and finance in 2007. Hall dismisses this idea too casually, in my opinion.

Another pointer from Tyler

Comments and Sharing

CATEGORIES: Macroeconomics

COMMENTS (11 to date)
spencer writes:

If you look at both the job creation and job destruction data for this entire cycle the job destruction data has appeared fairly normal. But the job creation data has been weak the entire cycle,
implying that one of the reason this has been a weak cycle is that nothing but housing -- a small sector -- was pulling it along this cycle.

This size of growing versus contracting sectors plays a role in most long wave theories. In these theories the new emerging sector is too small to offset the weakness in the old contracting sectors in the depression part of the long wave. You can not get back to long term growth until the new sector is large enough to offset weakness in the old sector.

David Tufte writes:

I noticed something like too, with this voluntaryXchange post on hires and fires that I put up a month or so ago.

The data shows that the West definitely has problems that are different from the other three regions. There hires and fires are down just about equally, which supports this post. The West seems to be in much more classic recession with hires down and fires up.

fundamentalist writes:

The article starts of with "A modern recession is
one occurring in an economy with well-executed monetary policy..." I could hardly keep reading after that. Since when has the US had a well-executed monetary policy?

Lord writes:

As I recall, job loss is fairly constant but job creation is highly procyclical, pretty much defining the cycle.

fundamentalist writes:

I realize you guys get a rash every time someone mentions Austrian econ, but you'll never find your keys under the street lamp if you didn't lose them there. Mainstream econ has been sifting through mountains of data for about 80 years now hoping to cobble together a theory of business cycles from scraps of materials culled from the pile, and has failed, as Hall admits at the end.

Kling: "If this theory is true, a recession happens when a leading sector collapses."

But that's only half a theory. The other half asks what causes a sector to become the leading sector? Why doesn't the economy grow evenly?

Hall: "Though the proposition that markets are in equilibrium—in the sense that pairs of actual or potential transactors cannot alter the terms of their transaction to their mutual advantage—is virtually the defining concept of economic science..."

There's the real problem: assuming whatever circumstances exist are an equilibrium. Because of this assumption, mainstream econ believes that all booms as normal and good and exhibit equilibrium, even though substantial disequilibrium has built up during the boom.

Hall: "...the central bank responds to outside influences, with the objective of keeping inflation low in the longer run and offsetting booms and recessions in the shorter run. The central bank is not a source of disturbances to the economy." " is hard to see how monetary policy could have caused either of the modern recessions."

This completely ignores the very long lag time, emphasized by even Friedman, between Fed action and its effect on the economy. Empirical estimations of the lag between changes in the money supply and inflation are 12-18 months, but the Fed can't impact the money supply without a lag either. An in spite of the fact that the Fed remains vigilante, by the time price inflation raises its ugly head, it's too late for the Fed to act. The damage has already been done. In fact, the very act of countering recessions with monetar pumping plants the seeds of the next recession.

This is an aside, but it's kind of funny that he's hard on Caplan's alternatives to the Austrian business cycle--rational expectations, sticky prices and sticky wages.

Hall: "We have no idea how to generate a modern
recession from the MP model

At least he's honest. For mainstream econ, recessions hit like a bolt of lightening on a cloudless day. Isn't it time to at least consider the Austrian business cycle? When the Fed tries to rescue the economy from a recession, it lowers interest rates too low and keeps them too low for too long. This causes consumers to spend more on durable goods, such as housing, and manufacturers to invest more in capital equipment and producing consumer durables, such as housing. A boom follows. During the boom, some industries lead the expansion because that's where the new dollars go. For example, the expansion after 2001 occurred largely in real estate and commodities because investors had been burned in the stock market. Investors often pick the next hot field to invest in, which then becomes the leading industry for the expansion, by choosing the industry that was ignored in the previous expansion.

But because the expansion is based on an increase in money and not savings (reduced consumption), a disequilibrium immediately exists between supply and demand for resources, for while increased money has increased demand, the supply of goods and services do not increase as much. As Hayek put it, the plans of producers and consumers don't mesh. Eventually the competition for scarce resources causes price inflation. It's only when price inflation arises that the Fed wakes up to the fact that something is wrong, but by then it's too late.

But it's not the raising of interest rates that cause the recession as mainstream econ believes. Hall recognizes that the Fed didn't do that in the last two recessions. What caused the recession is the fact that the previous monetary pumping of the Fed caused people to make bad investments. An obvious example is the overbuilding of fiber optic cable in the expansion to 2001, and the current overbuilding of housing.

Until mainstream econ realizes that the seeds of recession are sewn in the preceding expansion, you'll never get anywhere with a theory of recessions.

Ajay writes:

fundamentalist, what you say makes sense but is it really the Fed to blame given Arnold's earlier post about how they may not control rates any more? Also, how important is the Fed's control of the $900 billion of Fed notes in the money supply when household assets are currently estimated at $72 trillion and banking reserve requirements are not really much of a restriction on banks nowadays? I would like to get the Fed out of the money supply because it fosters the delusion that there's some quasi-government agency out there supposedly supplying stability. But I wonder if the Fed isn't just a giant knob that Bernanke spins up and down that has no effect. Perhaps it did something in the past- I don't know- but certainly not recently. I would finally note that the bigger problem might be creating financial institutions that do a better job of funneling money to worthwhile projects rather than shitting it away during every boom.

Bill Stepp writes:

The real business cycle/productivity/monopoly power macro stuff espoused by Hall was always off by a country mile. His paper demonstrates the bankruptcy of empiricism combined with a bad theory.
The leading sectors (tech in the 90s, housing and mortgage-finance after 2001) get blown up because of expansive monetary policy, which drives the loan rate of interest below the natural rate.
Bubbles are caused by investors responding--bad word alert--rationally to distorted market signals. The discount rates they use to present value expected cash flows are too low, and the expected top line growth rates they use are too high (this was especially evident in the derivatives markets).
At the top, everyone sees smooth sailing ahead (except for a few shortsellers, who must have learned the ABCT through osmosis, or maybe they just read Mises, Garrison et al.). The process unwinds when rates go up from their lows toward their natural level. Of course, the Fed usually gets in the way and tries to stop the market from working.
Btw, all the hand wringing about mortgage brokers allegedly deceiving and committing fraud against their clients is so much nonsense. They, after all, were responding rationally to bad market signals too in a competitive environment. If Countrywide was pimping cut rate mortgages with little money down to applicants of questionable financial means, they did so for competitive reasons, just as their competitors had to do to retain (or gain) market share. True, there was the oddball First Horizon (a Tennesee-based firm whose CEO must have had a copy of Human Action on his shelf) which steered clear of most of the bad stuff. His m.o. was to save like a squirrel in good times to tide his firm over in the inevitable bad times, and to stick to the tried and true fundamentals through thick and thin. It worked.

Matt writes:

Wow! These comments reflect an enormous insight by most of these posters.

I am still working the problem, and I am only half way through the core of MP labor model, and I can see my work is expanding by these comments.

Back to research.

Matt writes:

Before tis thread drops away, I should hand wave an employment model using our quantum mechanical tools.

The quantum mechanical model of starts with the acquisition of new technology, starting point. In our model the investment firms estimate the discounted value of the technology.

Quantum mechanicals first posit that the technology is a potential energy that is going to be turned into a kinetic energy; an idea turns into a product flow.

We start out energy balance with a Hamiltonian in the potential state, for economists this means that the technology has wealth M equal to one transaction/period (the investor writes a check) at the discounted value of the technology. The firm seeks to turn this technology into wealth T equal to M, computed as many transactions/second at the minimum accuracy of value (accumulate value per sale).

The market swing will be determined by the ramp up and ramp down of production, which will take a non-finite amount of time. The ramp up and ramp down time sets the limits of integration such that the integral of potential wealth and actual wealth is constant. If we have perfect quantum efficiency, then we instantaneously build the best match organization, run the production a matched speed until the technology is depreciated. Then we ramp down instantaneously.

Now we apply our quantum restrictions.

The quantum of aggregation, the efficient number of works per manager places us in a straight jacket. If w call potential technology a right branch step, the firm must ramp up a left branch production organization to match energy flow. More importantly, the firm must use the same organization left,right branching to do this, within the company. So the original right branch is the frontier, and the left branch within the firm, the production system.

But, as the kinetic wealth approaches the potential wealth, the firm has a difficult choice. It can add another quantum layer, but to be the most efficient, that quantum layer will be an entire additional left branch. Each additional staffing is part of a move from N rank to N+1 rank, and the differential addition of staff is huge compared to the incremental addition of profits.

The firm can only partly approach potential and kinetic wealth with a high degree of volatility, so, depending on the quantum efficiency, the economy will always reach a point in which past estimates of value must be downgraded to the future realization of value.

The firm must downgrade the original potential energy, or the firm must hire out or outsource.

fundamentalist writes:

Ajay: " it really the Fed to blame given Arnold's earlier post about how they may not control rates any more?"

The Feds still control short term rate, just not long term. some economists think that long rates are more important for business investment, but the miss the fact that money is fungible. Businesses often borrow short term, because it's easier, in order to free up their own cash for long term investments, especially if they consider long term rates to be too high. In addition, long rates are loosely connected to short rates; they don't exist in different worlds.

Ajay: "Also, how important is the Fed's control of the $900 billion of Fed notes in the money supply when household assets are currently estimated at $72 trillion and banking reserve requirements are not really much of a restriction on banks nowadays?"

Good point, but the money we need to worry about is in checking accounts, not currency. Currency expansion isn't the problem it used to be because people and businesses use bank accounts. Most of the money in the country is in digital form in checking accounts and demand deposits, which expand rapidly with lower interest rates. Keep in mind that reserve requirements are something like 2% now, so every new dollar in reserves added by the Feds expands through the magic of fractional reserve banking to about $98 in the money supply. With that kind of leverage, you can imagine how small changes in the interest rate cause enormous swings in money.

Bill: "At the top, everyone sees smooth sailing ahead (except for a few shortsellers, who must have learned the ABCT through osmosis..."

That's an interesting comment because Skousen writes in his book "Structure of Production" that in applied economics fields, such as investing, people instinctively follow Austrian econ. I noticed this too a few months ago when I stayed home from work a few days due to illness and watched a lot of CNBC. I was amazed at how closely financial thinking reflects Austrian thinking, even though I know those guys never heard of Mises or Hayek.

fundamentalist writes:

Sorry, Matt, I couldn't follow your mechanics illustration. Don't know the lingo.

Comments for this entry have been closed
Return to top