Arnold Kling  

Lectures in Macroeconomics, No. 1

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These lectures will cover macroeconomics as I think it should be taught, not the way it is normally taught. The focus is not on model-building. The focus is on the two most troubling questions in macro.

1.How is it that financial markets affect the real economy?
2.How is it that an economic slump involves unemployment?

This lecture will be focused on the second question. However, I will not get to the answer in this lecture. The focus of this first lecture will be on ordinary labor market dynamics, both in theory and in practice.

To a non-economist, the answers to the two fundamental questions may seem obvious. The answer to the first question is that when the stock market goes down, that tells everyone that times are bad, so consumers and businesses tighten their belts. The answer to the second question is that when times are bad, people cannot find work, until somebody can figure out a way to create jobs.

To a first approximation, the non-economist's answers violate fundamental economic logic. That does not mean that those answers are wrong. However, the economist cannot simply give those answers and leave it at that. Even if the non-economist's intuition is right (and I am not saying that it is), we need to reconcile it with microeconomic analysis that we know works well in other contexts.

Take the issue of unemployment. Thirty years ago, Lester Thurow was fond of trotting out a tale of a basketball coach asked by a player, "Why is the basketball round?"

"Son, you've asked two questions," Thurow's fictional coach replies. "First, 'why?'" That is a very deep question, one which the great philosophers have struggled with for years. I cannot help there."

"Second, you've asked, 'Is the basketball round?' The answer to that is yes."

Thurow took the basketball coach's approach to the question of why there is unemployment. Do not ask why, just take it as given that there is unemployment. That might work for Thurow, but it does not work for us. If macroeconomic theory is to be of any use at all, it must include an explanation for unemployment.

From a traditional economic perspective, unemployment looks like a labor surplus. Surpluses and shortages are corrected by the pricing mechanism. So, if there are surplus workers, then a simple drop in wages should solve the problem. Bring wages down and you reduce labor supply, increase labor demand, and get rid of the labor surplus. There cannot be any unemployment, at least if the wage-adjustment mechanism works properly.

The classical economic logic may be easier to understand if we think about the reverse of a labor surplus--a labor shortage. What would happen if there were a shortage of, say, computer network administrators? (I picked network administrators because I want to stay away from other occupations, such as nursing, where regulations impede the operation of the laws of supply and demand.)

If there were a shortage of network administrators, I would expect the salaries of network administrators to rise. That would cause some firms to look for ways to economize on their use of network administrators. Perhaps they would outsource the function to service providers. Perhaps they would select computer systems that require lower levels of manual administration.

Another effect of higher salaries would be to draw more people into network administration. People who happen to be working in other jobs but who have experience in network administration might return to the field. Others might take training courses that would allow them to qualify for job openings.

The American economy is dynamic. People often quit jobs, take new jobs, or drop out of the labor force to retrain themselves. When the aggregate unemployment rate is 5 percent, the typical person who is out of work finds a new job within one or two months. Of course, there will be a significant minority of unemployed workers whose unemployment spells last much longer than that.

Each month, there are millions of new quits and millions of new hires. The monthly change in employment is equal to the net difference between the two. If there are 3.1 million new hires and 3.2 million new quits, then unemployment goes up by 100,000. These net figures-- monthly changes in the number of unemployed--tend to be plus or minus 200,000 in any month. That is really quite low relative to the gross flows in and out of unemployment.
For further reading on labor market dynamics in practice, I recommend Steven J. Davis, R. Jason Faberman and John Haltiwanger. Some excerpts (note that most of their period of analysis is 1990-2005, and today's labor market may be working differently):

for every dozen or so filled jobs at a point in time, on average one job disappears in the following three months. In a growing economy, a somewhat larger number of new jobs are created at new and expanding establishments.

...job flow rates are three times larger in construction than in manufacturing, and worker flow rates are three times larger in leisure and hospitality than in manufacturing. the third quarter of 2001, 31 percent of establishments contracted during the quarter and so contributed to job destruction. Another 26 percent expanded and so contributed to job creation. Most job destruction, 68 percent, occurred at establishments that contracted by 10 percent or more during the quarter. Perhaps more surprising, 63 percent of job creation occurred at establishments that expanded by 10 percent or more. In fact, the prevalence of such large employment changes is the norm in both booms and busts. Hence, most job destruction cannot be interpreted as the product of modest contractions achieved by normal rates of worker attrition. Neither can most job creation be seen as the outcome of modest establishment-level growth rates. That is, although most establishments experience little or no employment change within a quarter, job flows mainly reflect lumpy employment changes at the establishment level

Because unemployment escape rates are high, spikes in job destruction and layoffs lead to short-lived rises in the unemployment rate unless the spike itself is long-lived. The unemployment escape rate is also highly procyclical, and movements in the unemployment escape rate account for most of the time variation in the unemployment rate

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COMMENTS (8 to date)
Ajay writes:

Leave it to economists to examine a topic solely by examining numeric changes and not examine the underlying reasons at all. The labor market is a highly inefficient market, accounting for why unemployment remains relatively high. Most employers want experience above all else, limiting themselves to the employees who have it rather than developing new talent. Hiring and firing is treated like marriage and divorce, obsessed over for no purpose than I can see and in dumb ways, making potential employees jump through hoops that have almost no connection to the job duties. Also, there is almost no recognition that most people have a range of work hours they'd like to put in. Some people would like to work 30 hours a week, some 50, but standardized shifts are imposed that rule out potential employees for no reason. When one market sector is contracting, there exist very few ways for even a highly competent person to switch to another sector. He doesn't have the background or "experience." This one is largely because the education/job training market in this country is a non-existent joke. There exist huge entrepreneurial opportunities in the job location and training market because of the giant failures of current market participants, opportunities that I hope to address someday. I am confident that nobody will beat me to these opportunities before I'm ready to take them on as the current thinking is so weak.

Greg Ransom writes:

"labor" isn't an aggregate.

Because it isn't an aggregate, there isn't a "labor" supply. Most people I know are highly specialized in highly specialized markets.

Think about how crazy it is to have and economics of an aggregate like "labor". By comparison, consider an "economics" of the "stuff supply". Microeconomists don't give us an economics of the "stuff supply", because microeconomists deal in relative prices and the adjustment of the various prices and quantities of heterogeneous goods in the market.

So we are are getting closer to understanding why "macroeconomics" isn't really economics at all -- it's more like a "cargo cult" practice, closer to the incantations of a witch doctor than to the causal explanations of a Darwinian biology or an astronomer.

To repeat, the fact that "macroeconomics" is all about aggregates is your first clue that it isn't economics -- it's pseudo-science.

There can be a macroeconomics dealing with dis-aggregated labor and capital, Hayek gave us such a macroeconomics.

But not 1 economist in 10,000 is capable of understanding it.

A tragedy, that.

Skeptikos writes:

Thanks for the .pdf.

MattYoung writes:

I would have picked consumer dynamics vs labor dynamics, and skipped financial all together in macro.

The consumer reaches a new level of expectation in relation to technology change much faster than labor does. So, changing consumer expectations leads to new equilibria, or capital structure. The lag in labor adaption causes recessions.

I think the finance industry operates like the shoe string industry, namely the same standard rules apply and no further explanation is needed except to note the effects.

El Presidente writes:

Greg Ransom,

To repeat, the fact that "macroeconomics" is all about aggregates is your first clue that it isn't economics -- it's pseudo-science.

Aggregates are important, but detail yields clarity and a deeper understanding of the movement of aggregates. Knowing that animals have muscles is good. Knowing that muscles are made of proteins is better; molecules, better still; atoms, subatomic particles, et cetera.

It is my chief criticism of modern Macroeconomics that it assumes to predict the behavior of an aggregate by pretending that its composition is irrelevant and without inquiring about the range and order of motivations individuals might have at any particular point in time. This allows us to adopt Solow's growth model (perhaps the most eloquent economic half-truth) and blithely dismiss the importance of distribution in causal modeling. It is not necessary to ask each and every person what motivates them and to what degree, but it would be instructive to entertain the possibility of ranges within which differences change the expression of the aggregate.

I wish we had the academic integrity to declare that there are at least two dimensions of material prosperity (the obsession of modern macroeconomics) that cannot be divorced from one another without disrespecting human life itself: wealth and distribution. Unfortunately, we are not inclined to engage in this synthesis and our discipline is poorer for it.

I would like us to ask, "What is the utility of growth?" In order to answer that question, we would have to acknowledge that growth of average material wealth, like everything else, has diminishing marginal utility. Then we would have to ask, "Why?". Our answer might be very enlightening if we had the courage to apply our discipline in seeking it. The use of "Animal spirits" by neo-classicals and libertarians is the biggest intellectual punt ever. To see non-Keynesians redeem it from his catalog ought to raise questions. In that context, I translate it as:

Things proper economists don't discuss in polite company.

I can't tell you how many of my profs demurred on such questions. We need to take our silk gloves off and get our hands dirty.

notsneaky writes:

This is good ... but ... this is generally how macro IS taught in the principles course.

H Roark writes:

I understand that this is Macroeconomics 1 and I can't disagree with any of this basic theory. But I want to take the chance to ask a question as a kid in the lecture room might:
'Why is there any unemployment at all?'

Logic tells me that as long as someone can do something worth more than the cost of managing them, they will be employed.
Do you think I’d be right that saying the only causes for permanent unemployment (temporary is a matter of cycles and you've covered this) is:

a person not able to produce more value than
-the minimum wage
+the time of staff hiring and managing that staff (including training if necessary, but at this level this could be very minimal)
+the liability of potential workplace safety (and other labour-law) breaches

or that person is not able or willing due to
-welfare opportunity cost
-genuine disability (inc. old-age)
-child labour-law
-aristocracy, dependence
-preference of starving to death

Caliban Darklock writes:

H Roark, a job is a sale. The employee sells a service; the employer buys that service. An employee may refuse to sell that service for the same reasons he might refuse to sell anything else - his shoes, an apple, a kidney. By the same token, an employer might refuse to buy that service for the same reason it might refuse to buy anything else - pea gravel, fresh eggs, live weasels.

It might be productive for you to think of unemployment as comparable to a service inventory. It's work that might have been done, but wasn't. Perhaps it wasn't the work that was needed. After all, when I need fresh eggs, I am unlikely to buy live weasels no matter how cheap they are.

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