Arnold Kling  

Ed Leamer's Head Fake

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Ed Leamer's new book is called Macroeconomic Patterns and Stories: A Guide for MBA's.

I do not know why he positioned it as a guide for MBA's. It is clearly a treatise, aimed at the economics profession, to try to change the way we think about and teach macro. I think that anyone who claims to be a macroeconomist ought to read it, think about it, and criticize it. It needs to be aired out and discussed, the way The General Theory was aired out and discussed when it appeared.

Leamer puts housing at the center of nearly every postwar economic recession. He is careful to say that housing does not cause the recessions, but a drop in construction is typically a key component of the recession, and this in turns is followed by (and probably largely causes) a drop in spending on consumer durables.

If housing is at the center of nearly every postwar economic recession, then this recession ought to be a doozy. We went from nearly 2 million housing starts a year to 0.5 million starts in about two years. I suspect that it did not matter one way or the other how we handled the banks. We were destined to get a whopper recession, because we had to adjust housing construction down by so much to restore balance to supply and demand.

To a first approximation, the bank bailouts were irrelevant. We closed that barn door after the horse had already left. If you want to avoid the steep recession, you have to go back and stop the housing boom.

Some excerpts from the book:

p. 109-110:


the 40-hour week is a thing of the past...In the expansion of the 1990's, weekly hours reached the record average of 42 per week...One possible reason for the rise in hours is the increase in benefits, especially health care...when a worker is paid a fixed benefit per year or per week, there is an incentive to keep her working as many hours as possible to spread that fixed cost over a larger labor input.

p. 143:

pathological idleness is a problem confined mostly to two sectors: manufacturing and construction.

p. 185:

It is a consumer cycle, not a business cycle! Businesses wait to see what consumers are doing. Businesses are the passenger, not the driver.

p. 196-197:

In both manias and depressions, the housing market does not work right...demand is upward sloping not downward sloping. When the price is rising in a mania, a higher price suggests even higher prices later on, and buyers rush in before it is too late. Thus higher prices lead to more buyers. When the price is falling during the depressions, a price cut suggests more cuts are on the way, and buyers decide to wait to get a better deal. Thus lower prices lead to fewer buyers.

...This creates an inevitable boom and bust cycle in residential real estate. This cycle affects the whole economy, since, during the boom, there are substantial income accruals to everyone involved in the building [of] homes or selling homes, including brokers and bankers. The increase in home values also puts phantom assets onto the personal balance sheets of homeowners who use that paper wealth to finance the purchase of cars and other durables. The income and the phantom assets disappear when the real estate bust occurs, precipitating some serious belt-tightening.

p. 229:

An economy is not a system of pulleys and motors. It is an organic, evolving, self-healing system. A recession is not the propagation over time of a "shock." A recession is a disease. Our job is not to find the "shocks" and the propagating mechanism. Our job is to determine the symptoms and the causes.

p. 272:

The recession story in manufacturing is V, V, V...The first stroke of the V is layoffs of about 8% of workers, and the second stroke is hiring them all back a year or two later. The 2001 downturn gave us an L, not a V. We trimmed 3 million jobs in manufacturing but not one of them has come back...it does not seem likely that manufacturing is positioned to contribute much to the weakness in the labor market if we have a recession in 2008, which is unlikely to occur without a contribution of job loss from manufacturing.

Obviously, we have had a recession, and a job loss in manufacturing has been part of it. Maybe the contribution of manufacturing to the overall job loss has been smaller than usual. I have no idea.

UPDATE: Note my previous comments on Leamer, not necessarily consistent with what I am saying now.


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COMMENTS (4 to date)
Don the libertarian Democrat writes:

"In June 2004, however, the Fed commenced what turned out to be 17 consecutive interest rate increases. The combination of increasing interest rates and higher home prices initially prompted a still higher spike in demand, as many borrowers
rushed to buy homes for fear of getting priced out of the market."

http://oversight.house.gov/documents/20080307121803.pdf

That's Angelo Mozilo. Here's Leamer:

"When the price is rising in a mania, a higher price suggests even higher prices later on, and buyers rush in before it is too late. Thus higher prices lead to more buyers."

This only makes sense if buyers believe that this is their only chance to buy a house. Even then, it makes no sense to a prudential person, whether it be a lender or borrower. My take is that, in this crisis, the need to own a house was linked to the fear of not having enough assets for retirement. In any case, as Thaler now argues as well, if down payment requirements rise as housing prices rise relative to other goods, we won't have this problem. There is no way to make such buying as described above prudent.

Justin Ross writes:

If I remember correctly (apologies if I don't), his story for why the housing market serves as a indicator for the overall economy is because of wealth effects (described in the excerpts above). If this story is true, I think it is more likely that people buying houses recognize that they have to care about resale value, just like shareholders do when purchasing stock. The major difference is that housing is far less liquid than stock, allowing it to possibly serve this notice much earlier.

Drewfuss writes:

In both manias and depressions, the housing market does not work right...demand is upward sloping not downward sloping.

Does he mean that the law of demand is no law at all?

Bill writes:

In both manias and depressions, the housing market does not work right...demand is upward sloping not downward sloping.

This is a fallacy that looks only at the price of the home. It ignores the PV all the costs and benefits of home ownership over an extended period of time. Interest rates, expectations of interest rates, expected ROI, tax treatment of both the property and the mortgage, individual tax situations - just a myriad of factors that limit the signaling information contained solely in the price of housing.

Remove every intrusion in the market from the government and I'd bet the demand curve looks more normal. Of course, I haven't read the book, so i don't know if he addresses this.

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