Two helpful critiques of my post on non-hydraulic macro. I will address both of them in more detail below, but let me start by questioning the label "real business cycle model."
Back before I tuned out of academic macro, Franco Modigliani could mock the real business cycle model as treating a downturn as a "mass outbreak of laziness." You could get a real downturn from a productivity shock in a one-good, one-type-of-labor economy. Heterogeneity was not part of he story.
Imagine that we had a central planner. The planner decides what goods to produce and how to distribute them according to his own tastes. The planner does not know the optimal way to allocate resources relative to his tastes, so he arrives at an allocation by trial and error. After enough trial and error, he gets the right number of auto workers, doctors, teachers, and so on.
Then a major event comes along that makes his current allocation wrong. Until he is able to grope his way to the new best allocation, some firms have idle workers and some firms have shortages of workers. In this telling, unemployment results from a calculation problem.
Think of the stimulus package. Why isn't it immediately putting people to work? Because the planners want to put people to work productively, and it takes time to organize projects that do so. They could have hired people 6 months ago to do nothing, but coming up with useful work takes years.
Now, substitute the decentralized market for the planner. We think of the market as this wonderful calculation mechanism, with wages and prices adjusting to get the optimal allocation of resources. But this calculation mechanism, like our planner, works gradually through a process of trial and error. Like our planner, it can be temporarily overwhelmed by the extent of reallocation required.
Think of our current economy as The Great Recalculation. Our planner (the market) is trying to figure out what to do with former mortgage brokers, real estate agents, manufacturing workers, construction workers, and so on. Which of them should wait for their industries to come back? Which ones should switch careers? Which ones need to go back to school? While our planner tries to figure it out, lots of folks remain unemployed, waiting for the planner to give them clear direction.
Perhaps the biggest policy difference between the hydraulic model and the Recalculation model concerns the value of bolstering state budgets. In the hydraulic model, sending money to the states keeps them from tightening their budgets, helps to maintain total demand, and therefore plays a really constructive role in mitigating the downturn.
In the Recalculation model, the challenge is to employ people who have been thrown out of work by the dislocations in the system. Since relatively few state and local government jobs have been lost, but millions of private sector jobs have been lost, throwing money at the states seems unlikely to help with the transition.
If people are retooling I see a huge demand for retraining. Or them accepting very low wages in a new industry but why persistent unemployment. Why doesn't the labor market clear.
There are many labor markets. But why don't they all clear?
My answer is that they are groping, and if wage adjustments were rapid,they might grope inefficiently. A wage drop that is sufficient to clear the market in the short run in, say, construction work, might be so drastic that it would exceed the drop that will be required when the recalculation is all finished. The adjustments that result from rapid wage and price movements might be excessive and destabilizing. They could cause people to shift back and forth too much, incurring all sorts of transition costs. Sluggish wage adjustment reduces the transition costs, but it leads to some unemployment.
Or, it could be the case that wages are just plain sticky and that is a bad thing. It could be that wage stickiness is something that impedes recalculation rather than helps it.
Smith goes on,
how do you get from here to the Fed being able to start a recession. The experience of the early eighties seems to clearly show us that the Fed can.
It is possible that the Fed did cause the recession of the 1980's. It is possible that the Fed raised interest rates, and higher interest rates changed the mix of employment away from housing and consumer durables to other stuff. Maybe the market never even figured out what that "other stuff" was--later in the 1980's interest rates came down, so housing and consumer durables were able to come back.
It is also possible that the Fed had little to do with it. It is possible that bond-holders got tired of being surprised by low ex post real returns, and so interest rates would have gone up regardless of what the Fed did. My personal opinion is that this is what would have happened had the Fed not explicitly changed course, but under Volcker the Fed got the process started sooner.
Finally, Smith asks,
How do we get the Great Depression from here?
We think of it as another Great Recalculation. Compare the economy in 1950 with that in 1930. Huge differences. Land has been taken out of local farming, and instead used for suburbs, with food shipped in from longer distances. Manufacturing is moving out of big cities. Women are a bigger part of the labor force. Many fewer people are being paid to lift and pound, and instead more are doing clerical work.
The theory of Great Recalculations does not imply that the unemployment is benign or that government should not attempt to offer relief. I could easily imagine fiscal or monetary measures that moderate the downturn, because they happen to stimulate temporary employment in ways that do not impede long-term adjustment. However, in practice, we have not yet had proven instances of fiscal and monetary success. (In any event, it is hard to prove success or failure, because we do not have controlled experiments. Already, we are seeing vehement arguments over whether the measures taken over the past eighteen months have worked, and we cannot settle these arguments empirically.)
in the mean time, why should good and willing labour go unused? What digging out is being done, that involves millions of workers sitting around doing nothing while they'd like to be working? Are workers doing penance for the time they spent in, say, the housing construction industry? I suspect that most of the working population is wishing they'd done something differently in terms of occupation or education nearly all the time, and yet this typically doesn't lead to 16% un- and underemployment.
Again, it is possible that fiscal or monetary measures can temporarily put people to work productively. However, I come back to the fact that the fiscal stimulus enacted earlier this year is coming on stream slowly. The market does not have a rapid solution to the Recalculation Problem. But the planner does not have a rapid solution, either.
It is certainly possible that the planner can do things to make the transition less painful. The challenge is to come up with ways to employ the most out-of-demand workers without repressing the signals that tell them how they need to re-tool themselves.