Arnold Kling  

Rethinking Macroeconomics, Continued

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Two links to discuss in this post. First, David Altig discusses the "output gap," which I put in scare quotes because it is a concept that I am about to attack. Pointer from the indispensable Mark Thoma, who also provided the link to the Ray Fair paper I will discuss second.

1.The output gap

You might not know it from Altig's post, but the debate over the output gap can get quite heated. See Greg Mankiw.

I think it is misleading to speak of the output gap. It is part of what I call "hydraulic macro," which thinks of the economy as producing a single good with a single type of labor and a single type of capital. As I stated here and expanded on here, I think that this is a dangerous simplification.

Macro makes a number of simplifying assumptions. There is a longstanding battle over the rationality assumption. Akerlof and Shiller's book, Animal Spirits, is one huge attack on the rationality assumption. I am sympathetic to that attack. My problem with their book is the implicit assumption that there is no irrationality in government. It is as if one goes from having animal spirits to being perfectly rational simply by switching from the private sector to the public.

But I think that the simplifying assumption of homogeneous output, labor, and capital is equally dangerous. My claim (which is not original with me--it is recognizably Austrian) is that a recession can be thought of as a recalculation. Imagine a central planner who decides to radically change plans. He has a huge recalculation to make in order to figure out where to allocate labor and capital. He says to some people, "Wait a minute. I am thinking. Some of you just have to stand idle while I figure this out."

The market economy is like that central planner. We are undergoing a Great Recalculation.

In macro, we teach that there are different types of unemployment: structural unemployment, where there is a mismatch between skills and needs; frictional unemployment, where the skills and jobs match up in theory, but in practice people are stuck in the search process having not yet found the right match; and cyclical unemployment, where people are unemployed because of inadequate aggregate demand.

People who are out of a job cannot really tell the difference--they could not tell you whether their unemployment is structural, frictional, or cyclical. As an economist, I would say that if you are laid off from a manufacturing firm that accumulated excess inventory and you will be recalled once the inventory is worked off, then you are cyclically unemployed. Otherwise, I cannot tell why you are unemployed.

Up until about 1980, most of the unemployment in a recession was unemployment that I would recognize as cyclical. However, certainly since 2000, most of the unemployment has not met my definition of cyclical.

The old-fashioned inventory recessions involved one class of miscalculations--firms over-produced relative to demand, and then had to cut back for a while. Those miscalculations are less important today, in part because computerized inventory and integrated supply chains tighten the connection between production plans and reality, and in part because a lot of the actual production of stuff for U.S. consumption is done overseas, so our inventory miscalculations affect foreign workers relatively more and U.S. workers relatively less.

The recalculation that followed the Dotcom bubble was different. So is the current situation, which I call the Great 21st-century Recalculation. (The 1930's might be called the Great 20th-century Recalculation.)

In conventional, hydraulic macro, we think in terms of this one good called GDP, and the output gap is the difference between how much of this GDP stuff we could produce if everybody were working and how much we are actually producing with all the unemployment over and above "normal." We assume that "normal" unemployment, which is structural and frictional, is some roughly constant fraction of the labor force.

The way I look at things, we have a huge amount of structural and frictional unemployment these days. There is very little cyclical unemployment--limited to autos and household durable goods. If you measure the output gap using my definition of cyclical unemployment, then the output gap is tiny.

But I think it is better to drop the concept of the output gap altogether. Let us just say that we are in the middle of a Great Recalculation. Before the housing bubble popped and we figured out that our housing and financial sectors were messed up, we had something like full employment. Now, we need a Great Recalculation to figure out a new allocation of skills and jobs that gets us back to full employment. Because we got so messed up before, it will take years for the recalculation to be completed. Meanwhile, if you insist on thinking in terms of a large output gap, you are talking about an imaginary world in which the Recalculation takes place instantaneously. What you are not talking about is a gap that can be closed with government action, unless the government miraculously does the Recalculation faster and more effectively than the market.

2. Macro forecasting

Ray Fair has a new paper. Ray is the last macroeconomic forecaster left in academia. In fact, he was already the last macro forecaster in academia in 1977, when he visited MIT to teach a course in the macro sequence, where I remember John Huizinga sitting in the back of the classroom laughing at the fact that every equation in Fair's model used the lagged dependent variable. See The Lost History of Macroeconometrics.

In his latest paper, he says that what made it impossible to forecast the current recession was a combination of not knowing the path for: house prices, equity prices, import prices, exports, and random shocks. If you had known all of those, you could have forecast the recession. Not knowing those, from a forecasting point of view it was a "perfect storm."

The way I would put it is that macroeconometric models built on the assumption of one good called GDP and one type of labor work fine as long as nothing happens in the economy that requires a major recalculation. But once something dramatic occurs, all bets are off. Obviously, that does not leave me highly enamored of macroeconometric models, but you already knew that.


Comments and Sharing





COMMENTS (15 to date)
Adam writes:

Professor Kling,

Do you think you could write one post that just concisely summarizes the whole recalculation model? I find it very interesting.

Mike writes:

Self-proclaimed progressive and devout Paul Krugman follower here.

However, I completely and whole-heartedly agree with everything written in this post.

Hmmm.

El Presidente writes:

Arnold,

How is it that these events that prompt recalculation are so thoroughly exogenous? Aren't they caused predominantly by human behavior?

I'm with you on respecting the diversity of output, capital and labor. More precision is better as we attempt to make sense of our economy. Why then do we not include land in our production function? Precision is better when we talk about labor and capital, but even mentioning the output of land is taboo? Let's be consistent. Let's think comprehensively so that our modeling can improve. Then we can improve focus without losing perspective.

Arnold Kling writes:

Adam,
If anything, I probably would revise and extend the posts that I called "lectures in macroeconomics." I put those all together on this page.

Adam writes:

I remember them; glad to see you consolidated them to one page. Thanks for the pointer!

Robert writes:

It's a very persuasive theory and it's probably true in part, but this amateur doesn't fully buy it. My real-life experience tells me that it is not very difficult to train for most jobs, assuming the person is smart and not completely close-minded and inflexible.

fundamentalist writes:

What makes the recalculation necessary in the first place?

Jake McCloskey writes:

I probably would have agreed with you a few months ago but now I'm not so sure. Generally, structural unemployment should be accompanied by growing industries. This happened immediately after the housing crash- some sectors of the economy began to grow to "pick up the slack" as it were. Right now, almost all industries are shrinking.

While there certainly is a structural change going on, to say that there is no demand "deficiency" seems wrong. Even if it were initially just structural unemployment, if there were no growing sectors then there would eventually be demand deficiency.

To say that it is all structural, you would have to think that all industries were being propped up by the distortions in the financial sector. But banking and finance are relatively stable right now and so you would have to have a pretty pessimistic view of the market's ability to recalculate if it hasn't started to recover by now.

quadrupole writes:

I've often thought something similar, though less succinct.

The market recalculates constantly. Usually the recalculation is nice and smoothly continuous, so it lives mostly at the microlevel.

Occasionally, a major recalculation, larger than can smoothly and continuously be processed occurs.

The natural question is: why?

My gut feeling is because something has delayed the normal continuous recalculation problem. Think of it as pent up demand for recalculation. Then, at some point, that becomes unsustainable and the amount of recalculation that has to happen is larger than the market can compute all at once.

Wilmot writes:

Sounds particularly Schumpetarian. The economy is sick and the recalculation is it's medicine. As the doctor, I don't care if the medicine tastes good or not.

You're going to take your medicine and like it.

That's a hard sell for a lot of political types but I think it's observably and logically consistent that markets will rise and fall naturally - and probably faster absent government interference.


For all the talk about spiraling depressions, I have to ask whether it's even feasibly possible to have one. After all, wouldn't a depression just create too many opportunities for arbitrage? I can't see a recession ever lasting in an unregulated economy simply because falling prices and increasing margins are too tempting for investors to pass up on.

El Presidente writes:

quadrupole,

Occasionally, a major recalculation, larger than can smoothly and continuously be processed occurs.

The natural question is: why?

My gut feeling is because something has delayed the normal continuous recalculation problem.

People want to go up, not down. Upward movement takes two forms: up-and-up, or up-and-down. The first is a wealth/income effect; a genuine sustained increase in standard of living. The second is a bubble or cycle; a temporary increase that is not sustainable, at least in part. The incentive for each is the same: we want more. When we get them confused and pursue the latter, we get a crash or a recession.

There are two important questions that follow:

1. How can we tell the difference between them before or while they occur?

2. Is there some reason why any of us would want to confuse these two types of movement?

Then, there is a third:

3. What should we do about it?

If we can tell the difference based on severly disproportionate growth in output relative to long-run equilibrium and/or severly disproportionate growth between industries, then the pattern should have something to do with rents and speculation. That will inform the answer to the third question.

Skeptikos writes:

Recalculation sounds similar to real business cycle theory...

Deryl G writes:

fundamentalist writes:

What makes the recalculation necessary in the first place?

Too much capital is invested in inefficient production. For some reason a lot of capital was invested in the housing industry and now it has to move to more efficient areas.

If your question is why do the capital flow into housing, then I have a couple of answers. Some people would say loose monetary policy + government created incentives (taxes for instance).

I think others would claim it is because of irrational exuberance. The housing market was booming, so people would invest more money, which would cause a bigger boom. Rinse and repeat.

I'm sure there are other reasons that I'm unaware of. I hope someone (or ones) will post them.

Hal Varian writes:

The recalculation model is appealing, but is there any empirical evidence for it? I don't think that the 1930s would provide useful evidence since the production patterns after the Great Depression were obviously different than before due to WW II.

But will employment patterns be dramatically different in 2011 than in 2007 as compared, say, to changes during a 4-year period without a recession? I would guess "no", but I could be wrong.

If private savings and exports increase, and imports decrease, we should see some shifts in employment patterns but would it be noticeable?

Mike Rulle writes:

I assume you were being "ironic" on Prof. Fair. If we knew the future about a lot of things I suppose we would have many more options available to us.

Re: your recalculation concept. Isn't "Austrian" economics the study of the constant and continuous "recalculation". Consistent, I believe, with this is the notion that "economic threats or promised economic behavior" by the central government interferes with that continuous calculation.

Arguably, we have part "great recalculation" and part interference into the constant and continuous recalculation--thus making that size of the current recalculation problem larger than it need be.

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