First, I note that Paul Krugman is sounding Austrian. In a follow-up to his longer piece, he writes,
the economy is a complex system of interacting individuals -- and these individuals themselves are complex systems. Neoclassical economics radically oversimplifies both the individuals and the system...even where the evidence clearly shows that they're wrong. What economists have to do is learn to resist that temptation. But doing so will, inevitably, lead to a much messier, less pretty view.
Thanks to Mark Thoma for the pointer. Indeed, every macro story is a simplification. The challenge is to choose the simplification that is most illuminating. The problem with macro in the past thirty years, in my view and apparently also in Krugman's, is that the simplifications were chosen to conform to a particular mathematical/philosophical approach (a "haiku" as Olivier Blanchard aptly put it). Constrained in this way, macro became intellectually sterile.
Here, let me try to tell the Recalculation story in a way that distinguishes it from other stories.
Suppose that there are two industries for transforming present output into future consumption. There is a housing industry, in which you can obtain a house that will provide shelter for many years. And there is a venture capital industry, that will try to pick a portfolio of businesses in which to invest. These businesses have various technologies that might or might not produce dramatic improvements in health care, energy production/efficiency, or computing/communication.
The main drama in this story will concern consumers choosing to allocate their saving between these two industries. Gradual changes in their allocation can be handled with few problems. However, a sudden, dramatic shift will require a major Recalculation.
Some notes about what this story is not about.
1. The story is not about the choice between more roundabout and less roundabout means of production. Both the housing industry and the venture capital industry are roundabout, and we could tell the story even if they were equally roundabout.
2. The story is not about the choice between investment and hoarding, nor is it a story about liquidity preference. Neither housing nor venture capital are liquid (although we may have financial intermediaries that provide liquidity instruments for funding these industries).
Next, suppose that there is a bubble in housing, and when the bubble pops, many people want to put less income into expanding the housing stock and more income into investing in venture capital. This shift disrupts the economy and requires a major recalculation.
The economy needs to reallocate labor away from housing and related industries and into other industries. This means that the composition of the work force has to change, which takes a lot of time. Meanwhile, unemployment rises, which causes further disruption (there are multiplier effects).
In addition, the economy needs to reallocate its financial sector. It needs less banking involved in mortgage funding, and it needs more banking involved in venture capital. This requires changes in skill sets, in the structure of financial institutions, and so forth. Once again, this takes a lot of time, and meanwhile unemployment rises.
The Recalculation story can be thought of as an Austro-Keynesian model. It is Austrian in that it emphasizes the role of markets in processing information. During a Recalculation, there is too much information to be processed in too little time. The story is Keynesian in that during the Recalculation there are multiplier effects. Unemployed people cut back on their spending, and that in turn requires further adjustment, including more temporary unemployment.
The policies that I advocated last year are consistent with the Recalculation story.
1. Cut the employer contribution to the payroll tax. This will lower the price of labor, which at the margin should reduce unemployment. Also, it will increase profits, which will help firms function as financial intermediaries, while we sort out the banks.
2. Don't try to keep people in houses they cannot afford. Instead, give them subsidies to move their belongings to apartments that they can afford. The attempt to bailout home owners just interferes with and prolongs the recalculation.
3. Don't focus on bailout out existing financial institutions. Those institutions are suited toward making mortgage loans that the economy no longer needs. Instead, shut down the insolvent banks and allow a new financial industry to emerge.