Arnold Kling  

Paul Krugman asks a Question

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He argues that the Recalculation story falls apart


when you ask why, say, a housing boom -- which requires shifting resources into housing -- doesn't produce the same kind of unemployment as a housing bust that shifts resources out of housing.

This is a good question. I would say that answer may be that the dynamics of booms and busts are asymmetric.

Note that the housing boom took place slowly, and it built up over a period of years. Several economists, Krugman included as I recall, were already talking about a housing bubble in 2004, even though in hindsight the biggest price excesses were still to come. So the housing boom must go back even further, to at least the late 1990s. In contrast, the collapse of house prices took less than two years (assuming they have bottomed out, which may be a brave assumption).

I think it is reasonable to generalize this notion that booms are longer and relatively gradual, while busts are sudden. If this generalization holds, then it ought to be harder for the economy to adjust to a bust than to a boom.

As an aside, I do not want to associate myself with the view that Krugman finds in Schumpeter, which is that the unemployment of a recession is a good thing. Instead, I am telling a descriptive story. Imagine the economy being run by an imperfect central planner (the market), which finds itself for a period of time unable to come up with productive uses for an unusually large number of workers.

This Recalculation story does not imply that government can do nothing or should do nothing about unemployment. On the contrary, it suggests that the market is faltering. However, the Recalculation story does say that it matters how the government tries to redirect resources. If it increases demand where demand already is sufficient, or if it increases demand in sectors where the needs are only temporary, it is not helping.

One advantage of something like a payroll tax cut (or an employment subsidy, which is the same thing but sounds better to people on the Left), is that it does not require government planners to make the right guesses about which firms or industries should expand. Another advantage is that a payroll tax cut can start right away, without having to wait for bureaucrats to go through the procedural hoops needed for spending. One disadvantage of throwing money at state and local governments is that the contraction in that sector has been miniscule compared with the contraction in the private sector, and in fact in the long run we may need some contraction in the state and local government sector.

The Recalculation story does not tell me that we should drop the concept of stimulus and balance the Federal Budget. However, it tells me that we should not use a crude, aggregative notion of macro to justify what looks to me like a permanent transfer of resources and power from the private sector to government.

UPDATE: Russ Roberts says more about asymmetry. Also, Alex Tabarrok emails me a link to a paper by Bloom, Floetotto, and Jaimovich that uses Dark Age macro to argue that variations in uncertainty are a cause of recessions. When uncertainty rises,


firms become cautious and postpone decisions. Productivity growth falls since reallocation across production units pauses when uncertainty is high. Once uncertainty falls back down activity quickly resumes as firms address their pent-up demand.

Again, too much Dark Age macro for my taste, but I think that uncertainty and hesitancy are an important issues to consider.


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CATEGORIES: Macroeconomics



COMMENTS (25 to date)
Ryan writes:

The answer to Krugman's question seems (suspiciously?) obvious: velocity. In a boom environment spending occurs more rapidly, and although resources may be shifted toward the booming industry, the non-booming industries are, to some extent, benefiting from the velocity at which boom money filters to non-boom areas. In a bust, you have the struggling industry being kicked while it's down because of reduced spending velocity.

wm13 writes:

"it is reasonable to generalize this notion that booms are longer and relatively gradual"

I think this follows from the second law of thermydynamics: creating a complex structure is difficult, whereas destroying one is much easier.

fundamentalist writes:

Here is an interesting example of recalculation that took place in Germany in the hyperinflation of the 1920's:

V. THE MOVEMENT OF THE WORKING CLASSES TOWARDS INDUSTRIES PRODUCING GOODS FOR DIRECT CONSUMPTION
10. After the monetary stabilization the working classes were moving in a direction opposite to that which had occurred during the inflation. The number of men employed in the mining and iron and steel industries decreased and they turned instead to agriculture and the building industries. Miners who had come originally from the eastern agricultural districts began to return to their old homes and former occupations. From some mining districts of the Ruhr emigration was so great that some towns were almost depopulated. Towards the end of September 1925 the total number of Ruhr miners was reduced to little more than 400,000 (from 562,174 at the end of 1922), which was even lower than the 1913 figure (at the end of the year: 420,000). The same phenomenon appeared in the iron and steel industry. According to the statistics of the "north-west group of the Iron and Steel Union," in 1925 the number of workers had fallen from 260,000 in 1913 to 190,000 and that in spite of the entry of new companies into the Union. During 1925 the raw steel syndicate was obliged to reduce the quota assigned to each firm, at first by 10 per cent (January), later by 15 per cent (March), 20 per cent (June), and finally by 35 per cent (September).* Even the non-ferrous metal industries proceeded to close firms and discharge workmen, but to a much less degree than in the iron industry. Another example is the number of men employed in the shipyards: in the principal ones in 1913, 49,744 men were employed; more than 100,000 in 1921; 33,456 in 1924, and 27,812 in 1925.
These are only examples of special cases. But in a more general way the movement of the working masses is revealed by the following figures.

TABLE XXXVIII
NUMBER OF MEN EMPLOYED IN

Industries producing
means of production
Percentage
Industries producing
direct-connsumption goods
Percentage

1913 6,732,354 7O-4 2,829,632 29-6
1922 7,277,795 72-3 2,787,565 27-7
1923 6,262,079 73-5 2,253,159 26-5
1924 6,143,302 68-5 2,800,780 31-3


In 1922, compared with 1913, the number of workers employed in the industries for goods for direct consumption had fallen, and that of men in the first broad class of industries had risen. In 1923, as a result of the serious general economic crisis in both of the categories the number of workmen fell, but comparatively less in the industries producing the means of production. In 1924 the opposite movement began and the number of workers employed in the industries producing direct-consumption goods suffered a considerable increase, both absolutely and relatively.

P. 371 The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany by Constantino Bresciani-Turroni 1937

Bill writes:

Why do I keep thinking that at the end of your recalcualtion journey, you are going to find ABCT?

I think the question from PK is a silly one that ignores the expansion in credit/easy money that causes the boom, much more so than any capital shifting from other industries.

Even if resources did shift (and not expand) during a boom, why would there be an *aggregate* increase in unemployment? Especially into something as labor intensive as housing. Maybe I'm just thick and am not understanding this.

winterspeak writes:

Glad that you are warming up to the idea of a payroll tax cut, although your "employer only" implementation is miserly, and further interferes with the non-Govt sector recalculating its desired level of net savings.

"The Recalculation story does not tell me that we should drop the concept of stimulus and balance the Federal Budget." True, the recalculation story says nothing about stimulus and budgets because it completely ignores the balance sheet elements of net Non-Govt savings.

Until the Recalculation story also includes balance sheets and financial accounting, it will be incomplete, and lead to bad recommendations.

SRF writes:

I also think that Recalculation sounds suspiciously like the Austrian Business Cycle Theory. Why don't you just subscribe to that? I've yet to come across a good refutation...

Anyhow isn't the answer to Krugman much simpler: In a boom people who ALREADY HAVE JOBS are bid away into the boom industries by higher wages. When the bubble pops all those new jobs at higher wages can no longer be supported, but everyone obviously can't just go back to their old jobs. An adjustment period of unemployment is required to re-absorb them.

Am I missing something here?

Dave writes:

Mish addressed Krugman's Hangover Theory post. Very relevant to the current conversation.

downunder writes:

So Krugman wants to know why unemployment does not go up when the Federal Reserve is pumping billions of dollars into the economy? I thought this guy was a Keynesian, or have I missed something here?

Larry writes:

"...a payroll tax cut...does not require government planners to make the right guesses about which firms or industries should expand."

True, but we know that state government payrolls will recover post-decline. I.e., there's not going to be any recalculation there (although it would be nice.) Thus, subsidizing them is truly counter-cyclical.

A sales tax holiday is superior to payroll tax cuts, because:

- it helps every consumer
- it's less biased (toward labor-intensive employers)
- it encourages people to spend, which is what changed (people still want to work) and is therefore countercyclical

Jacob Oost writes:

To answer the Krugster, I believe that credit booms borrow resources from the *future*, which is why we don't see unemployment of the kind he is discussing.

Gu Si Fang writes:

Your story and Russ Robert's say it all : the boom and bust are asymetrical from the point of view of entrepreneurs' expectations.

During the boom, entrepreneurs believe that they know the consumers' needs. Their past investments sometimes turn out slightly differently from what they had expected. But these are normal, marginal errors. Therefore, they don't suspect that price signals have been distorted. It is only ex post that they will be able to tell that their expectations were wrong. Meanwhile, prices are going up. Do consumers want more houses? Let's invest and hire. Does it turn out ok? Let's hire more...

During the bust, it's different. Asset prices change brutally and past investments clearly turn sour. Entrepreneurs immediately realize that their expecations of consumers' needs had been wrong. Where to invest? What to produce? Why hire when you don't know, and you know you don't know?

Lord writes:

The argument is not one of asymmetry but why the absence of other booms attracting the resources as they are freed up. The asymmetry may induce a temporary sectoral unemployment, but does not justify general broadbased unemployment. Why can the economy only do one thing at a time?

Gu Si Fang writes:

@ Lord

It is investors who pays wages, and if some people who have resources to invest don't invest them, that's not necessarily going to be compensated in another sector. So let's say people stop hiring in the real estate, automobile and financial sectors, and ultimately more people are needed in the (say) clothing and food sectors. How much more should you invest and hire in food and clothing? How much scarce physical and human capital should be removed from one side of the economy and put elsewhere? My understanding of the recalculation story is that this is a tough decision and people will not make large moves until they are confident enough about the future consumer needs. Until that occurs, better keep your capital at hand than spoil it in the wrong venture.

Adam writes:

Simple answer:

Booms create jobs
Busts destroy jobs

wjd123 writes:

Ah yes, the consumer needs a lot of things. That's not the question, the question is what can the consumer afford. If he or she is unemployed, or employed at subsistence wages consumption will be the least where needs are the greatest.

The answer is a government exchange that will hire and train anyone willing to work. And since public interests have gone begging for years there is plenty of work for government to find.

The minimum wage should be at least $15.00 an hour with FICA tax taken out so workers can continue on their way to being invested in Social Security. Also a basic portable health care policy should come with the job.

These exchange workers will spend, not only because their needs are great but also because they will feel secure in their employment.

However in order to keep the stimulus to our economy going these workers will need to buy American. Tariffs should be reintroduced to bring about a balance of trade with China. For those industrialized countries which have democracy, freedom of association, and the ability to enforce rules and regulations this won't be necessary, they can compete under a canopy of procedural fairness.

Employers will have less power over employees. It will be harder for them to retard wages. More taxes will be collected to pay for services and a virtuous cycle can ensue once we get through the transition phase.

The transition for putting Americans back to work and stabilizing our society should be payed for--since it's not going to pay for itself--not only through tariffs and increased tax receipts from the employed but by taxing the rich and eliminating corporate loopholes. Other progressive taxes can follow.

We can't get to this virtuous cycle of stability and harmony until income inequality in our country is addressed and the new economy is no longer based on bubbles.


bakho writes:

A key problem for the US labor market is the lack of job creation 2001-present. Backward policies failed to promote the emergence of new sectors that would create the jobs and inhibited investment. Two examples are 1) uncertainties in the energy area that have allowed the Europeans to get a jump on the US in wind power and other alternative energies, failures to invest in upgrades to the power grid that must be in place for new technologies to succeed and policies that allowed BigOil to collect record profits instead of allowing those dollars to be invested in alternatives. and 2) failure to expand broadband access and allowing corporations to collect rents by monopolizing access rather than requiring them to make money through innovation. There are many more failures to create jobs because short term greed was promoted over long term sustainability. The utter failure at net job creation is the legacy of Bush policy failures.

The lack of job creation was papered over by the housing bubble. Labor was employed building too many too big houses, a recipe for the collapse of employment in construction. Government employment increased during this period providing additional cover for the lack of job creation.

Once the housing bubble burst, the failed policies for lack of sustainable job creation were fully exposed. We are faced with a situation where 10 years of opportunity have been squandered. We need to finally start doing what we should have been doing for the last 8 years, investing resources into areas that are sustainable.

fundamentalist writes:

Booms and busts are asymmetric for a very simple reason. Free capital, such as money, is easily converted into fixed capital, such as buildings. That happens slowly as the expansion progresses. However, when the bust happens, it's darn near impossible to convert fixed capital back into free capital for reallocation elsewhere. Instead, those fixed assets lose value.

Michael Turner writes:

"One advantage of something like a payroll tax cut (or an employment subsidy, which is the same thing but sounds better to people on the Left), ..."

With no apologies to "people on the Left", whoever they might be, an employment subsidy is, at best, "the same thing" only down to the point where payroll taxes have been cut to zero. After that, if you go to some kind of "negative tax" (true employment subsidy), that subsidy will also go into bubble businesses. And that is tantamount to government planners saying that investment in those sectors was good because, for a while, the market said so. But if you don't have a 100% cut in the payroll tax, it reflects the same government concurrence with the same market misjudgment. So your argument that a payroll tax/employment subsidy "does not require government planners to make the right guesses about which firms or industries should expand" isn't very persuasive: it's basically saying the market always comes up with better answers than government, no matter how catastrophically bad the market's answers have already proved to be. If the recession was caused by a market failure, why treat all investment classes equally? And how much worse could the government's investment choices be, especially if most of the money goes toward work that the government would have funded anyway, eventually if not sooner, such infrastructure development and repairs, which will pay public-good dividends for a long time hence?

andy writes:

Couldn't it just be that during boom people move from one industry to another - because they know they are in a good position and see a better one, while during a bust they are simply in a bad position where unemployment is actually BETTER then what was before (i.e. you are working in a company and get paid nothing, a company is losing more money every month)?
I mean unemployment in a recession is a better phase then to remain employed (and get paid nothing), while during a boom it usually is not?

Boonton writes:

Arnold,

Here is my beef/concern about recalculation. Basically it sounds like just a dressed up version of Krugman/Keynes.

Let's take a simple model. Suppose an economy has too much housing and too little healthcare. A crash comes in housing to be followed by a boom in health. Let's look at two variations of the model:

Perfect planning or recalculation happens in an instant - The bust in homes is immediately followed by a boom in healthcare. Unemployed housing workers are reemployed in health. If its the case that housing workers lack the skills of health workers, wages for healthcare workers soars while home workers collapse. In theory the wage differential will create the incentive for home workers to get the needed training to get jobs in healthcare. Alternatively healthcare workers can use their higher incomes to help out unemployed house workers (i.e. the unemployed real estate agent can marry a nurse).

Time lag- Here the economy needs time to figure out that health is the 'answer' to recalculation but it knows in an instant housing has grown too much. House workers are unemployed but since the economy doesn't know health is the answer yet there's no great immediate increase in healthcare wages. Since there's no visible change in health wages there's no price signal to tell home workers, the gov't, the economy that healthcare is where to go to catch the next big thing.

My problem with your model is that its missing a rational response to this:

Time lag w/probs - Demand falls in housing, doesn't appear in healthcare right away. Since no one knows that health is the next big thing yet, speculators seek out opportunities in multiple sectors. Dot coms are tried. Avon businesses are started. Cell phone stores are opened. Someone tries to start a 'anti-Obama t-shirt of the month' club and so on.

Here the economy exercises a type of 'conservation of demand'. Destroyed demand in housing shows up as new demand in 'probs' or 'startups' until it centers on healthcare and that becomes the next new wave of innovation and growth.

Your model, though, seems to be asserting that the economy is so spooked by the crash in housing that demand doesn't show up in 'probs'. Demand is scared crapless and is hiding under the mattress. That results in basically a collapse in 'animal spirits', panic and a liquidity trap (lower interest rates don't help, investors won't invest because demand won't even try to spend).

You've basically retold the Krugman/Keynes/De Long story but inserted a rather antiseptic sounding term you call 'recalculation' which doesn't really capture the spirit of things IMO.

And you still arrive at the same place. Stimulus in such a situation makes sense. You would rather stimulus be broad based, like a payroll tax cut. But the stimulus package was more or less broad based. You had payroll tax cuts, unemployment/food stamp extensions and yes state aid that mostly went to Medicaid spending for....those left unemployed by this recalculation.

You would caution that stimulus shouldn't try to pick winners or massively reallocate resources. OK but even Keynes more or less said that. He said throw money in bottles and bury it in caves if you absolutely must....but its better to spend it on useful things. The infrastructure portion of the stimulus was modest and mostly represented accelerating spending of things that were going to be done anyway. I'm not seeing anyone advocating that we should try to recreate the real estate bubble or 'pick winners'. Only keep the system from collapsing until the economy figures out where it wants to find the next wave of growth again.

ech writes:

One factor that doesn't seem to be addressed by anyone: in the sunbelt, much of the semi-skilled labor in housing is provided by illegal immigrants. I live in Houston, where I have seen estimates that as many as 80% of the labor in homebuilding is provided by illegal alien day workers. Roofing, drywall, and painting seem dominated by immigrants.

Using the 80% figure for proportion of illegals in construction and some pre-bust unemployment numbers for Harris County, TX, I found that if all the illegals went home at once, you could employ every unemployed person in the county in construction. Of course, many of them couldn't fill the jobs due to skill set, age, strenght, child care issues, etc. (Roofers work from 7 AM until dark on every day without rain, for example. Not optimal for a single mom.)

Philo writes:

"Imagine the economy being run by an imperfect central planner (the market), which finds itself for a period of time unable to come up with productive uses for an unusually large number of workers."

It might find itself unable confidently to assign workers to *optimally, or nearly optimally*, productive jobs. But how could it be unable to assign workers to jobs that, it was confident, were *more productive than unemployment*?

Steve Sailer writes:

Yes, clearly, immigration absorbed much of the increase in employment generated by housing construction and home remodeling. American blue collar guys in the Rust Belt normally would have moved to places like Las Vegas to build stuff if wages had gone up. But immigrants, legal and illegal, were keeping the wages down, so the Americans got left in the Rust Belt.

Boonton writes:

Free capital, such as money, is easily converted into fixed capital, such as buildings. That happens slowly as the expansion progresses. However, when the bust happens, it's darn near impossible to convert fixed capital back into free capital for reallocation elsewhere. Instead, those fixed assets lose value.


This brings to mind a mental image from the notes of one of De Long's pdf lectures. During the Great Depression unemployed families shifted through the dirt for discared bits of coal to keep warm. Meanwhile the coal that could by operating just a day a week provide these poor people many times the coal they found, sat idle and rusting.

A poorly produced fixed asset is almost always more sensibly put to some use rather than no use at all. If 10%, 15%, or 20% of the economy must sit idle for an extended period of time this represents a tremendous loss of potential output and income....income that could be partially channelled into The NExt Great Thing(tm).

There are probably some assets that are best left to rust. I can imagine, perhaps, homes in new developments that are hundreds of miles away from useful jobs. But this is a very small set of fixed assets. Even the thousands of miles of 'dark cable' that was strung during the dot com bubble found use carrying ultra-cheap phone calls and broadband access for everyone.

Those who advocate avoiding stimulus and enduring a worse recession are advocating a policy with a great cost. The greater that cost the greater must the eventual benefit be to justify it. Optimalization may mean Detroit should have even fewer car factories left but that doesn't mean that the factories that exist in Detroit magically turn into liquid capital by sitting on the ground rusting. Rust just turns to dirt, not checking account balances.

Nir Jaimovich writes:

Hi,

I am one of the authors that Mr. Kling referred to above when he said "Also, Alex Tabarrok emails me a link to a paper by Bloom, Floetotto, and Jaimovich that uses Dark Age macro to argue that variations in uncertainty are a cause of recessions."

Since the paper was classified as "Dark Age Macro" I was wondering if you could clarify what that label exactly means (are all models with optimization/rationality classified as dark age? Just if they have one of those elements?)

Thanks,

Nir

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