Arnold Kling  

Distinguishing Recalculation from Aggregate Demand

Easterly Contra Galbraith... Question for Sumner...

Tyler Cowen writes,

We're also seeing job losses in virtually every sector. It's not for instance a "sectoral shift away from services and into matchstick production and tungsten." It's a shift out of jobs which are revealed as unprofitable and a lot of people not knowing where the new jobs will be created.

If someone wants to insist that "this is really an AD shock, not a sectoral shift," I'm not so keen on fighting to keep one term over the other. I would insist, however, on an issue of substance, namely that not all AD shocks are alike. If we are going to switch terminology, it could be said that this is a real AD shock and not just a nominal AD shock.

Again, I would caution that terms like "aggregate demand" and "aggregate supply" are totally artificial constructs. Back in the real world, the economy has no idea what they mean, and the unemployed have no way of labeling themselves as cyclically or structurally unemployed.

It may be useful to behave as if one had never been taught to think in terms of aggregate demand. Instead, suppose that I had to start with a blank sheet of paper and describe the state of the economy. I would say that the balance between workers exiting declining firms/industries and entering expanding firms/industries has disappeared. Instead, we have had over a year in which exit took place at a faster rate than entry.

Another way to put this is that the economy is only gradually learning where the expanding firms and sectors will be. As it learns more, employment growth will resume.

In the first two decades after the second World War, the recovery from a recession required little or no learning about where expansion was needed. A recession consisted of unemployment among construction workers and factory workers. Once the excess inventory of housing units and/or consumer durable goods was eliminated, jobs in these sectors would come back.

These were recessions in which we knew where the employment gains would take place. The current recession is one in which we do not know this. That is the primary empirical distinction between Recalculation and Aggregate Demand. The more precisely you know where the employment growth is going to take place, the more reasonable it is to think in terms of aggregate demand. On the other hand, if you do not know where job growth will take place, then we must include Recalculation as part of the story.

In the aggregate demand story, the recovery comes from restoring consumer spending. Make consumer credit more readily available, get people buying houses and consumer durables, and the economy will recover.

In the Recalculation Story, the recovery comes from profits in new businesses. As new businesses emerge and earn profits, they expand employment. If you are going to stimulate anything, stimulate business profits. That is why cutting the employer portion of the payroll tax appeals to me.

I have a longstanding bias in favor of profits and internal finance for business. In my first book, Under the Radar, I tried to talk entrepreneurs into selling to customers, not to investors. I said, "Fundraising is not for businesses. Fundraising is for charities." So keep in mind that it could be that my bias in favor of profit-financed business as opposed to investor-financed business is creeping into my macroeconomics.

I am prepared to argue that both the Great Depression and the current recession fit the Recalculation Story. The economy that woke up around 1950 was very different from the one that went to sleep around 1930. The post-Depression economy was much more oriented around gasoline-powered transportation. Farming became concentrated in farm belts and diminished near cities. Manufacturing dispersed out of central cities. Clerical work expanded relative to physical labor.

The biggest problem with the Recalculation Story concerns timing. The economy is restructuring all the time, and for many decades this can proceed smoothly. What is it that throws the economy off of the smooth restructuring path and throws it into Recalculation?

I have sort of a hand-waving answer to this question. I think that what happens during a boom is that you get an accumulation of postponed adjustments and maladjustments. Too many people stay for too long in obsolete occupations and too many people chase illusory opportunities.

A farsighted planner in the 1920's would have stepped in sooner to shrink the farm labor force and expand the clerical labor force. The planner would have reshuffled people into suburban communities, rather than waiting for the second World War to uproot men from their rural communities and urban ethnic enclaves. The planner would have tempered the enthusiasm for highly leveraged bets on electric utilities and automobile manufacturing plants. The planner would have aligned workers with an economy that could transport people and goods over paved roads, with less dependence on rivers or railroads.

A farsighted planner in the past decade would have stepped in sooner to shrink the manufacturing and construction labor force and expand the work force in health care and education. The planner would have tempered the enthusiasm for highly leveraged bets on housing and mortgages. The planner would have aligned workers with an economy that can transmit information wirelessly, with less dependence on paper or traditional telephones.

For a while, the postponed adjustments and maladjustments are papered over by financial enthusiasm. Financial euphoria allows profits and wealth to seemingly persist in spite of accumulating underlying imbalances. When the euphoria breaks, the imbalances are exposed, and it takes a long time to Recalculate.

Still, do not forget Scott Sumner's cyclical theory of cyclical theories. That is, during a boom, there is a tendency to think that macroeconomic stabilization policy is easily accomplished, using simple monetary rules. Right after a crash, people decide that the good times were false (and hence my story about underlying imbalances). As bad times persist, people decide that both the real business cycle and monetary stabilization stories are wrong, and that we need fiscal expansion.

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CATEGORIES: Macroeconomics

COMMENTS (3 to date)
Mitch Oliver writes:

A farsighted planner in the past decade would have stepped in sooner to shrink the manufacturing and construction labor force and expand the work force in health care and education.

It is very sad that the two sectors you target for expansion are thoroughly dominated by government (with maybe more on the way). For this reason, I think recovery from this recession will be a long time coming.

One thing a friend of mine (a former insurance agent) suggested to any recently laid-off/early retired auto workers was to take their lucrative severance and enter a two-year nursing program. Male nurses in particular are in such demand that they can work wherever they want, whenever they want, and nearly for however much money they want.

Matthew C. writes:

I agree wholeheartedly with Mitch. More $$$ on education and health care? Yuck! We already get so little return on investments in these bloated and government-laden sectors of the economy.

If I had to hope / predict where future economic growth "should" go, I would suggest entertainment (books, movies, tv series, computer games, music, performance arts), personal services, tourism, sports, and related services and intellectual property areas.

E. Barandiaran writes:

Arnold, these are some ideas based on reading your posts on the Recalculation story and C. Mulligan’s recent review of macroeconomics (The Economists’ Voice, November 2009).

1. In theoretical models, all relevant terms are totally artificial constructs. Indeed, people have no idea what they mean. To learn about a model one has to spend quite a lot of time understanding the constructs and how they are related. More important, one has to learn how the constructs can be related to reality and the model applied to it. 

2. In economics, most models deal with a few tradeoffs. Thus Mulligan points that the neoclassical growth model deals with two tradeoffs: current and future consumption of an homogenous good, and market and non-market allocation of labor. You may want to expand on that model and add a third tradeoff by introducing two different market goods. Why would you want to do it? Because people differ in many ways, for example, in their abilities as reflected in their comparative advantage (a good example of an artificial construct).

3. Indeed most microeconomic models of markets assume two goods--one that is the focus of the analysis and a second one that could have been produced with the resources used by the first one (usually the second one is a basket of other goods). There have been several attempts to introduce two goods in macro models. My favorite is the one that distinguishes between tradable and nontradable goods. Tradable goods can be produced by all countries and are demanded by the world population--they are traded in world markets. Non-tradable goods cannot be traded abroad because of high transaction costs so they are produced and consumed locally--they are traded in local markets. The relative price between these two types of goods (sometimes called the real exchange rate) becomes the third "key" price of the model (the other two are real the interest rate and the real wage of Mulligan's model).

4. Let us now assume that we want to use the expanded model to analyze what happened in 1998-2007 that might have led to the current recession. We know that 1998-07 was a period of increasing globalization so to apply the model means that for some goods (say cars) there are world markets and for others (say housing) there are local (say country) markets. Cars have the same price in all countries. Housing has different prices across countries. This is not a model of the US economy, it’s a model of the world economy. To explain the current recession, I have to go beyond what happened in the US economy at the time it started. Mulligan focuses on the US economy and argues that labor supply shocks have been critical to explain both the Great Depression and the current recession. I believe that once the focus is changed to the world economy and to what happened during the period leading to the recession, one can argue that a positive productivity shock in the supply of tradable goods has been critical for the expansion of the world economy in 1998-2007 and the subsequent crisis. The expansion would be largely the result of the emergence of China, India and a few other countries as suppliers of a variety of tradable goods, whereas the subsequent recession would be a consequence of distorsions that the shock brought about in developed countries. From the perspective of the US economy, it may look as if the recession were the result of a consumption shock (in particular, too much current consumption of non-tradable goods) or a labor shock (too much labor allocated to markets), but from the viewpoint of the world economy is the result of the large increase in the production of tradable goods brought about by the productivity shock.

5. Since I have lived most of my life in the “world economy” and not in the US economy, I look first at what happens in the world economy and then I ask myself how the US economy relates to it. Both Mulligan and you analyze the US economy and mostly ignore what is happening in the rest of the world. In addition, Mulligan’s analysis and to a lesser extent your analysis is focused on the crisis without paying enough attention to what happened for many years before the crisis. Your analysis ignores the analytical work that has been done on “small open economies” where at least two types of goods have always been recognized.

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