Arnold Kling  

The Macro Doubtbook, Installment 2

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The first installment was The Northwest Passage. An excerpt from the second installment, called General Equilibrium Theory:


suppose that unemployment did not exist, but that instead there was a very low-value job (say, dishwashing) that is always available, at whatever wage will clear the market. In that case, we would always have full employment. However, I would argue that we could still observe recessions in such an economy. During good times, the only dishwashers would be people who have no other skills. During a recession, many skilled people would be working as dishwashers, and they would drive down the wages of dishwashers. Income would be much lower in a recession, even though there is full employment.

This dishwasher story is my argument against one commonly-held view about macroeconomics. That view says that recessions are a product of inflexible prices and wages. Or, to put it another way, a common view is that if wages were fully flexible, then the labor market would clear, and we would not have unemployment. In the dishwasher story, the labor market clears in the sense that everyone is employed, but the economy is generating a low level of output and income, and workers are not fully utilizing their skills. We see that simply increasing the willingness of workers to accept low wages is not a cure-all. Still, it may be that wage stickiness in high-skill labor markets might be the problem that lies in the background in the dishwasher story.


The whole installment is below.

General Equilibrium

If you did not know that there was such a place as macroeconomics and you wanted to get there, you probably would start down the path of general equilibrium theory. That is because general equilibrium theory keeps track of everything. All income is allocated. When resources leave one sector, they go somewhere else.

It is tempting to say that macroeconomics can neither live with the theory of general equilibrium nor live without it. Macroeconomics cannot live with general equilibrium theory in the sense that the general equilibrium path usually leads in the direction of predicting full employment. However, macroeconomics cannot live without general equilibrium theory in the sense that partial equilibrium theories tend to leave troubling gaps of logic.

Suppose that an economy is presented with the invention of a low-cost, labor-saving machine for harvesting wheat. In a microeconomics class, a professor might ask:

1.What happens to the price of wheat and to the quantity of wheat consumed?
2.What happens to the wages of labor and to the quantity of workers engaged in wheat production?1

General equilibrium theory asks, "What else happens?" As consumers buy more wheat, do they buy less of something else? Their purchasing power has risen, and how do they choose to allocate the additional income? If the number of workers in wheat production changes, where do the displaced workers go to or come from?

Economists are particularly careful to ask "what else happens?" when we analyze international trade. Suppose that cheap Japanese televisions displace domestic American production. The general equilibrium theorist is trained to ask what the Japanese do with their American dollars and what happens to the capital and labor that leave the American television industry. In the simplest general equilibrium model, with only two countries, two goods, and no savings, the capital and labor shift to precisely the industry that produces the good on which the Japanese will spend their dollars.

If you do not think in general equilibrium terms, it is likely to seem obvious that the cheap Japanese televisions reduce the income of Americans. In the full general equilibrium story, the result is more likely to be the opposite.

Trade increases income. The more that people consume goods that they do not produce, the better off they are. Our measures of economic activity take this proposition to extremes. If I cook my dinner and you cook yours, then the value of our cooking does not count as GDP, and my work does not count as employment. However, if I pay for dinner in your restaurant and you pay for dinner in my restaurant, then our cooking does enter into GDP, and both of us are counted as employed.

In general, if I am employed in the market, the output produced during my work hours counts as economic activity. However, if I am not producing for a market, then none of my output counts as GDP. As fas as measured economic activity is concerned, when I am not doing market work it makes no difference whether I take a nap or repair my air conditioner. Neither use of my time counts.

If one wished to be contrary, one could argue that what we call a recession is merely an artifact of failing to properly count the value of leisure and household production. If people stay home, this line of thinking goes, then they are doing something more valuable than what they could produce in the market. However, they are no longer counted as employed and their leisure and home production are not included in GDP.

Most economists would say that it is wrong to go down this particular contrarian path. As Franco Modigliani once put it, was the Great Depression nothing but an outbreak of laziness? Instead, we believe that there is such a thing as involuntary unemployment. We believe that in a recession the market activity that people forego because they are unable to find employment is more valuable than the non-market activity in which they engage.

The Dishwasher Story

To press this point further, suppose that unemployment did not exist, but that instead there was a very low-value job (say, dishwashing) that is always available, at whatever wage will clear the market. In that case, we would always have full employment. However, I would argue that we could still observe recessions in such an economy. During good times, the only dishwashers would be people who have no other skills. During a recession, many skilled people would be working as dishwashers, and they would drive down the wages of dishwashers. Income would be much lower in a recession, even though there is full employment.

This dishwasher story is my argument against one commonly-held view about macroeconomics. That view says that recessions are a product of inflexible prices and wages. Or, to put it another way, a common view is that if wages were fully flexible, then the labor market would clear, and we would not have unemployment. In the dishwasher story, the labor market clears in the sense that everyone is employed, but the economy is generating a low level of output and income, and workers are not fully utilizing their skills. We see that simply increasing the willingness of workers to accept low wages is not a cure-all. Still, it may be that wage stickiness in high-skill labor markets might be the problem that lies in the background in the dishwasher story.

Liquidity Preference

General equilibrium theory looks at economic activity as trading. We do not separate the act of supply from the act of demand. I produce because I want to consume. The theory of general overproduction, so intuitively plausible to laymen, violates general equilibrium.

For example, during the Great Depression, many experts argued that the problem was overproduction, due to supply outstripping demand. This view was held particularly strongly about agriculture, where it was suggested that as technology improved, the prices for crops fell, farmers tried to restore their incomes by producing more, driving prices down further, creating a vicious cycle of impoverishment.

From the standpoint of general equilibrium, the story of agricultural overproduction invites the question, "what else happens?" If productivity increases faster than demand in one industry, then it is necessarily the case that demand grows faster than productivity in some other industry. The general equilibrium result is for workers to shift from the former to the latter.

John Maynard Keynes addressed this challenge of reconciling general equilibrium with excess supply in at least two ways. First, he suggested that an increase in the desire to consume output in the future through saving could fail to cause an increase in the production of future output through capital investment. Second, he suggested that an increase in the demand for money, which is not produced, would result in a general shortfall in what Keynesians call aggregate demand.

Some simple stories can illustrate the promises and pitfalls of the Keynesian approach. For example, Paul Krugman has used a "babysitting co-op" story to try to illustrate Keynesian ideas. In that story, parents trade babysitting services with one another. However, rather than trade bilaterally (I'll sit for you next Friday if you will sit for me the following Saturday), they trade using chits or coupons. That is, when you sit for me, you earn a coupon that you can use to buy babysitting services from someone else in the coop.

According to Krugman, a problem arises if a lot of people want to accumulate coupons to obtain babysitting services in the future, but not many people want to use babysitting services in the near term. With every family hoping to accumulate coupons, none of them can obtain babysitting jobs, and economic activity comes to a halt, in the sense that no one babysits for anyone else.2

In a real-world economy, you can do something with output now in order to have output in the future. For example, you can plant and tend to a fruit tree, which yield fruit years from now. However, in the babysitting economy, there is nothing that can play the role of fruit trees. The only form of saving is money (coupons).

I find this babysitting coop story unsatisfying, because the imbalance between saving and investment is ensured by assuming away the existence of capital. If we were to make the babysitting economy a bit more realistic by adding fruit and fruit trees to the list of tradable commodities, perhaps the problem of excess saving would disappear.

Here is another simple fable of excess saving and liquidity preference:


Once upon a time, Joe lived in Keynesiana, where he was a typical worker/consumer.
Joe worked in a GDP factory, making GDP. Every Monday morning, he went to work, and he worked five days a week. He was paid $1 for every 24-minute segment he worked, and he worked 100 segments (40 hours), so he earned $100 a week. Every Friday afternoon, Joe cashed his paycheck and went to the GDP factory outlet, where he spent it all on GDP.
One day, Joe decided that he needed to accumulate some savings. He made up a rule for himself. Knowing that he needed to consume at least $40 of GDP each week, he decided that his rule would be to save 20 percent of everything he earned over and above that $40. Since he made $100, his rule called for saving 20 percent of $60, or $12. So he cashed his $100 paycheck, but that Friday afternoon he only spent $88.
Next Monday, morning, Joe's boss had some news. "A funny thing happened last week. We sold 12 percent less GDP than usual. So this week, we're gonna put you on a short week. You work 88 segments, instead of 100."
Joe was disappointed, because this meant he would only be paid $88 this week. Sticking to his new rule, he resolved to save 20 percent of $48, or $9.60. So that Friday afternoon, he cashed his $88 paycheck and spent $78.40.
Next Monday morning, Joe's boss said. "Well, golly, it looks like we sold even less GDP last week. I'm afraid we'll have to cut you back to 78.40 segments this week." Still following his rule, Joe resolved to save 20 percent of $38.40, or $7.68. So he spent only $70.72 at the GDP factory outlet that Friday.
Seeing where this was going, the country asked Krug Paulman, the famous economist, what to do. He said, "The stupid people are saving too much. We need government to spend what the idiots are not spending." So the government borrowed $29.28 from Joe and spent it at the GDP factory outlet.
Now, when Joe came to work on Monday morning, his boss said, "Good news, we sold 100 percent of what we used to sell, so you can work 100 segments this week." Sticking to his rule, Joe saved $12 on Friday afternoon. But the government borrowed the $12 and spent it at the GDP factory outlet. They all lived happily ever after.

In the fable of the GDP factory, consider what would happen if we took money out of the picture, and instead the factory paid Joe by giving him GDP. Once Joe (and everyone else) saves in the form of GDP, rather than in the form of money, there can never be excess supply of GDP. Joe would find that every week the factory can employ him full time.

These simple stories suggest that pure barter economies would work better than economies that include money. Money only mucks things up, by creating a disconnect between demand and supply. That leads us to the path of monetary theory, which we will explore soon.

These stories also show that in the absence of capital goods production, saving can be dysfunctional. The question is whether this carries over into a the world in which there is capital goods production. That leads us to the path of capital theory, which we also will explore.


Comments and Sharing


CATEGORIES: Macroeconomics



COMMENTS (14 to date)
david writes:

All income is allocated. When resources leave one sector, they go somewhere else.

Phenomena like 'involuntary unemployment' become a lot less mystifying once you drop the assumption of gross substitutability.

But supposing we keep it.

However, I would argue that we could still observe recessions in such an economy. During good times, the only dishwashers would be people who have no other skills. During a recession, many skilled people would be working as dishwashers, and they would drive down the wages of dishwashers. Income would be much lower in a recession, even though there is full employment.

Rational expectations - rational consumers should be borrowing from the future during such temporary recessions (by reducing their savings), mitigating the impact of such temporary decreases in current income. Unless you're abandoning the permanent income hypothesis as well?

Boonton writes:

Arnold,

Lot to read here and I'm still digesting it but the question I see with your dishwasher story is who supplies the dishwashing jobs? Why during recessions, when people are probably not eating out as much, are there so many more dishes that need washing that the unemployed can pick up work as dishwashers? Why during booms when the well off eat out every night of the week does the lack of dishwashers not cause the job's wages to shoot up?

If I didn't know better, it sounds like your dishwasher is a backdoor Keynesian policy. When the economy goes bad, instead of sending out unemployment checks the gov't is paying people to wash dishes that are already clean. When the economy booms it stops subsidizing dishwashing.

Arnold Kling writes:

Boonton,
My dishwasher market is not a solution for recessions. It is a manifestation of recessions that happens to allow full employment.

Think of an economy in which the demand for brain surgeons suddenly falls, so brain surgeons enter the dishwashing market. Wages for dishwashers fall, and the market clears. We have full employment, but we still have a recession.

For the moment, think of the demand curve for brain surgeons as almost perfectly inelastic, while the demand curve for dishwashers is reasonably elastic.

Nick Rowe writes:

It reads well.

"These stories also show that in the absence of capital goods production, saving can be dysfunctional. The question is whether this carries over into a the world in which there is capital goods production."

Yes, yes, yes, it does! Or rather, the problem has got nothing to do with capital, or with saving per se. The problem is an excess demand for the medium of exchange, in a monetary exchange economy.

We could even get a recession if total desired savings decreased, if the demand for money increased.

The *only* relevance of saving is that if desired saving increased, this is likely to reduce interest rates, and increase the demand for money. It's the increased demand (or reduced supply) of money that matters.

Awaiting the next installment, to see if my hero (money) comes out on top!

Boonton writes:

Arnold,

Think of an economy in which the demand for brain surgeons suddenly falls, so brain surgeons enter the dishwashing market. Wages for dishwashers fall, and the market clears. We have full employment, but we still have a recession.

OK so basically you're assuming sticky wages for much of the economy but there's a 'bottom section' where wages are erractic. During recessions wages fall and during booms they increase. This variable section asorbs the adjustments that don't happen in the rest of the economy due to sticky wages.

It occurrs to me then that this section needn't be the bottom of the economy. It only needs to be a section that doesn't have great barriers to entry so people can enter or leave as they seek their fortunes. We did have this at one time in our history, when we had the frontier. If things weren't working for you in the big city, you could head west and either take a plot of land in some frontier or supply goods in one of the many frontier towns that were cropping up. Or you could head back east if you felt the economy in the 'civilized' portion of the nation was booming.

This opportunity closed off, though, when required capital grew. It is no longer possible to just take a piece of land and start farming. Agriculture today requires a good chunck of start up capital. I wonder if this is the real source of the 'sticky wages' and business cycle. As an economy demands more and more capital per worker it becomes more and more rigid in its labor markets.

The economy cannot expand the supply of brain surgeons without first adding a lot of physical and mental capital (operating rooms and education). It can't even add a lot of dishwashers without adding some serious capital (kitchens, sinks, water supply, sewers etc.). A certain amount of labor has no choice but to sit idle as the capital gets redeployed to accomodate job choices. The unemployed brain surgeons can't enter the dishwashing market until the plumbers get around to adding sinks.

Go back one to two hundred years and agriculture served, I suspect, as an alternative economy from the industrial one. If the industrial economy which ran on money and credit produced unemployment it was still relatively easy for some workers to leave the factories, return to the farms and offer a day's labor in exchange for a day's bread. This world, though, disappeared as more and more capital accumulated making even the 'backwards farm' a place that it was difficult for labor to shift in and out of.

Rolf Andreassen writes:

I suggest that Krugman's babysitting story does have an activity which increases future production: Make more babies. In 12-14 years they will be of an age where they can be trusted to babysit. :D

Thomas DeMeo writes:

When the term of the loan Joe made to the government is up and he wants to buy more GDP than he earns, what happens then?

Pareto writes:

This post is more edifying than a hundred DSGE models.

Doc Merlin writes:

The possibility I accept is that macroeconomics isn't in equilibrium, but is always moving towards equilibrium.
It isn't statically efficient, but is dynamically efficiency seeking.

Yancey Ward writes:

Arnold,

How is the story changed if Joe works in a factory producing GDP1 and Jim works in a factory that produces GDP2, but each consumes an equal mixture of both?

Bob Layson writes:

Mass chronic involuntary unemployment is not and can never be a laissez-faire market phenomenon. Would you pay people to engage in it?

Those in receipt of unemployment benefit are providing a service to the state - the pay isn't great but it's easy work. They show the government to be caring and progressive. They don't undercut the union wage rates. They refrain from operating in businesses that evade state regulation and tax.

It is certainly no good thing when, as is usually the case, state intervention, often through monetary manipulation, produces a deformation of the structure of capital and consequent recessionary readjustment. People then have to find a job of some kind, anykind - e.g. dishwashing. Talented people who cannot find a suitable job and so take a less suitable one are involuntarily underproductive.

Getting talented people into more productive engagements requires malinvested capital to be shifted to other business, written-off or replaced and this takes time and savings.

However, paying people to look for work near where they reside and at the going wage rate, to wait, that is, for normal trade and full employment to resume, merely ensures it will be a long time coming. Both for them and those they would have indirectly employed by earning whatever a crummy job would give them.

Boonton writes:

Mass chronic involuntary unemployment is not and can never be a laissez-faire market phenomenon.

This is the same type of mindset that allows government newscasters in North Korea to announce their economic system is the envy of the world.

Mass involuntary unemployment is an observed phenomenon of market economies. It existed before unemployment insurance became the norm for developed nations, likewise unemployment insurance cannot explain unemployment's cyclical behavior as unemployment is a relatively constant policy with no damatic changes in benefits up or down. If your theory cannot explain that then the problem is your theory, not the reality you're trying to study.

You basically admit as much when you say that workers have to wait for capital to be redeployed. In developed economies there's a lot of capital, its relatively heavy and not quickly 'redeployed'. This IMO explains not only mass unemployment but economic 'panics' that cause unemployment to be higher than simply 'recalculation' requirements.

Boonton writes:

So my beef with Arnold's 'model' is that its basically Keynes by another name. If labor markets were fast adjusting, unemployment wouldn't happen. They aren't, so there is unemployment. Why?

I suspect because each job is a comination of labor and specialized capital. The brain surgeon will not take a job as a dishwasher because more dishwashers means more sinks and water supply systems which simply will not be produced and installed that quickly. Likewise brain surgeons have special human capital which they won't want to ruin by taking any other job that requires them to do things with their hands.

But while so much capital is fixed, the future is very unpredictable. Hence people want liquidity. While their homes stay put for decades, they want to know they can turn them into cash quickly by selling them or taking out a home equity loan. While the huge hospital isn't going anywhere, shares of its holding company can be quickly traded on the stock exchange.

You get a crises when people all try to get more liquidity at once simply because there just isn't that much liquidity out there. Why the panic? Well a good way to set one off is for people to start believing that stuff they thought was liquid (highly rated debt, their home equity, AAA-CDO bonds etc.) really isn't.*

If you have a crises mindset, it's not only the capital that needs to be 'recalculated' that gets shorted by the market but all capital that isn't highly liquid. That's why fans of recalculation keep trying to describe this recession as the market's way of 'reallocating' home builders and mortgage brokers yet the unemployment is cutting across many sectors that had nothing to do with the housing boom. Stimulus is unlikely to interfere with recalculation but it does minimize the collateral damage caused by wider panic in the economy.

* This I suspect is why the dot com crash didn't result in a major demand side recession. Most people did not think the collapse of high flying, no-profit dot-com stocks meant that 'boring, safe' investments were really illusions.

Bob Layson writes:

Dear Boonton

If you a still about let me say that I have thought my way into my political (anti-political) position, by following the arguments of others. I did not simply swallow an ideology and then cast around for whatever arguments that could be bent to support it.

Chronic mass unemployment is long run (that's what chronic means) and very expensive to buy and only government ever buys it.

Unions or laid-off employees may use their savings while waiting for business to recover, aka engaged in voluntary job search or investing in availability - see W H Hutt on idle resources, but in a non-interventionist economy many would take whatever jobs are going and then move on up as things revive. Things would revive precisely because people have returned to production rather than sitting things out.

If being in receipt of unemployment benefit equals being involuntary unemployed then its reality is manifest. But since benefit receipients are given money for working with the paymaster's capital and acting as required then it sure looks like they have a job.

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