Arnold Kling  

The Recalculation Story: A Summary

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I have had a number of requests for this. I will put it below the fold.

1. Try not to think of macroeconomics in terms of equations or in terms of aggregate demand. Try to learn to think in a new language, rather than translate from the Recalculation language to something you are used to.

2. "Economic activity consists of sustainable patterns of specialization and trade." That is the mantra of the Recalculation Story.

3. Note how difficult it is to squeeze patterns of specialization and trade into a model of a single representative agent. Robert Solow has more good points.

4. If you cook for yourself and I cook for myself, that is not economic activity. If we eat at each other's restaurants, that is economic activity. This is true in the national income accounts, and it is justifiable. It is better to have millions of people working for you to produce your food, computers, health care, and so on than to produce them for yourself.

5. Part of the challenge of creating sustainable patterns of specialization and trade can be described as a matching problem. Think of two decks of cards, one with a list of workers with specialized skills and one with a list of occupations that utilize specialize skills. If you draw two cards at random, the chances are that they will not match. The skills of the worker will not match the skills required in the occupation. In that case, the marginal product of the worker in that occupation is very low, and the worker is unemployed.

6. The economy's calculation problem is to sort the two decks in ways that match workers to occupations in which they have value. This problem becomes more complicated with each increment of technological progress. The number of occupations has increased, because even as some occupations become obsolete, even more occupations emerge as useful. Also, the amount of human capital needed for many occupations has increased.

7. The patterns of specialization and trade are interdependent. In some instances, there is negative feedback. A new pattern that involves automobile production has negative impact on horseshoe makers. In other instances, there is positive feedback. A new pattern that involves automobile production has a positive impact on gasoline refiners.

8. Economic profits are what indicate a sustainable pattern of specialization and trade. Ultimately, the way that we know that we have a good set of matches of workers and occupations is that employers are not losing money.

9. The sustainability of patterns of specialization and trade is always changing. New opportunities emerge, and some older patterns become obsolete.

10. A danger in the economy is that an unsustainable pattern will go unrecognized for a long time. In the recessions of the U.S. between the end of World War II and the 1980's, excess inventories were accumulated. In the most recent episode, excesses in housing construction and mortgage finance went unrecognized for a long time.

11. If the excesses are merely short-term inventory problems, the old patterns of specialization and trade can be restored once the inventories are worked off.

12. However, if the old patterns of specialization and trade are not sustainable, the economy faces the Recalculation Problem. New patterns of specialization and trade need to be created. While the economy is creating new patterns even in good times, when it faces a Recalculation Problem it cannot create new patterns rapidly enough to prevent widespread unemployment.

13. Government can create temporary jobs for the unemployed. However, that is not the same thing as creating sustainable patterns of specialization and trade. For example, if the government subsidizes a firm that builds solar panels and those solar panels are not efficient, then this does not really represent a sustainable pattern of specialization and trade.

14. The more that patterns of specialization and trade involve government direction of resources, the greater the risk that those patterns are not sustainable.

15. It is possible that lower real wages will help to solve the Recalculation problem. However, generally speaking, when you pick a card from the worker deck and a card from the occupation deck, the match is either a good one or it isn't.

16. The production process has become more roundabout over the years. Fewer workers are engaged in hands-on production of output. Instead, they are engaged in building what Garett Jones calls organizational capital, as indicated by functions such as marketing communications, management reporting systems, or corporate training. This means that the relationship between output and employment has become looser. It means that patterns of specialization and trade reflect not just what goods and services are produced but how they are produced.


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CATEGORIES: Macroeconomics



COMMENTS (37 to date)
ChrisW writes:

If it all comes down to skills and specialization, isn't the obvious government stimulus to spend on education?

John V writes:

Specialized Leggos....not generic play dough.

Capital is not "k" in the real world.

Any average Joe (like me) who takes a layman's reading of Austrian Economics learns this "organically" and "holistically" intricate view of the economy (catallaxy...sp?) very quickly. Once you take it in and appreciate it, it makes generic aggregates and "prime pumping" seems laughably inadequate and simplistic...if not harmful.

Hyena writes:

But, on the plus side, creating organizational capital--unlike working in a factory or even farming by hand--is something we've been selecting for since before there were modern humans.

We're really good at it. What I've noticed is that a large segment of the population doesn't know how to communicate effectively in the modern world. Surprising numbers of people have trouble with e-mail, instant messaging and other basic skills.

That, I think, is the major mismatch. The fact that older people and minority workers are disproportionately unemployed. Both are less likely than average to have basic technological skills.

Dave writes:

This explanation seems remarkably uncontroversial to me. I'd like to see a Keynesian blogger try to take this down point by point. I imagine he or she would sound out of touch attempting to do so. Yet Brad DeLong claims that he sees "an economy in which there is enormous slack pretty much everywhere". And then uses store fronts as his example. Of course, he does realize that store fronts are all retail. Surprising, no doubt, to DeLong that retail would have over expanded during a credit bubble. How would he describe 27.1% unemployment for construction workers against the national average of about 10%?

Dave writes:

Oops. Forgot my reference for that last stat about construction workers.

bdm writes:

On point 16, it seems the point you are making is not that production has become more roundabout (i.e. involving temporally longer processes) but rather that production has become more social and the individual's contribution is less quantifiable.

I believe this is a really important issue. Part of why the health care and education sectors are so inefficient, I believe, is because it is just really difficult to assess the quality of an individual doctor or teacher. Both medicine and teaching are still more of an art than a science. You've mentioned in other posts that it is a lot more difficult in reality to determine the marginal product of a worker than it is in a textbook economic model. But I think something you should emphasize more in the future is that this difficulty is increasing over time, as more quantifiable production processes can more easily be automated and mechanized.

rjw writes:

Dave,

As a 'keynesian', maybe I can comment. Much of what Arnold writes here seems pretty sensible to me too. This matching perspective is certainly useful.

I should say though, that I reject your implicit premise that a 'keynesian' economist by definition is only interested in issues such as shifts in aggregate behaviour. An understanding of how the supply side is currently changing is vital to understanding what is going on in the world economy. Reading about the different organisational structures of say, the chinese, japanese, german and US economies, is something that every economics student should do.

If one were to criticise the post from a 'keynesian' perspective, I would simply say that nothing in the post precludes the argument that shifts in aggregate demand affect the environment in which firms find themselves, and constrains their profits and affects expectations. Personally though, I see that as a complementary aspect of the analysis, not a competing one.

rjw writes:

Just to add to my comment above, I like Arnold's posts because he makes an attempt to avoid often empty labels such as 'keynesian' and 'monetarist' and instead focusses on talking about the causal processes that are going on in the economy.

I have a lot of respect for Arnold's approach, even though our broad orientation on economics is, I think, rather different. In my view we need more and higher quality interaction between people from different 'schools' in economics, and the way to do this is focus on discussing mechanisms.

Rebecca Burlingame writes:

@Hyena,
I am one of those older people who still has trouble with the newer technological skills, and taking computer classes does not always solve the problem. When I asked my teacher about different applications for blogging (Wordpress, Typepad), he was completely clueless and could only answer questions about the textbooks we used which were basically a front for learning everything Microsoft instead of the Macintosh computer I had hoped to be able to use.

This is just one reason why I believe there is a tremendous market for people sharing their skills for things not necessarily talked about in the classroom. To me, this would be every bit as economic in nature as anything accomplished in a business.

Randy writes:

Its good. I'd figure out a way to incorporate trends in some way. For example, the long term trend of less labor required to produce necessities and thus more labor dedicated to the production of luxuries and/or political activities.

Andrew writes:

rjw appears to understand what it takes for a robust institution.

W.M. writes:

On point 15: "generally speaking, when you pick a card from the worker deck and a card from the occupation deck, the match is either a good one or it isn't". Obviously though, there are a lot of cards that require unskilled labor, and a lot of cards offering the same, yet many factors currently prevent this match from occurring (minimum wage laws, collective bargaining agreements, health care and tax provisions). I think the card match analogy is more obvious and appropriate for skilled workers/work.

To bdm's comment: "Part of why the health care and education sectors are so inefficient, I believe, is because it is just really difficult to assess the quality of an individual doctor or teacher" I reject this, especially for teachers. What you are really saying is that it is hard for ADMINISTRATORS to make such judgments. However, it is easy for the consumers (students and parents) to make this judgment and they do so all the time. I guarantee you that identity of the worst and best teachers at every school is common knowledge for the student body, and probably even the faculty. Protection of this class of worker makes it difficult, if not impossible, for the consumers to take their business elsewhere based on those value judgments.

Victor writes:

How does your recalculation story relate to the Econ 101/102 story of structural unemployment?

Can we view the 1990s as an internet bubble and the 2000s as a housing bubble? Does this fit your point 13 that suggests government cannot permanently boost employment unless it identifies a fundamentally sound specialization pattern?

Lastly, can a government ever institute a sustainable specialization pattern unless it is permanently obligated? (e.g., military industrial complex)

Lewis writes:

I'd like a definition of sustainable that doesn't depend on hindsight. The way I read this story, we say something was unsustainable if it stopped happening all of a sudden. Although a good definition might depend on information that is impossible to obtain, it should correspond to a state of affairs that exists in a moment. This seems like handwaving.

Also, I don't see how this story explains the majoriy of unemployed workers who are not inconstruction. Their unemployment is easily explained by a lack in aggregate demand, however.

Les Cargill writes:

Lewis:
"Also, I don't see how this story explains the majority of unemployed workers who are not in construction. Their unemployment is easily explained by a lack in aggregate demand, however."

Homeowners spend more, until they run out of room to put things. The trend away from ever increasing home size negatively affects aggregate demand.

My favorite is still the Garret Jones, #16 point - firms are increasingly convenient fictions, and increasingly brittle. Without real competitive pressure on firms, they become increasingly arbitrary. The resulting mistakes are very Schumpeterian. This also makes firms with rent-seeking business models much more competitive.

Patrick Dennis writes:

Point 6: "... The number of occupations has increased, because even as some occupations become obsolete, even more occupations emerge as useful. Also, the amount of human capital needed for many occupations has increased."

Not obvious.

Lee Kelly writes:

This is all very well and good, but it assumes your calculator is working correctly.

With a faulty calculator, the recalculation isn't going to be very fun. The claim made by people who "think in terms of aggregate demand," I think, is that when the supply and demand for money is in disequilibrium and prices are "sticky," the calculator is faulty.

Therefore, the first priority of macroeconomics policy is to fix the calculator. The recalculation is what happens next.

Yancey Ward writes:

Perhaps the recalculation is forced to occur due to the different preferences and characteristics of creditors and borrowers. If I loan you money to buy a house, and you pay me back in the future and I buy a house, then there is no mismatch. A mismatch occurs if, in the future, I wish a different consumption profile than you had today, or it occurs when you don't pay me back at all.

JJ writes:

There is a lot of unemployment in construction which makes sense. What worries me is that the financial sector has hardly reduced employment, if at all. In fact, wages and bonuses seem to be rising again. This worries me. It's a sign that the government is still subsidizing the financial sector and preventing the reallocation away from finance that should take place.

Bill Conerly writes:

This is a very useful explanation, but I'll offer two responses in a Keynesian/Monetarist spirit:

1) Some of the people have sustainable trade opportunities IF most of rest of the people in the economy are well matched. Auto sales are today well below long-run average by 25%. We have not all gone to bicycles and mass transit. The car production and sales industry would be in much better shape (though not perfect) if a bunch of other matches were being made. Keynes would say, I think, that subsidizing some less-than-perfect matches would help those folks who are unemployed despite sustainable matches. Then we could gradually reduce the stimulus to aggregate demand.

2) I think that the story of skill matching overstates to some extent the specificity of job skills. The construction industry grew employment by 12 percent over the 24 months ending in Feb 2006. That sucked in a lot of people fairly quickly. I know many, many people, now working in fields for which they did not train. Most undergraduate econ majors are not economists, most undergrad psych majors are not psychologists.

There are useful insights in this recalculation model, but it's too soon to throw out aggregate demand.

Yancey Ward writes:
Auto sales are today well below long-run average by 25%

How "long run"? How do we know that average wasn't an aberration itself? One could simply look at housing since 2002 and conclude that same thing- that it could return to that trend if we just did this or that to subsidize certain matches in the economy.

Lord writes:

Eating at each other's restaurant is not a sustainable activity. Either we are equivalent cooks or prefer our own cooking, or one is better and the other has nothing to offer. It is only finding specializations that each prefers or does better that work.

The odds of matching jobs and workers is not just low but infinitesimal and only happens when the employer is optimistic or desperate and is willing to undertake the investment needed to make them productive in their organization. Education is nearly irrelevant in this and even experience almost so. It is only expected growing markets that can induce them to invest. It is not primarily a matching problem but a creation problem.

Recalculation is at most half the story. The other half is how those earnings from the previously profitable activity were spent. Those would still be doing well if demand were still there.

Lower real wages will help employment. That won't generally help real standards of living, only redistribute income more equitably among workers, but that is not a reason not to do so. The alternative is smaller markets with lower degrees of specialization and higher taxes on the working to support the nonworking.


Eric Falkenstein writes:

"Economic activity consists of sustainable patterns of specialization and trade."

That's good. I don't think any dynamic macro models capture this well.

Paul Seabright writes:

This account, to which I am very sympathetic, also suggests a reason for favoring tax cuts over government spending in fiscal policy interventions (other things equal, of course). This is that private spending is somewhat less likely to freeze existing patterns of specialization, since individuals do not face political lobbying from insiders over how to spend their money, and since individuals benefit from distributed private information about their likely future needs. Of course, if they save the tax cuts they don't make use of that Hayekian advantage, and their potential contribution to Recalculation evaporates.

Jason writes:

I see two major problems in this account.

First an issue of internal consistency with observational implications. If good matches are identified with profits, then how can the economy build an unsustainable pattern? Shouldn't companies be losing money, prompting a change of direction? And I suspect the theoretical profit profile does not match up with 2007 pre-crash, and current post-crash corporate profit statements.

Second, this is ultimately a 'Real' description. Finance is conspicous in its absence.

Bob Layson writes:

We know the economy can build an unsustainable pattern because it recently did. The Austrians would explain the sudden unprofitability - or malinvestment- of construction on the credit binge (cheap money and ever more of it) and the popping of the housing bubble. It paid to get into housing because prices were rising and then prices rose ever higher as foreign money pumped the bubble fuller: 'It can't last for ever but I'll get out in time'.

The financial crisis, and consequent fear driven run to liquidity, followed the crisis of over-investment in construction. Then the cut in spending by those laid off and the increase in saving by those who feared they might be laid off produced the secondary recession.

The recession is prolonged by paying the unemployed to wait for the return of normal times and by government intervening in such a way as to keep business confidence abnormal. The recalculation approach points out that the pattern of investment cannot and should not return to the pre-downturn constellation of workers and capital.

Tracy W writes:

What is your definition of sustainable? And how does this fit in with the concept of creative destruction?

fundamentalist writes:

Excellent article by Dr. Kling and good responses. People wonder what causes the unsustainable structure in the first place. Mainstream econ theory says it's just a random event. Keynes said it was the animal spirits of investors. Austrians say it's credit expansion.

A big part of the problem is understanding that money is not wealth; even gold is not wealth. That's hard for most of us to get our heads around. Bastiat started trying to explain it to the French in the late 19th century. Wealth and capital are material goods and services. Money merely helps make exchange easier. So think of a barter economy. What coordinates investing with consumption in barter? Savings! In barter, no one can invest more than what he and others have saved.

Money changes that coordinating ability of savings. It loosens the joints, or connections, as Hayek wrote. But without credit, investing more than we save is still very difficult. Credit loosens the joints even more. Credit expansion allows us to invest far more than we have saved in terms of money, but not in terms of wealth. Credit expansion does not increase the amount of material goods at all. And it does not increase available capital (in terms of material goods, and not money). So when investment increases in money terms while consumption has not lessened in real terms, the sustainable ratio of investment to consumption becomes unsustainable. Capital goods makers and consumer goods makers compete fiercely for a limited supply of goods that is too small to meet the demands of both. For the reasons given by the Ricardo Effect, capital goods makers always lose, go broke and lay off employees. Then the depression starts.

Yancey Ward writes:
Of course, if they save the tax cuts they don't make use of that Hayekian advantage, and their potential contribution to Recalculation evaporates.

Why do the decisions of savers to save contribute less to the recalculation than the decisions of others to consume? If you believe this, then you must also believe that recalculation can be eased by forcing previous savers to save less than before.

fundamentalist writes:

Actually, savings the tax cuts would be the best thing according to Hayek's Ricardo Effect. A shortage of actual physical capital goods is what sets off the crisis and reveals the unsustainable aspects of the boom. A lot of capital got wasted during the boom. The quickest way to recovery is to rebuild the wasted capital goods through savings and investment.

Remember, the depression happens mostly in the capital goods industries and in the durable consumer goods which act like capital goods. If consumers spend tax break money on consumer goods, then prices will rise and profits increase in consumer goods. That encourages businesses to buy less labor-saving equipment (like computers) and hire more labor, but the consumer goods industries haven't been hit by the depression so unemployment isn't high in them.

What capital goods makers need is for profits in consumer goods to fall so they look for labor-saving equipment in order to boost profits. That spurs demand for capital goods, where unemployment is the highest, and gets them hiring again.

Tracy W writes:

What is your definition of sustainable? And how does this fit in with the concept of creative destruction?

Paul Seabright writes:

Yancey Ward, I didn't mean it was necessarily a bad thing if the savers saved the tax cut; it's just that they don't then make this Hayekian contribution to recalculation, by signaling to the market the kinds of goods they are saving up to buy. Actually almost nobody signals to the market in advance what kinds of goods they are hoping to buy; the market normally does a pretty good job by presuming that the demand for each good tomorrow will be predicted by the demand for it today. When there's a big recession that mechanism is no longer so reliable. That's a Keynesian point in Hayekian garb.

Max writes:

[Comment removed for supplying false email address. Your last 10 comments, submitted over the course of the last year, have not been posted for the same reason. You've been warned and banned repeatedly. You can keep trying if you like, but we will not keep warning you; and we will not bother our readers further with these notices to you. You know how to reach us should you ever want to discuss reinstating your comment privileges, so that someone may actually read your comments.--Econlib Ed.]

Yancey Ward writes:
When there's a big recession that mechanism is no longer so reliable. That's a Keynesian point in Hayekian garb

But a Hayekian (Arnold) might reply that it is totally missing the point of a recalculation. The recession is telling us that the recalculation is necessary. A return to the past trends isn't possible.

the market normally does a pretty good job by presuming that the demand for each good tomorrow will be predicted by the demand for it today.

This is true- humans extropolate. The recession is telling us that those most recent extrapolations were more wrong than before (the recession is the proof of this). What I am getting at is that, where some see a "mechanism" that "is no longer so reliable" in a recession, shouldn't be so quick to assume that the reliability of those extropolations has declined. I would argue that the extrapolations have, at the very least, adjusted to a point where they can be improved.

fundamentalist writes:

There is a recalculation in terms of job types going on, but it is driven by the recalculation between the ratio of capital goods to consumer goods being produced. Recalculation is necessary because the capital goods to consumer goods ratio became distorted and too many capital goods were produced. That happened as a result of credit expansion far beyond the ex-ante savings rate.

As Hayek wrote in "Economics and Knowledge", before we can determine how disequilibrium happens we have to understand how anything can go right in the first place. It can only go right an produce equilibrium if all of the plans of individual actors dovetail. The two main groups who must coordinate are producers and consumers. In equilibrium, savings and the resulting interest rate do the coordinating. In the real world, credit expansion distorts the interest rate signal about savings and disrupts the ratio between consumption and production. In the recovery, the ratio between capital good production and consumer goods production that pleases consumers must be reestablished.

Consumer spending determines which consumer goods will be produced, but savings and the interest rate determine the ratio of capital goods to consumer goods that will be produced. Tax cuts and stimuli drive consumer spending and don't help with the recalculation of the capital:consumption ratio.

Higher interest rates will slow consumption by encouraging saving. In turn, that will put pressure on consumer goods profits, and motivate the makers to buy more capital equipment in order to save on labor. That will boost the capital goods markets.

Gene Callahan writes:

"Obviously though, there are a lot of cards that require unskilled labor, and a lot of cards offering the same..."

"Unskilled labor" is pretty much a fiction. Even the jobs teenagers hold need skills.

Madison writes:

I like this post a lot because 8, 9, 10 and 14

"8. Economic profits are what indicate a sustainable pattern of specialization and trade."

"9. The sustainability of patterns of specialization and trade is always changing. New opportunities emerge, and some older patterns become obsolete."

"10. A danger in the economy is that an unsustainable pattern will go unrecognized for a long time...."

"14. The more that patterns of specialization and trade involve government direction of resources, the greater the risk that those patterns are not sustainable."

suddenly made clear what had been floating around in my head for a little while: The beneficiaries of yesterday's sustainable (profitable) patterns, aka today's obsolete patterns, run a mutual benefit society called 'the government,' which works to ensure that the unsustainable patterns go unrecognized as long as possible.

Of course this isn't how the government has to be, I wish it weren't.

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