Arnold Kling  

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Brad DeLong writes,


When you ask believers in "recalculation" what pattern of production and trade proved to be unsustainable in 2007, they answer: "building so many houses." When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing--silence. When you say that OK, there were $300 billion of excess houses at the start of 2007 but now construction has been so depressed for so long that there are $1 trillion fewer of houses than trend and why isn't the 2007 pattern of production and trade sustainable again, they answer once again with nothing--silence.

Pointer from Daniel Kuehn.

I am well aware that the current economic slump includes more than just housing. Let us focus on just one example of an industry that is undergoing a severe contractionary adjustment: the legal industry. Many large firms have undertaken massive layoffs, and new law school graduates are having a horrible time finding jobs. How can we explain this?

Here, my thinking is somewhat reminiscent of Leijonhufvud's "corridor" theory. The economy behaves differently inside the corridor than outside the corridor.

Most of the time, individuals and firms are adjustment-averse. Adjustment-aversion is rational in a world that is mostly mean-reverting. If you stand pat in the face of a transitory drop in demand, as a firm you avoid paying excess adjustment costs associated with hiring and training, and as an individual you avoid paying the excess adjustment costs associated with making new investments in human capital.

However, the world is not always mean-reverting. There are secular changes taking place as well. In my view, the Internet and globalization have produced a lot of secular change. Because of adjustment-aversion, by 2008 a number of industries, such as the legal industry, had not kept up with these secular changes. Because they had failed to adjust gradually to the underlying technological changes, what we got was a large step adjustment, greatly reducing the size of the legal industry relative to its previous trend. This took place in many other industries as well.

So far, the market has managed to figure out that we do not need so many lawyers. What it has not figured out is where the excess lawyers should go and how to make the transition happen. Again, multiply this out by many sectors, and you get a lot of unemployment.

For economists who use the paradigm of aggregate supply and demand, there is an aggregate production function, which ties aggregate labor demand to aggregate output. In AS-AD, this aggregate production function seems so real that you can touch it. But I have lost this macro religion. I do not think of employment as a function of output. I think of it as part of an incredibly complex system that creates patterns of sustainable specialization and trade (PSST) that can persist for a while.

Many of these patterns, not just housing construction, were unsustainable as of 2008. The patterns had persisted because individuals and firms acted as if they over-estimated the mean-reverting component of ongoing change and under-estimated the secular component. Once a shock took place, the need for adjustment was exposed in many sectors. These sectors, including the legal industry, have since adjusted relatively rapidly and painfully to what now are recognized to be secular trends.

The AS-AD paradigm says that we can go back to something like the 2007 status quo with expansionary fiscal and monetary policy. The PSST paradigm says that there is no going back. The market needs to figure out new ways to best utilize would-be lawyers and other unemployed workers. Maybe expansionary fiscal and monetary policy can speed this process, but the mechanism by which policy will do this is not as simple and reliable as the AS-AD paradigm suggests.


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CATEGORIES: Macroeconomics



COMMENTS (24 to date)
John writes:

First I should point out that I know little about PSST, other than what I've picked up from a number of posts, primarily here, on the topic.

"why isn't the 2007 pattern of production and trade sustainable again, they answer once again with nothing--silence."

This strikes me as an odd question. Why should anyone expect a return to the same patter if it proved unsustainable in the past. Perhaps this is a bad analogy but would anyone ask why a dean end branch in evolution was not returned to for a new try? Perhaps silence is the appropriate or the polite response.

Joshua writes:

I'm with John on this. The overwhelming evidence is that the 2007 pattern was not sustainable. In fact, as far as I can see the only thing that makes De Long suppose that it was is you could draw a trend line and say, see, you could revert to...points...here, and presto the egg would be unscrambled. Meanwhile, every single detail of how that market worked at that point in time has changed, but somehow De Long thinks why aren't people borrowing like crazy to build new housing like it was 2007 is a sensible question.

Daniel Kuehn writes:

I'm not sure DeLong is saying that housing construction in the mid-2000s was sustainable. There's fairly broad agreement that it was a bubble. Unsustainability of complex exchange is a fact of life that I don't hear many people denying. The question is - how does it fare as an argument for recessions?

John Hall writes:

John,
Brad isn't saying we go back to the same pattern as before. He's asking why housing isn't on a sustainable pattern now after it has fallen so much.

I think Kling makes a good reply. PSST is a different way of looking at the world than AS-AD. Unfortunately, there's no more "scientific" way to know when one pattern is sustainable than there is to determine whether a price is just.

The housing market is still plagued by excess existing home supply and shadow inventory held on bank balance sheets. New home construction will not meaningfully improve until the excess existing home inventory and shadow inventory is cleared. In addition, the existing inventory, combined with elevated foreclosures, puts downward pressure on home prices, discouraging further sales. The weak labor market is also a negative. The biggest positive seems to be that long-term rates are low.

Hugh writes:

Did anyone ever say that the only imbalance in 2007 was an excess housing inventory of around 2 miilion units ($300 BN equivalent)??

Were not personal balance sheets also weighed down by all sorts of borrowing? Had this borrowing not increased over the prior decade? Was not the change from increasing borrowing year by year to a painful deleveraging sufficient to knock the economy completely off track?

David Rockwell writes:

I believe that the primary obsticle to adjustment is the inflexibility of wages for those who retain their jobs. Some lose their jobs and others retain their jobs and former salaries. If wages adjusted during contraction as they do during growth, demand for legal services or other industries in decline would not be as severe. If the culture allowed workers without jobs to bid for employment against incumbents, labor markets would clear much more quickly and prices would reach a sustainable level.

Lord writes:

The question you need to answer is why is nothing else growing. It takes time, they are being searched for, are really not adequate for it always takes time and they are always being searched for. The only explanation I can see is one of technological waves where all notable trends have been exploited and exhausted and any new trends have not developed to a sufficient degree to scale up. Discoveries are lumpy and unpredictable and we are waiting for them to occur, develop, and be perfected sufficiently to pursue. The issue would then be whether there is sufficient inducement to develop and experiment with new patterns and technologies, to overcome perceptions of expense and risk. This is where AD can still have a place. It can't produce new discoveries but it can provide more incentive and lower the expense and risk and speed them along. There may be a limit to what it can accomplish and how quickly, but that limit is still higher than what we have been seeing in the economy.

Harrison Searles writes:

I think that what a lot of commentators on the recalculation story of the recession fail to realize is that the housing bubble had consequences across the entire economy. If it were the case that the housing bubble only resulted in the building of houses and purchase of those houses by consumers out of their pocket, then DeLong would have a point. However, to argue this would be absurd.

Instead, the housing boom had a large influence upon the entire economy. One of the most important factors here, if not the most important, is the way that the housing boom changed the financial situation of Americans and Wall Street.

The former changed because so many people were convinced that housing prices would continue to rise and that their house could be used as collateral to finance loans. In addition, many bought houses that they could simply not afford either because they foolishly thought they could afford it or because they hoped to flip the house later on. When housing prices crashed and there was a gradual realization that the housing market was doomed beyond saving, then a large number of Americans were stuck in a terrible financial situation and the facade of prosperity suddenly was replaced by the reality of dept. It is obvious that something like this would be a shift in the expectations of consumers and would result in many people recalculating their own specializations and trades.

The latter is also very important because without the involvement of the financial sector in the housing boom, it would be very plausible that the boom's collapse would have simply been a slump in the housing-market rather than an economy-wide recession.

"When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing--silence."
Schumpeter has a terse answer to this:

"What we face is not merely the working of capitalism, but a capitalism which nations are determined not to allow to function"

The government has been doing everything it can to stabilize the market and to prevent a recalculation. Like it or not, voters would like to return to the conditions of the boom and too many are not aware of its inherent unsustainability. The Great Recession to them is simply an evil and not as a necessary result of the boom. Politicians react to these ideas and have sought at every possible time to assure voters that everything will be as it was. What do politicians say when they go to Detroit? We'll get your jobs back! What do politicians say when it comes to home-owners who cannot afford their houses? We'll keep you in that house!

It is essentially government-policy to prevent a recalculation and that is why there has not been one yet.

Nicholas Weininger writes:

BTW this pattern of "when you ask my opponents rhetorical question X, what do they answer? Nothing! Mwahahahaha!" is a recurring sign of intellectual laziness. As Harrison Searles illustrates, DeLong didn't even consider the simple and common "because the government has deliberately stopped it from working!" answer; he's debated enough libertarians that if he were actually thinking things through he'd come up with that answer, but the point is not to think things through but to burnish his own supposed unanswerability.

Ayn Rand was a particularly egregious practitioner of this tactic: she would answer her own rhetorical questions with "Blank out" whenever she wanted to avoid acknowledging any sort of multi-step nuance in an opposing view.

Steven Gordon writes:

Great post. Does anyone know where I can find out more about PSST? Like an article? It seems the only stuff on it is in these posts and the podcast from EconTalk...

mark writes:

i agree with the comments and would add that the task of sorting out the oversupply of houses is not merely left to "the market economy". The "political economy" has driven that process. There are all kinds of legal barriers to repossession and resale. There are something like 45 attorneys general and half a dozen federal agencies trying to stop the operation of contract and market exchange with respect to residences. There are also regulatory barriers to deveolopment too. All of which may be fine socially but then don't call it a market failure. To the extent one is asking why so long, that is in large measure why.

Second, the prior financing mechanism for home ownership remains in a diminshed state. In that vein, it's just deleveraging to a sustainable level, a recalculation of what balance sheets should be to be sustainable and what lending levels in a less subsidized environment for credit should be to be sustainable.

D. F. Linton writes:

You end with "Maybe expansionary fiscal and monetary policy can speed this process...", I don't see how politically-driven top-down spending or raw monetary expansion could aid the process of individual actors moving to a new emergent PSST, since by definition no one knows or can know where things will end up.

There's the Lucas critique and Mises' proof of the impossibility of socialist calculation, but there's also the simple common wisdom: "If you're so smart, how come you aren't rich."

Any individual or group able to reliably predict the new pattern of the economy could easily make fabulous profits in stocks or options. They would make much more quietly exploiting their foretellings than they could in consulting to the powers that be.

Tom Powers writes:

Forgive me for not keeping up with the latest on PSST. It's a very interesting theory.

What sort of empirical predictions does the PSST model make? How can we compare it against the AS-AD model?

Dave writes:

What is this caricature DeLong presents about people answering, "Building so many houses?" No one thinks it's that simple. First, the credit bubble extended well beyond housing. Second, even if you focus on just housing, you can quickly name several other industries that would be affected in a housing downfall.

Mish summed it up in 2008 as:


Direct Impact of Housing Slowdown
Manufacturing
Retail
Shipping
Finance
Construction
Travel
Leisure
Restaurants
Energy
Commodities
Trucks and SUVs
City, State, Local Government Spending


Little Impact of Housing Slowdown
Health care
Education

Details at the link. Point is, no one is dumb enough to just answer, "building so many houses." But then again, if you view economics as a system of equations, you probably have trouble thinking through how different industries are related and interact in a complex system.

John writes:
John Hall writes: John, Brad isn't saying we go back to the same pattern as before. He's asking why housing isn't on a sustainable pattern now after it has fallen so much.

So you're where my conscience ran off to ;-) My last name is Hall as well.

I see your clarification about what Delong is saying but still don't quite get it. I take PSST as a general economic view, not quite GE but perhaps something along an austrian version of Say (again, my highly uninformed description) by mixing some Lachmann in. You seem to be saying Delong is asking a partial equilibrium type question, specific to the housing market. So in one regard I'm not sure what a partial sustainable pattern would even mean.

I agree with your summarization of the conditions and would suggest that we can find a lot there that helps explain the rate of stabilization -- we really don't know what supply and demand are for either existing homes or new construction, Though new construction may be easier to discover: will the the person write the check?

I suppose the above may not really matter if the level of discussion was the theoretical framework rather than the observation itself. But then I also don't see how the question raises some critical aspect about the framework.
The fact that some areas of economic activity will have slower rates of adjustment and other much faster rates is not surprising. Exploring why would be interesting.

Yancey Ward writes:

DeLong is beating a straw man really good with that one.

Lawrence Kramer writes:

I've heard Dr. Greenspan derisively cited as saying that the government should buy up all the excess housing supply and burn it. My suspicion is that the laughter is nervous, because no one has a better solution. Indeed, what we are doing is allowing the houses to decay, which is to say we are burning them slowly, and the housing market won't recover until little enough of the "overhanging inventory" is habitable. Yucch.

I think of the housing boom as structural unemployment delayed. We had a cadre of home-building humans who could supply more effort and material than potential homebuyers could afford, i.e., who valued their outputs more highly than they valued the outputs of those for whom they would build their houses. That's just another way of describing structural unemployment, except that the unemployment was logical rather than physical. Homebuilders don't trade with buyers. Homebuilders trade with buyers' financiers. So, all a buyer has to do is lie to the financier about the value of his future outputs, and the financier will lend him the money to buy the house, and the builder will build it. Still, the builder is working for someone who cannot pay him; he is thus an idle man working. When the word did get out that buyers were liars, these logically unemployed workers lost their physical jobs as well.

Can we return to those glorious days of yesteryear? Yes, but. In my version of events, the disparity in the relative outputs of buyers and sellers was intermediated: the sellers did not have to rely on the buyers' ability to pay so long as the buyers could convince someone that they could afford the house. But the fiction had to be maintained, or the deal would never have been made. To resume building, we will have to find a way to let people whose outputs do not equal the cost of the house nevertheless buy the house at a price they cannot afford on the money they earn. What I'm saying is the mirror image of Dr. Greenspan. Instead of burning the houses to get them off the market, why don't we give them (i.e., the excess of their cost over the buyers' price limit), and that of the next batch, too, away?

Is that nervous laughter I hear? Keynesians have no problem putting people to work building public infrastructure. And we have certainly built public housing before, only it was for poor people. It failed miserably, but only because of cultural problems in the projects. Why not build nice public housing for people who can afford to put in some equity and will pay a mortgage, only not as much as the house costs to build? We could hold a lottery. Move people out of houses that were worth $50,000 before the crash into houses that are worth $50,000 after it. Instead of destroying the nice new homes, demolish the crappy one people are living in now.

The deeper concept behind this idea is that we have entered, or will soon enter, a period of non-scarcity, i.e., a period in which potential, easily scalable supply far surpasses the aggregate outputs of potential users. To use the polar case, imagine that one guy owning a bunch of robots could churn out every manufactured good needed by anybody on the planet. To whom would he sell them? Or, put another way, does it make sense that, because we lack the technology to distribute entitlement to outputs, we must forego the technology to produce outputs?

The glut of cheap foreign-made goods, soon to be replaced by cheap machine-made goods, will pose that dilemma: if the unanswerable question is "Sell it to whom?", maybe we're asking the wrong quesion; maybe "selling" has obsolesced as the mechanism for deciding who gets at least some of what. The housing glut poses that question now. We have the houses. Do we really have to waste them? And we have the excess capacity to build more. Do we really have to waste that, too?

Lord writes:

I would feel more comfortable with PSST if I saw all manner of projects and startups trying new things and abandoning them and shutting them down when they failed as they proved impossible, undesirable, or unprofitable, and that investment opportunities were being depleted without success but we see less being tried and even less being abandoned. Are things so bleak we have no more ideas to pursue or just no will to pursue them?

Josh S writes:

Actually, answering DeLong's challenge is very simple. When he says, "they answer once again with nothing--silence," he is simply lying. Free-market economists have written extensively on why we're still in recession, both informally (blogs, op-eds, etc) and formally (published journal articles). What we are experiencing here is that Keynesians are trained to deal with counterarguments by denying that counterarguments even exist.

Eric Morey writes:

"The market needs to figure out new ways to best utilize would-be lawyers and other unemployed workers. Maybe The market needs to figure out new ways to best utilize would-be lawyers and other unemployed workers. Maybe expansionary fiscal and monetary policy can speed this process, but the mechanism by which policy will do this is not as simple and reliable as the AS-AD paradigm suggests. can speed this process, but the mechanism by which policy will do this is not as simple and reliable as the AS-AD paradigm suggests."

This still leaves a good case for expansionary fiscal and monetary policy being able to significantly help expand real and nominal GDP even if we don't understand exactly how the mechanics work. I believe that DeLong has said as much on his blog. So why not more expansionary policy (especially monetary)?

Joe writes:

I think this is a good news story. Less jobs for lawyers.

There is an expansion in technology jobs. It won't take long for education to refocus if it hasn't already. The internet is crippling any number of industries while creating new ones all the time.

Philo writes:

You write about "an incredibly complex system that creates patterns of sustainable specialization and trade (PSST) that can persist for a while." The complexity is, of course, a function of the complexity of human psychology. Note that how long a pattern persists depends on how vaguely it is specified--at what level of generality. I can't do today *exactly* what I did yesterday, but certain broad behavioral features will persist. Most changes from what I did yesterday strike one as minor, occasionally a change will seem earth-shaking, and there are intermediate degrees. You won't have much of a theory until you can say how to measure these various degrees of change. Also, you must explain the fluctuations that occur--why, for example, the degree increased sharply in the U.S. in 2007 or 2008. (I am pessimistic about your chances of success.)

George X writes:

The market needs to figure out new ways to best utilize would-be lawyers...

Soylent Green?

Orlando writes:

No one notices the big 800 pound gorilla in the room. 84M baby boomers are beginning to retire and, at most, 64M new workers will be replacing them. In addition, the replacements are not as well educated or experienced as the soon to be retirees. The economy is going to be in a period of deflation until this excess is taken out, probably 15-18 years. This translates into a NET loss of 1-1.2M jobs PER year. It is also apparent, based on the current debt to income ratio that the boomers are NOT ready for retirement.

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