Arnold Kling  

Two Papers on PSST

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In the latest issue of Capitalism and Society. I wrote one of the papers, and then Peter Howitt wrote a comment. I recommend both of them, although personally I find Howitt's paper more interesting, because I already knew what I was saying. I will use the rest of this post (below the fold) to comment on Howitt's paper.

Howitt argues that we ought to think of unemployment as a coordination failure. He points out that even Keynes can be read that way. That is, savers want more future output, but entrepreneurs are not sure which type of output they want, and the result is a coordination failure.

Howitt argues that this coordination failure paradigm focuses attention on organizations that provide coordination services. Call these coordinators. Let me give two examples of entities that were coordinators. Borders Books brought together suppliers of books with readers of books. AIG Financial Products brought together people who wanted to earn a low-risk return on saving with companies that needed credit default swaps on mortgage-backed securities.

As you know, both Borders and AIG FP are no longer with us. We could look at this in three ways.

1. Their demise is an autonomous, causal factor in economic fluctuations.
2. Their demise is a symptom of lower aggregate demand.
3. Their demise is a symptom of economic displacement, as their patterns of specialization and trade are no longer sustainable. In the case of Borders, the problem is technology. In the case of AIG FP, it was the combination of mortgage lending to unqualified borrowers and falling house prices that changed the value of the options that they had written.

It strikes me (and this may be uncharitable) that Howitt is leaning toward (1) as a way to describe coordination failure. You can think of the Bernanke model (this is Bernanke the academic, not Bernanke the Fed chairman, although the first clearly influenced the second) of bank failures destroying the "relationship capital" that allows banks to intermediate between savers and users of savings. So, in Howitt's model, one can get a wave of failures among coordinators, and this means that there will be less coordination in the economy, so that there is more unemployment.

If the failures of coordinators are autonomous, then one does not need a PSST story. I think that is why Howitt believes that PSST does little to advance the coordination story. Instead, I think it does, although I am aware of its many shortcomings.

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CATEGORIES: Macroeconomics

COMMENTS (8 to date)
J Oxman writes:

Prof. Kling,

How do you view PSST in relation to the Austrian view of capital and production? What differences do you see?

Thank you,
J Oxman

Dave Tufte writes:

Borders came up in the blog my ManEc students write, and that I comment upon.

My ManEc oriented explanation is that Borders wasn't very viable from the start.

GlibFighter writes:

Thanks for the reference. On pp. 8-9, Howitt emphasizes the cumulative nature of business failures in a recession, e.g., the collapse of one firm can lead to a cascade of failures. How does this fit into the typology given by your (1), (2), and (3)?

Arnold Kling writes:

@J Oxman, I think that the causes of temporary breakdowns are broader than just over-lengthening of the cycle of production. I think that a disruptive general-purpose technology can cause a breakdown. I think that a new pattern of international trade (following a war, for example) can cause a breakdown.

@GlibFighter, I think that a cascade of failures could be part of any of these. What causes the cascade of failures, though? I think Howitt wants to see it as the failure of one critical co-ordinator, like a major bank, causing failures among firms that depend on it. I want to think of it as a an entire business ecosystem collapsing, for whatever reason. For example, the ecosystem around securitized mortgage lending collapses, or the ecosystem around music distribution via CD's collapses.

MMJ writes:

Arnold, you wrote "I am aware of its [PSSTs] many shortcomings." Can you elaborate on what you think those are?

On your comment to J Oxman, you seem to be making an RBC-type argument.

Arnold Kling writes:

On the shortcomings, both Howitt and I (and many others) point out that the more broad-based the decline in activity, the more awkward it is to tell a story without aggregate demand. Also, there is no nice, neat mathematical model.

On RBC, I think of that as saying that a temporary, adverse productivity shock that affects all workers causes a reduction in employment. I do not think of it as dealing with co-ordination failures, as Howitt calls them.

Costard writes:

Arnold - In terms of the adjustment period, there is no difference between overproduction caused by monetary easing and production rendered obsolete by a sudden shift in technology. In either case there is a period of liquidation followed by a period of reinvestment. But in practice the two almost always line up; some new paradigm is always used to justify the excesses of the boom, and technology or trade usually fill this void. And also many good things are invented that fail inexplicably, and trade opportunities arise only to die quietly in the down side of the business cycle. Survivor bias is unavoidable. It's a mess, I don't how you can derive a useful theory from it, and I certainly don't see anything un-Austrian about any of this.

I also don't see how you could ever answer your multiple-choice question with certainty. Each answer is plausible, and the only provable reality is that Borders failed. Perhaps it deserved to and perhaps it was a good company victimized by the recession, but there is no experiment you can devise to test your hypothesis, all evidence is circumstantial, and any action by policymakers is based upon belief rather than knowledge. The market doesn't exist to provide justice any more than science exists to prove God. In terms of the business cycle 1, 2 and 3 are all accurate descriptions at some point. Aggregate demand more or less describes the liquidation phase, and coordination - re-bridging supply and demand - the reinvestment phase. But each is insufficient by itself and turning one into orthodoxy, and orthodoxy into economic policy, means perpetuating one stage of the disease and forever preventing a cure.

Floccina writes:

Would you like to make that 3? Stiglitz makes a PSST case for the great recession.

Forget monetary policy. Re-examining the cause of the Great Depression—the revolution in agriculture that threw millions out of work—the author argues that the U.S. is now facing and must manage a similar shift in the “real” economy, from industry to service, or risk a tragic replay of 80 years ago.

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