"How Much Do We Understand about the Modern Recession?"

One story you can tell about recessions is that the presence of wage and price stickiness throws relative prices off their optimal paths, and this sends false signals to markets and causing resource misallocations -- some sectors have too many resources flow into them, others not enough. At some point, however, these misallocations correct themselves and as resources become unemployed and move from the sectors where they were in oversupply (e.g. out of housing) and into sectors where they were underutilized, a process that takes time, a recession occurs. But this statement by Robert Hall has me wondering about those stories:

How Much Do We Understand about the Modern Recession?, by Robert Hall: ...One of the most important facts about the modern recession is at all sectors of the labor market slacken at the same time. ... Abraham and Katz (1986) were the first to recognize the significance of this feature of the economy, which rules out theories of recession that rest on reallocation from shrinking to expanding sectors. If unemployment in a recession were the natural, efficient result of reallocation of workers from shrinking to growing sectors, the growing sectors would open their doors wide to absorb the flow of workers leaving the shrinking sectors. Vacancies would be high in the growing sectors and low in the shrinking ones. The facts ... refute that view... Some force made all sectors cut back... Later I will discuss the idea that sticky prices and wages could explain these facts. I find that they could, but that the traditional way of thinking about stickiness is theoretically unsatisfying...

Here's part of the later discussion:

The primary defect with this class of explanations is their failure to meet the Abraham- Katz standard. If housing fell because of financial constraints, but all other sectors were unaffected, it is hard to see why all the other sectors’ labor markets turned so slack. The focus of the tech collapse was even narrower. Why didn’t the winning sectors expand to absorb the workers released by the single losing sector in each of the two modern recessions?

A traditional answer to this question is that the wage-price system fails to send the right signals to consumers, workers, and firms to expand the unaffected sectors. One view is that real wages are sticky and remain too high to yield firms high enough profits to expand. Another is that prices are sticky and remain too high given the central bank’s policy rule to result in full employment—the central bank keeps the interest rate too high for the expansion to occur. Recent models combine both views. Christiano, Eichenbaum and Evans (2005) is a leading example of modern research in this vein.

Sticky wages and prices are not a full explanation, however. They seem to be a fact without a deep rationalization. A sticky wage that keeps employment below a mutually desirable level creates an opportunity for a worker and an employer to make a Pareto improvement for themselves by adjusting employment upward. What happens to the wage is immaterial here—what matters is the increase in employment. The same holds when a sticky price keeps the quantity traded below its efficient level. The traditional sticky-price literature has not come to grips with the obvious tools that employers, workers, sellers, and customers possess to overcome inefficiently low employment or sales. The literature lacks a coherent theory of disequilibrium. Departures from equilibrium are an assertion, not a derived conclusion from fundamentals. Traditional sticky-wage and -price theory has a strong descriptive claim but not a strong theoretical underpinning.

Comments

[ken melvin]

In the abstract, ...

[anne]

Alan Greenspan argued repeatedly that resource-labor adjustments in the American economy had changed markedly from 1980, becoming far faster and thereby allowing shocks to be shaken off quickly and allowing for the lengthy expansions since. I have assumed Greenspan was correct, seemingly because much the same has happened in western Europe.

I think on an initial reading that Robert Hall is not correct, though interesting. Now to work out why.

[Friction]

Higher skill jobs reduce mobility. Computer programmers with a BS in computer science did not transform themselves rapidly into physical therapists when Y2K came. Journeyman carpenters (3 1/2 year apprenticeship) did not rapidly transform themselves into medical technologists (4 year degree) when housing starts fell.

[Patricia Shannon]

Friction, a voice of reality.

[anne]

There is something unique about this period, I have written of before; the American economy always creates and destroys significant numbers of jobs, but job churn has been relatively lacking through this perio of expansion. Why? Why was job creation so lacking through the expansion, and churn as well? Could the reason be the relative lack of domestic non-residential investment since 2001? But, why that, as well?

This period has just not been comparable to past expansions.

[Competition]

"What happens to the wage is immaterial here—what matters is the increase in employment."

The wage matters a great deal to the already employed in a field. They do not generally see lower wages as an improvement, regardless of whether the lower wage encourages more people to join the field. As a matter of fat, more people are just more competition for the already employed, which reduces job security. The already employed therefore seek rules that increase barriers to entry into a field. A very large increase in wages would be required to overcome some of these barriers, if the barrier could be overcome at all.

If there was perfect competition with regard to wages and products, the normal price signals would work more as advertised.

[Bruce Wilder]

Often, I get on one of my soapboxes, in response to this kind of post. I know most of the commenters are inclined to shrug their shoulders, but it seems to me that this issue goes to the very heart of macroeconomics as an enterprise.

Either you think the (macro)economy is fundamentally stable, and stable at some kind of unique, general full-employment equilibrium, or you don't. Given the history of the discipline, I would think that the consensus view would be that the (macro)economy, apart from certain stabilizing institutions introduced as a matter of government policy, does not, sans active management, tend to any sort of unique, general equilibrium. (By "general" equilibrium, I mean an equilibrium of full employment of resources, both generally, and in detail, i.e. in individual markets.) There's nothing, aside from deliberate intervention by government or the central bank, to ensure that any sort of gross equilibrium is maintained, and whether an equilibrium is attained in individual, particular markets is a matter of individual, particular markets, some of which have market-clearing prices and many of which do not.

Is it it some kind of "news" that lots of markets do not have market-clearing equilibria?

Does no one know why Keynes called his book The General Theory, to emphasize that many macro-economic equilibria would not fully employ available resources?

Is it some kind of revelation that wealth is an expectation of future income? Or, that such expectations are subject to a random walk of varying consensus estimation?

I wonder that more is not made of the nature of "capitalism", and the large role of highly-specialized, sunk cost investment in production. Large sunk cost investments, which are technically advantageous, make re-allocation of resources problematic -- no one can just transfer resources. And, prices -- which reflect some combination of marginal costs made minimal by the sunk cost investment and a somewhat arbitrary attempt to recoup the sunk cost investment -- are almost irrelevant in the short-run to allocation.

I don't mean to be critical, but I read this stuff -- and I know I reading it superficially, without working through the assumed modeling -- and I just wonder what planet these economists are living on, cause it does not bear much resemblance to the world I know. I tend to think in terms of examples, where the example serves as a model, and I just wonder how the economist thinks price adjustments are going to obviate some shock to expectations. I see others doing much the same thing, citing the need for sunk cost investments in job re-training to move resources from one use to another, or suggesting that prices, elevated by market power, might not be all that flexible.

Investment, investment, investment. What's so hard about that?

[john c. halasz]

I don't really see the explanatory problem here. Equilibrium is an analytic device and not a constant reality, and further there is no sure empirical criterion in fluctuating nominal prices that equilibriation is occurring, (though disequilibria can be observed in nominal prices and flows- an 800 billion CA deficit a huge disequilibrium and one that refuses to correct itself). There is no prior guarantee that capital investment will flow to and limit itself to an equilibrium level. There is always uncertainty about new investment and hence a speculative component. Further, there are bandwagon effects to successful investment. (The housing bubble which was clearly observable early on,- and its causal connection with the ever growing trade deficit was obvious too,- puts the lie to efficient markets/rational expectations type claims as its viral contagion sucked in more and more participants, not least by imposing severe competitive costs on those who refused to be deceived and attempted to maintain a rational, prudential position). And successful investment, (to the extent that it improves rather than just replaces capital stocks), precisely raises productivity and the producer's surplus accruing to it, which alters underlying ratios, not least intersectoral ones. And of course, the aim of investment is to produce and increase profits, especially as reflected in the raised prices of financial assets, and an redistribution of such increased producer's surpluses to consumers and workers, to prices and wages, will be a second or third round effect. And successful investment will result in additional investment and reinvestment, even as wage/consumption demand lags. Booming sectors will impart additional demand stimulus to lagging sectors, but that does not mean that those lagging sectors will become self-sustaining absent that additional stimulus. Eventually, overshooting investment and inflating asset "values" will overrun the revenues, profits and debt-bearing capacities that sustain them. Recessions are not caused by subjective factors, such as reversals of expectations or consumer or investor "psychology", as the cheer leading section so often claims, but by the objective factor of balance sheet constraints. There is a recession because neither asset values, nor debt-bearing capacities, nor further investment opportunities can be sustained any longer, hence there is a seemingly simultaneous pull-back by variously situated agents across many sectors, (though obviously it begins in some sectors and doesn't effect all sectors equally). Recessions are the exception to the "rule" in terms of time spans, but they are endemic to the process of capital realization.

[malcolm]

We have the beginning of a theory of disequilibrium: Malinvaud and Barro and Grossman wrote persuasively of the
important implications of the failures of markets to
clear. These argunments were condemned as ad hoc. We, as a profession, were more willing to listen to Lucasian perfect competition stories with their ad hoc informational problems in the 70's and disequilibrium went out of fashion.

[Winslow R.]

If housing fell because of financial constraints, but all other sectors were
unaffected, it is hard to see why all the other sectors’ labor markets turned so slack. The
focus of the tech collapse was even narrower. Why didn’t the winning sectors expand to absorb the workers released by the single losing sector in each of the two modern recessions?"

How about 'sticky debt' which is much more sticky than wages?

This is a bizarre post.

Tax Farming
Money flows from the government spending and is drained through taxes.

Interest Farming
Money flows from banks loans and is drained through interest/principal payments.

Neither farmer can take too much from the farm without the ecosystem collapsing. Banks and government decide while all other entities (workers/corporations) thrive or die based on whether they are connected more closely to the spigot or the drain.

Pay attention to those fighting to maintain a position between the spigot and the drain so as to distract you from the guy turning the knob.

'Sticky debt' drains money from the economy.

Shouldn't we be worrying about how to get the optimal number of people between the spigot and drain in optimal positions?

Increase access!

[STS]

Animal spirits, people! Animal spirits!

Oh, yeah, I guess that doesn't really count as a "model". But you'd think none of these economists had ever really entertained the idea that the "public mind" has mood swings. Call it behavioral macro-economics. There's a Nobel in it for some young academic out there. Pity we have to wait a few more decades for that recognition of an idea that was so obvious to Keynes in the 1930s.

[Winslow R.]

Give those 'animals' optimal access!

[Jay Aren]

Austrian school economics explains this quite well. With the risk of oversimplifying, the basic idea is that the normal "flux" of the economy, i.e. different companies and sectors doing better or worse at different times, is caused by changes in consumer preferences. As one company or industry dies off, new ones arise, and workers adjust to the change.

However, when a central bank tinkers with the interest rate, it has economy-wide repercussions. Artificially low interest rates result in "cheap money" flowing to projects and investments that wouldn't be funded under the higher, natural rate of interest. Typically, these types of investments are those with a longer time horizon and further removed from production of a final consumer good. Mineral exploration is an example (not that Austrians would say low interest rates will _always_ result in misallocation of investment to mineral exploration). At some point this artificially-supported allocation unravels, resulting in a recession.

A better description of the Austrian theory was written by Roger Garrison and is available at http://www.auburn.edu/~garriro/a1abc.htm.

[reason]

The missing variable is TIME. Things take time to happen and things happen at different rates in different places, markets don't instantaneously clear. People have invested badly go bankrupt and the procedure takes time and meanwhile funds are tied up and can't be used elsewhere. People's portfolios then a misadjusted and people try to save to make up the difference and stop spending on durable items. Then people who make durable go broke. Then add a dose of uncertainty (because nobody knows what equilibrium really looks like) and all is clear.

[reason]

I have strongly argued in the past that the problem is the comparitive static methodology traditionally used in economics. You need a proper dynamic disequilibrium model. (I have also argued, that the best way to do that is via object oriented simulation).

[reason]

What Jay says has some validity, but of course the Austrian's never expressed there ideas mathematically. What is missing besides time is a view of household and firm balance sheets, that recognises there can be sudden changes in asset prices. (And that recognises the fundamental instability of a leverage based money supply.) I don't see bankrupcy appearing in most econometric models.

[reason]

But of course Jay is wrong in another way - it is not just incorrect interest rates that can cause investment errors. The unexpected often happens.

[hari]

During my time at OECD (1970s) the *mantra* was *technological* comparative advantage which kept the *richman's club* ahead of the emerging markets. Then came South Korea and Taiwan, Asean bloc, and now mainland China and India - globalization has rendered the mantra null and void (may be). FDI from OECD cannot be stopped and technology transfers are inevitable as international division of labour exacerbates with rapid globalization. Although some - like Germany - are actually increasing their (relative) share of manufactures; other's find it (like Nokia) that FDI is only way to maintain global competitive markets for manufactures.

I wander what's the share of manufactures in US since WTO entry of China was consolidated by US Trade Rep?

[reason]

hari...
your comment is interesting but isn't it a bit OT?

[save_the_rustbelt]

Could modern recessions be more regional than in the past?

MYWAY

Many states appear to be in recession


Apr 25, 6:05 AM (ET)

By ANDREW WELSH-HUGGINS

(AP)

The finances of many states have deteriorated so badly that they appear to be in a recession, regardless of whether that's true for the nation as a whole, a survey of all 50 state fiscal directors concludes.

The situation looks even worse for the fiscal year that begins July 1 in most states.

"Whether or not the national economy is in recession - a subject of ongoing debate - is almost beside the point for some states," said the report to be released Friday by the National Conference of State Legislatures.

[Bruce Wilder]

str: "Could modern recessions be more regional than in the past?"

You don't think recessions were regional in the past? The Great Depression had been underway in the South and the Plains States, well ahead of the Crash. The Depression of 1893, although dramatic enough in the Northeast due to the novelty of massive industrial strikes was really severe in the West. Do you think booms are not regional?

[Bruce Wilder]

Separable curiosities:

If one thinks the (macro)economy is moving toward a full-employment path only or mostly because the Central Bank is predictably urging it in that direction, then there is the logical and imaginative possibility that the economy will instead move toward an equilibrium path, which leaves significant resources under-employed. And, there's also the possibility that the Central Bank might be fooled into accepting such a less-than-full-employment equilibrium as "natural", and therefore, I suppose, an incentive to fool the Central Bank as to what is, "natural", if there is an advantage to such.

And, on a micro-level, if employment depends on prior sunk cost investment, is it possible that the failure to make certain public, sunk cost investments would leave significant resources under-employed, out of the circular flow and unreacheable by Central Bank policy?

[Justin Rietz]

Reason is correct in saying that Austrians typically don't use mathematical models. The reason for this is that they believe such models can never capture the complexity of economic issues, and therefore can be misleading in their results.

Regarding sudden changes in asset prices, the question would be what causes these changes? Austrian Economists' first suspect (or only suspect) would be government policy, with monetary policy being the main suspect (as Jay pointed out). For example, the housing crisis is blamed on unnaturally low interest rates.

[Noni Mausa]

Could it be that the number of people needed in "the economy" is increasingly becoming fewer than the number of citizens?

If your high school is putting on a play, the number of participants is limited by the cast of the play and the number of support people needed for lights, sets, makeup etc. It's not efficient to try to include any more than that, and so you have the cast under the lights, doing the play, and the remaining un-needed students on the sidelines. You have developed a natural "cast system" * which excludes most students.

Suppose the economy is like that class play. Increasingly, people are extras, spare parts, because the play doesn't need any more Emily's or Stage Managers.

Of course, in the case of theatre, everyone could work in summer stock if they wanted. Employment is much more a life-or-death matter when being in the right cast determines your income and your wellbeing, or even survival.

I think this is what we are seeing, where high status individuals and specialized employees earn well, and a large fraction of citizens are merely spare parts when it comes to the workforce.

Noni

* Sorry

[Justin Rietz]

Noni-

More people means the need for more goods and services. In addition, an economy with higher productivity (which is what you are describing) frees up people to start new business or expand their current businesses into new areas.

Basically, in a free market, it is impossible to have "spare parts" except during adjustment periods in the short run.

[Winslow R.]

Noni wrote: "It's not efficient to try to include any more than that"

It may not be efficient to include everyone but it may be 'optimal'. The purpose of government is to govern. Inclusion tends to be an optimal form of government.

[Winslow R.]

BW wrote "And, on a micro-level, if employment depends on prior sunk cost investment, is it possible that the failure to make certain public, sunk cost investments would leave significant resources under-employed, out of the circular flow and unreachable by Central Bank policy?"

It should be made clear that 'public investments' provide money flows. If the money flows are not taxed out of existence (balanced budget) China/Saudi can 'save' those flows. If Chinese/Saudi savings exceed the flows, under-employed resources become apparent.

Not happening so far!

If China/Saudis 'save' too much, could CB policy reach these workers with broad macroeconomic tools such as the Fed Funds rate?

Not with the current transmission mechanism!

Banks are constricting credit and the Fed has not bypassed banks and gone directly to the people.

As long as China/Saudis continue to 'save' less of the money flows, unemployed resources have not become a significant problem.

Bank money flows stagnate while government money flows grow, and savers 'save' less of those money flows. Unemployed resources are contained......and the Repubs win in November!

[Winslow R.]

reason wrote: "(I have also argued, that the best way to do that is via object oriented simulation)."

I've thought this would be cool as well. Lee Arnold seems to have a talent for creating interactive presentations. Haven't seen him around lately.

[Winslow R.]

JR wrote: "Basically, in a free market, it is impossible to have "spare parts" except during adjustment periods in the short run."

Who controls the Knob in this 'free' market? Or is the Knob just not understood in this framework?

*the Knob is on the spigot that controls public and bank money flows.

[Justin Rietz]

I read your previous post, but unfortunately I don't quite understand what you mean by a "Knob" in the context of the discussion. Perhaps you would provide a bit more detail?

Thanks.

[Winslow R.]

What is a 'free market'? Where everything is free? As in Adam and Eve in the garden of Eden?

Cain and Able transformed from hunter/gather years ago along with pretty much everyone. People gathered into socially structured markets.

Given today's markets have a fairly highly developed social structure, it is readily apparent there are social controls on that structure.

Fiscal policy is one method of control.
Monetary policy is another method of control.

The 'knob' of fiscal policy is government directed spending.
The 'knob' of monetary policy is bank directed lending.

Where do these 'knobs' fit in the framework that tell you it is impossible to have 'spare parts'?

[Bruce Wilder]

Jason Rietz: "Basically, in a free market, it is impossible to have "spare parts" except during adjustment periods in the short run."

Faith without works is dead.

[reason]

Bruce Wilder...
But he is perfectly correct, except that the long run, like tomorrow, never comes.

[reason]

Jason Reitz,
I could imagine perfectly easily how technological change, geological discoveries and legal change could cause massive asset price changes without monetary policy mistakes.

[Justin Rietz]

Reason -

I disagree with technology changes. Technology changes tend to affect a subset of the economy. Even if there was a new technology that had effects across the economy, people and businesses take time to adopt and implement technologies (Geoffrey Moore gives a good description of this in his book "Crossing the Chasm").

I do agree with you to a certain extent on massive geological discoveries, specifically oil. However, note that Brazil recently had such a find, yet oil prices continue to sky rocket.

Regarding legal change, I apologize if I forgot to add "other government action" to my original comment. Certainly laws often have economic or society wide impacts.

Bruce Wilder -

I have been meaning to respond to you, but honestly I still am not clear on what you are saying, and therefore I risk making myself look like a "knob" ;-)

[reason]

Justin Reitz...
Imagine an economy totally specialised in producing some chemical which is then replaced by a superior and cheaper synthetic alternative. I believe this has actually happened wrt. Fertiliser (Guano). Technological change CAN massively affect asset prices.

[reason]

P.S. wrt to the finds in Brasil, no newspaper seems to have pointed out just how deep they are, and that there is no proven methodology for extracting commercial quantities at that depth. Hence, it is not certain when and if they will come into production.