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Thursday, April 24, 2008

"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.

    Posted by on Thursday, April 24, 2008 at 03:45 PM in Economics, Macroeconomics, Unemployment | Permalink  TrackBack (0)  Comments (37)


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