An Alternative to Hydraulic Macro
Mainstream macroeconomics is “hydraulic.” There is something called “aggregate demand” which you adjust by pumping in fiscal and monetary expansion.
I wish to reject this whole concept of macroeconomics. Instead, I want to get economists to think about unemployment in terms of the economic calculation problem.
[Before reading the rest of this post, you may wish to read something from about five years ago by Robert Solow (my dissertation adviser), dug up by Mark Thoma. In what you will see below, I take Solow’s emphasis on “heterogeneity” a lot farther than Solow had in mind.]In an article called “The Problem of Economic Calculation in a Planned Economy,” Bruno Leoni wrote,
Moreover, the comparison between costs and results, which often occurs instantaneously for consumers, may turn out to be disadvantageous for enterprises, as it is almost always out of phase in time for the producers. As a rule, they have to first pay the cost of production, and later cash the income from goods that have been sold, possibly at prices that are different and less profitable than those known at the time when the costs were paid.
The “socialist calculation debate,” to which Leoni was contributing, concerns the mistakes that a planner is likely to make in the absence of the information provided by markets. However, the paragraph quoted above shows that markets do not insulate the economy from planning mistakes. Entrepreneurs can make mistakes. Builders can construct houses and shopping malls that turn out to be unwanted. Individuals can obtain educational degrees that turn out to be in fields for which there is insufficient demand. Workers can develop experience in firms and industries that subsequently fail, leaving the workers with skills that have greatly diminished market value.
The Austrians emphasized planning errors, but to me they seemed focused on only the errors that entrepreneurs make in choosing the capital intensity of production in response to interest rates that are manipulated by the central bank. To me, all sorts of other errors are possible and ought to be allowed for in the theory.
Fischer Black had exactly the story of planning errors that I talked about, but he grafted onto it the theory of the Capital Asset Pricing Model, which says that people diversify away all idiosyncratic risk. Thus, everyone either does well together or does poorly together. Some people (think of government workers) choose “low-beta” assets, and so their economic circumstances change relatively little over the cycle, while others (think of people who buy stock index funds on margin) choose “high-beta” assets and get tossed around in whatever economic storms that blow in.
I don’t think that the CAPM is even a decent approximation for the distribution of risk. That is, I think people take a lot of idiosyncratic risk, particularly in terms of their human capital, which is for most people their biggest asset.
I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations. Digging out from these mistakes is going to take a long time. A lot of recalculation needs to get done, and the problem is really daunting.
I don’t think that fiscal and monetary policy solve this calculation problem. At best, they substitute the errors of fumbling central planner for the errors of fumbling individuals.