The Recalculation Model, Simplified
First, I note that Paul Krugman is sounding Austrian. In a follow-up to his longer piece, he writes,
the economy is a complex system of interacting individuals — and these individuals themselves are complex systems. Neoclassical economics radically oversimplifies both the individuals and the system…even where the evidence clearly shows that they’re wrong. What economists have to do is learn to resist that temptation. But doing so will, inevitably, lead to a much messier, less pretty view.
Thanks to Mark Thoma for the pointer. Indeed, every macro story is a simplification. The challenge is to choose the simplification that is most illuminating. The problem with macro in the past thirty years, in my view and apparently also in Krugman’s, is that the simplifications were chosen to conform to a particular mathematical/philosophical approach (a “haiku” as Olivier Blanchard aptly put it). Constrained in this way, macro became intellectually sterile.
Here, let me try to tell the Recalculation story in a way that distinguishes it from other stories.Suppose that there are two industries for transforming present output into future consumption. There is a housing industry, in which you can obtain a house that will provide shelter for many years. And there is a venture capital industry, that will try to pick a portfolio of businesses in which to invest. These businesses have various technologies that might or might not produce dramatic improvements in health care, energy production/efficiency, or computing/communication.
The main drama in this story will concern consumers choosing to allocate their saving between these two industries. Gradual changes in their allocation can be handled with few problems. However, a sudden, dramatic shift will require a major Recalculation.
Some notes about what this story is not about.
1. The story is not about the choice between more roundabout and less roundabout means of production. Both the housing industry and the venture capital industry are roundabout, and we could tell the story even if they were equally roundabout.
2. The story is not about the choice between investment and hoarding, nor is it a story about liquidity preference. Neither housing nor venture capital are liquid (although we may have financial intermediaries that provide liquidity instruments for funding these industries).
Next, suppose that there is a bubble in housing, and when the bubble pops, many people want to put less income into expanding the housing stock and more income into investing in venture capital. This shift disrupts the economy and requires a major recalculation.
The economy needs to reallocate labor away from housing and related industries and into other industries. This means that the composition of the work force has to change, which takes a lot of time. Meanwhile, unemployment rises, which causes further disruption (there are multiplier effects).
In addition, the economy needs to reallocate its financial sector. It needs less banking involved in mortgage funding, and it needs more banking involved in venture capital. This requires changes in skill sets, in the structure of financial institutions, and so forth. Once again, this takes a lot of time, and meanwhile unemployment rises.
The Recalculation story can be thought of as an Austro-Keynesian model. It is Austrian in that it emphasizes the role of markets in processing information. During a Recalculation, there is too much information to be processed in too little time. The story is Keynesian in that during the Recalculation there are multiplier effects. Unemployed people cut back on their spending, and that in turn requires further adjustment, including more temporary unemployment.
The policies that I advocated last year are consistent with the Recalculation story.
1. Cut the employer contribution to the payroll tax. This will lower the price of labor, which at the margin should reduce unemployment. Also, it will increase profits, which will help firms function as financial intermediaries, while we sort out the banks.
2. Don’t try to keep people in houses they cannot afford. Instead, give them subsidies to move their belongings to apartments that they can afford. The attempt to bailout home owners just interferes with and prolongs the recalculation.
3. Don’t focus on bailout out existing financial institutions. Those institutions are suited toward making mortgage loans that the economy no longer needs. Instead, shut down the insolvent banks and allow a new financial industry to emerge.
Sep 6 2009 at 9:19am
I think that one point that needs to be answered by this model is the drop in economic activity accross the whole economy, seemily disproportionate to the size of the construction sector. I know that you have brushed on this with stress on multiplier effects but I think a more complete explaination on this point would go along way to making the model more convincing.
A possible explaination could be disruption to the credit lines of non-construction firms after panic and uncertainty that was apparently widespread in the financial sector as a whole. Perhaps some sort of variation of the Minsky Moment, although I am no expert on that area.
A criticism of that explaination would be the fact that it didn’t seem to be a collapse of commercial and industrial loans that precipitated the recession, I seem to remember St. Louis Fed publishing alot of data showing many type of lending were at record highs right into 2008.
Sep 6 2009 at 9:31am
“Don’t try to keep people in houses they cannot afford. Instead, give them subsidies to move their belongings to apartments that they can afford.”
Why does our government subsidize home loans on the one hand, then on the other hand take it away in the form of property taxes? If government is really interested in getting more people to own their own homes how about reducing property taxes?
Sep 6 2009 at 10:20am
Your story works to explain what happens after a bubble occurs. It doesn’t work to explain the bubble in the first place. Taking bubbles for granted is a hallmark of _the_ problem. It presumes they are natural, persistent, and not to be messed with; that they are somehow efficient or that explaining them would be inefficient or impossible. It avoids addressing the incentives created by inequitable distribution to exploit opportunities to extract more value than one produces and thereby to spark herding behavior. So, while I agree that all of our macro models simplify in ways that do violence to reality and can’t provide us as clear a picture as we would like, I don’t agree that, “The challenge is to choose the simplification that is most illuminating.” I think the challenge is to _make_ the simplification that is most illuminating, and that requires a synthesis of several elements from each school/model, and the addition of a couple that we have persistently and doggedly avoided because they portend self-control or collective restraint rather than limitless self-righteous gluttony, which are harder to sell.
I wholeheartedly agree that, “The problem with macro in the past thirty years […] is that the simplifications were chosen to conform to a particular mathematical/philosophical approach[.]” I think this is, in fact, _the_ problem with our understanding. That means that we need to examine our assumptions and take another look at our tools. The model you propose is good in that it adds texture and it bridges between micro and macro. I think it fails to give any power to affect future outcomes beyond disseminating information to individuals in order to accelerate the transition. It doesn’t give much guidance to policymakers except to sit back and wait while things adjust to ‘exogenous’ shocks; a “particular philosophical approach” to quote a learned opinion. These shocks are cumulative/aggregate/macro, but not exogenous to reality. To the extent that they are exogenous to our model(s), our model(s) are incomplete and therefore less valuable than they could be for both descriptive and prescriptive purposes.
We’re getting warmer.
Sep 6 2009 at 10:26am
“If government is really interested in getting more people to own their own homes how about reducing property taxes?”
I don’t know where you live, but in California this would be a really, really bad idea (one ‘really’ wasn’t enough).
Not only that, but property tax rates are set by states or municipal governments, not the federal government. So, a national goal of promoting home ownership would have to be effected through diverse coordinated policy or by centralizing that form of taxation. I’m not saying it couldn’t happen, but decentralized coordination hasn’t worked and your libertarian peers here probably don’t favor giving the federal government more control over taxation.
Sep 6 2009 at 11:02am
The problem is not strictly economic. If it were, liquidatonism would be the preferred means of resolving economic crises involving bubbles such this. However, the problem is social and therefore political as well as economic.
The problem arises out of modern social organization, which makes workers (and working families) dependent on the modern economy for survival as well as progress. Since the industrial revolution, when agriculture was replaced by industry as the chief economic driver, the majority of the population is dependent on employment for sustenance. Therefore, employment has become the principal social and therefore political concern, in addition being to an economic factor along with many others. When the bubble is debt-driven and involves housing, this becomes even more pressing.
An recalculation narrative has to take this into account, because if it doesn’t politics will. Just wait until 2010 if the job situation doesn’t improve, which it won’t.
Why is this important economically. For example, expect a push to interrupt globlization based on neoliberal principles of free trade, which US workers perceive as labor arbitrage.
Whatever one thinks of Keynes, he recognized the political realities of employment and knew that if capitalism is to survive in modern complex societies where employment is necessary for survival, economists have take this priority into consideration or politics will. In this view, the recalculation/re-calibration process cannot be one that countenances lengthy high unemployment without social unrest becoming a pressing social, political and economic factor.
Add to this implosion the unsustainable energy situation that is bleeding energy dependent countries and it seems obvious that the recalculation involves both venture capital for industries based on new technology, as well as training workers for developing types of employment.
While the challenges are great, so are the opportunities. However, the re-calibration is going to take time, and in the meantime, there is going to be considerable slack, as both consumers and financiers rebuild balance sheets, and firms that misallocated capital in unwise expansion liquidate excess capacity. This is not being to be a simple substitution process. Many jobs aren’t coming back, and many people are going to be unemployed for a long time or take positions well beneath their former skill and pay level. This will have long-lasting and deep political repercussion that will affect economic policy. A populist backlash is rising.
Sep 6 2009 at 11:38am
Relating to Krugman as cited above, there is no single paradigm in economic history that put as much effort and brain power in conceptualizing the complex interaction of complex individuals as did the neoclassical-Walrasian paradigm. Don’t blame the theory for the choice of applied economics to rely on representative households and aggregates. After all, the Sonnenschein-Mantel-Debreu theorem is mainstream too, no? What is the alternative?
Sep 6 2009 at 1:10pm
@amv: What is the alternative?
Krugman as Architect, Bezemer as Mechanic
Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth by Wynne Godley and Marc Lavoie
Sep 6 2009 at 1:37pm
postkeynesian economics? let’s make a bet: in a few years the neoclassical mainstream will find a neater answer to the current mess than any alternative paradigm. Neoclassical economics rules the roost because it is by far the most productive. And most of the serious critique of the mainstream comes from within. Think of Stiglitz, Grossman, ect. Think of Arrow or Hahn. Unfortunately, there is less of such intellectual hygiene in competing standards. The ‘inbred’ Cambridge tradition is certainly no execption to this.
Sep 6 2009 at 5:16pm
ARNOLD: This is a good simplification of the recalculation story. Basically, you are saying that unemployment will be (temporarily) high as labor shifts from one industry to another. I think this is true.
I think it is also true that an increased desire for the private sector to save will result in insufficient demand, and cause unemployment to rise also (the Keynesian view).
Right now, targeted Government spending and industrial policy is messing with the Recalculation, with bad effects now and in the future.
I strongly recommend you read about the post-Keynesians, who basically update Keynes for fiat-currency, floating fx, non-convertible, non-gold standard regimes like we have now (but did *not* have when Keynes was around). I think you will see then how the Government funding private savings demand would help the recalculation happen without such a high human cost in unemployment and lost real output.
Sep 6 2009 at 9:26pm
I was astounded to find Krugman had written a book on the economy as a self-organizing system. On one hand, it seems he’s aware that the economy is incredibly complex and that therefore everything else he professes must be utter nonsense, and on the other hand, he nonetheless primarily professes utter nonsense. I do not understand how Krugman can on the one hand understand the economy and on the other hand recommend everything one could imagine to destroy it.
Sep 7 2009 at 12:21am
If you’re familiar with the “anything goes” Sonnenschein-Mantel-Debreu theorem, then you should know well why pure general equilibrium approaches went out of fashion back in the 70s. It’s just too difficult to give it empirical content.
If anything, the record of the neoclassical paradigm is dismal. All this effort and all that is produced is a negative result.
This blog itself has mocked DSGE approaches in the past, never mind its predecessor GE models.
“economy is incredibly complex” -> “therefore everything else he professes must be utter nonsense”
does not follow.
Sep 7 2009 at 2:09am
A note on Post-Keynesian macro theory.
According to this crowd, the private sector cannot increase it’s savings rate without the government running a deicit. Makes you wonder how we coped in the period between the invention of money and the writings of J.M. Keynes. Quite well in fact, as savings increased from zero to at least 10% of GDP in many advanced economies, with not a budget deficit in sight.
In Australia, there has been 19 years of continuous economic growth – for many of those years the budget has been in surplus or close to balance. In fact the avowed policy of both major parties there is to keep the budget, not in balance, but in overall surplus, throughout the trade-cycle. Both the theory and the results completely contradicting K/PK theory, and the results have been very positive.
Compare this to the fate of Japan, who unfortunately seems to have listended too much to economic gurus from the West, the government there has continually lowered interest rates for years until hitting the ‘lower bound’, then kept them at zero whilst running large budget deficits. The results are almost completely negative. 11% GDP growth in two decades! Btw, Australia and Japan are major long-term trading partners.
PK theory works great on a whiteboard, but not so great in practice.
According to one prominent Australian Post_keynesian academic, the following graph is evidence that budget surplus’s are unsustainable, and always result in an economic slide back into deficit.
What i see is – surplus up, unemployment down. You can see that in the 15 years prior to the GFC, unemployment falls continuously, whilst the budget goes from deficit (after the ’91 recession) to a surplus, and stays in surplus for several years. All this contradicts PK thinking quite nicely.
Full article by Bill Mitchell.
Sep 7 2009 at 8:39am
@ david: this is of course one possibility. If general equilibrium analysis suggests that it is impossible to aggregate meaningfully, than kill the bearer of bad news and aggregate nevertheless. Or we learn our lessons from general equilibrium analysis and are more modest in interpreting the empirical content of our models. The former is the approach taken by applied economists: I guess this choice is more about sociology and sunk costs than it is based on reason. what would most of the applied economists do, if they take sonnenschein, arrow, or hahn seriously?
Sep 7 2009 at 9:21am
A couple of problems/questions:
1. What about option #3? That is people get so scared *(itless that they think the world is ending and don’t want to invest in anything for the future other than cash in the mattress, gold bars in the basement and plenty of canned food in the pantry?
2. Even during the bubble there’s got to be some firms toughing it out in the venture capital business. When the Great Recalculation happens shouldn’t they see an immediate spike in business since it will take time for home-based financial firms to retool into venture capital firms? Is there any evidence that the collapse in 2008/09 was/is accompanied by a boom in venture capital firms? If not where is the incentive for firms to enter the market?
3. Might the dot-com crash of 2000/01 be the reverse, a collapse in a venture capital bubble that resulted in a switch to housing related investment? If so why the lack of such a major recession. DO NOT SAY Greenspan kept interest rates too low! Today’s interest rates make the 2000’s look like the era of the loan shark. Why the massive unemployment now? Was it easy for firm to switch from venture capital to housing but not so easy to switch back?
4. Construction I get. The skills needed to build a house aren’t the same as the skills needed to lay fiber optic cable, set up servers, build labs etc. Finance I don’t. You make it sound like we are having a recession because retooling a Wall Street firm to invest in venture capital is as hard as retooling an auto plant to make planes or tanks. It’s not. Is a mortgage loan officer really such a different creature than a business loan officer?
Sep 7 2009 at 9:24am
#5) This is a very limited area of spending we are talking about ‘future consumption’. Even if the ‘future consumption’ industry is littered with rigidities that make it very hard to accommodate a sudden shift in preferences why should that cause such a collapse in the much larger industry of ‘current consumption’? Frankly, why does this impact not only my 401K but also my potato chip consumption?
Sep 7 2009 at 4:43pm
DREWFUS: PK’s would say that non-fiat, convertible, non-floating fx regimes kept suffering from calamitous depressions and defaults.
A recent nonsense article on this blog by Hummell had a great list of these calamities. Of course, he was talking about the US fiat regime, which clearly he does not understand, but as Krugman points out that does not seem to keep one from being an econ professor (which he is).
Anyway, this is not functioning “well”.
Australia is a good example, as PK has done pretty well there (JE King has written about this at length, I believe). Australia’s in deficit now and is expected to continue to be so until the middle of the next decade. So whatever the politicians say, it certainly is not running surpluses through the entire business cycle (good for it!)
PKs would say that Japan’s deficits continue to be insufficiently large to fund the demand for its private sector to save. Given Japanese savings rate, this is obviously true. It’s also funny that you pick Japan as an example that disproved PK as it more obviously disproved monetarism and Keynesianism (Govt spending)!
Thanks for the link. Again, your interpretation of the data is funny. Of course surpluses rise and unemployment falls at the same time — the Australian budget is counter-cyclical thanks to automatic stabilizers, just like the US Federal budget! The thing to note is that it zig zags, and the zig zag trend not happening from 98-2008 was because they were on the same private sector credit binge that the rest of the world was at. Expect to see massive deficits working to counter high UR in the next 5 years.
Anyway, agree or disagree with PK, it’s the only school of though I know that looks at balance sheets, accounting, and private sector debt, all of which are very material in this current financial crises.
Sep 7 2009 at 5:30pm
“Cut the employer contribution to the payroll tax.”
Do you mean “Temporarily and expect how much relief compared with other forms of stimulus?”
Or “Permanently and increase which taxes instead?”
As Krugman says, tax cuts make pretty inefficient stimulus per dollar of deficit increase compared to outright government spending.
On the other hand moving taxes away from labour onto incomes of the richest 1%, income from capital gains, energy etc. would most likely result in greater economic efficiency.
But – when you propose decreasing some taxes, it is only fair to propose increasing some others.
Sep 7 2009 at 5:30pm
Talk of a general disruption of credit-lines is apocryphal. To begin, credit-spreads did not widen generally. They widened particularly on borrowing by financial institutions: http://lostdollars.org/static/moneycost.png
Second, the Fed’s loan officer survey showed that reduced demand was principally responsible for the decline in lending. Importantly respondents said neither reserve demands nor capital constraints nor tightening lending standards were a significant factor.
The connection between the financial implosion as inducing a general malaise is tenuous at best. Eventually we broached a point in late 2008 where poor economic conditions strained the financial industry–the marker of this is the rising default-rate on prime lending
Sep 7 2009 at 8:05pm
I think Lilien’s (JPE 1982) Sectoral Shocks story is close enough to your Recalculationism to merit some attention.
Blanchard and Fischer discussed the model in their classic textbook. It sounds good on the chalkboard, but then Haltiwanger et al. actually looked that the data, which didn’t support the story:
Haltiwanger and Davis found that typically, people switch jobs within the same industry. This quote from their intro sounds like a response to your blog post…but it was written in 1992:
“The inability of either sectoral shock theories or theories that stress learning about initial conditions to account for observed rates of job reallocation leads us to the following conclusion: any successful explanation for the magnitude of job reallocation must also explain why simultaneously high rates of job creation and destruction occur among mature plants in narrowly defined sectors of the economy.”
We’ll have Haltiwanger as a Public Choice Seminar speaker later this semester: I hope you can drop by to ask him some questions….
Sep 8 2009 at 7:49am
“A recent nonsense article on this blog by Hummell had a great list of these calamities. Of course, he was talking about the US fiat regime, which clearly he does not understand, but as Krugman points out that does not seem to keep one from being an econ professor (which he is).”
Paul Krugman really wants to have a bet each way. He both believes, or says he believes, that macro theory is in a poor state, lacking a real understanding of the complexity of the modern economy, and at the same time, he’s damn sure that almost everyone else is avoiding the fact that 1940’s Keynesianism is the way to go. So is he unsure or not?
“Australia’s in deficit now and is expected to continue to be so until the middle of the next decade.”
“PKs would say that Japan’s deficits continue to be insufficiently large to fund the demand for its private sector to save.”
And so does PK. So no matter how may times the policy fails, we just say – “do it again except more so!” Funny how Japan has had these high savings rates for decades but only in the last two has this necessitated monsterous deficits.
“Thanks for the link. Again, your interpretation of the data is funny. Of course surpluses rise and unemployment falls at the same time — the Australian budget is counter-cyclical thanks to automatic stabilizers, just like the US Federal budget!”
I decided to look at the data and take it at face value – rather than viewing it through the accepted schema. Surplus’s are associated with growth, deficits with stagnation. Similarly with interest rates – moderately high rates are associated with growth, ultra-low rates with recession, and with no tendency for change, even after many years. Some points:
1. At the height of the boom, Australia’s short-term rates were hundreds of basis points higher than in the U.S. – but growth was higher too. They are now recovery faster than the U.S., with the reserve bank rate at the ’emergency’ level of 3%. This is regarded as too low by many commentators, and the RBA is very close to increasing rates, with plans for further increases soon after.
2. The U.S. housing bubble actually started when the government finally got the deficit into balance and then surplus. Nor was this only due to automatic stabilizers. Coincidence?
3. The Japanese funds rate has been at near-zero levels for years, with no sign of recovery. They will do a lot better if they increase interest rates back up towards historical levels and make an effort to balance their budget. The depression settings have been tried at length and have failed.
“The thing to note is that it zig zags, and the zig zag trend not happening from 98-2008 was because they were on the same private sector credit binge that the rest of the world was at.”
Credit booms are actually associated with *lower* growth outside of the booming sectors. This was the case in the U.S. in the 2000s unfortunately. Australia also experienced a housing boom (to a lesser extent), but there was also healthy growth rates throughout the economy, and throughout an extended period of budget surplus.
“Expect to see massive deficits working to counter high UR in the next 5 years.”
“Anyway, agree or disagree with PK, it’s the only school of though I know that looks at balance sheets, accounting, and private sector debt, all of which are very material in this current financial crises.”
They have their strong points (as do most schools). I would say the micro-econ cost-plus pricing stuff is the best of all.
“It is impossible to begin to learn that which one thinks one already knows.”
Sep 8 2009 at 9:04am
The surplus of labor in housing and finance is clearly there, but it doesn’t explain much.
The great recalculation is not in the reallocation of labor, but in the reorganization of capital. Capital became hopelessly misaligned with reality and normal market pressures could not maintain an equilbrium.
Sep 8 2009 at 11:27am
“”Australia’s in deficit now and is expected to continue to be so until the middle of the next decade.”
Ummm… Australia? They do release budgets and forecasts.
And re: Japan, it would be great if you actually understood the basics of what PKs say, whether you agree with it or not. Their main contentions:
1. Private sector savings (or more particularly, private sector paid-in capital, the equity line on the liability side of balance sheets) is funded by Govt deficit spending, and cannot increase at a sector level without it.
(This is true as a matter of accounting).
2. Bank lending is capital constrained and has nothing to do with reserves. Banks increase both sides of their balance sheets to make loans. The private sector as a whole can expand it’s balance sheet. But that private sector balance sheet sits on a core of paid-in equity, which is funded by Govt deficit spending.
(This is true has a matter of operational reality and regulation).
Japan had dramatic credit expansion in its boom. It could have high “savings” with low deficits. Private sector credit collapsed in the crash, and much of those “savings” vanished. Savings were not savings after all. Since they, the private sector has been trying to increase it’s paid in equity, and that has barely been funded by Govt deficits. Two years of stagnation later, the private sector still isn’t having it’s savings demand funded. There was a good article in the Times about this.
“”Expect to see massive deficits working to counter high UR in the next 5 years.”
Automatic stabalizers have been what’s driven the massive US deficit to date!
I am also no fan of monetarism. I agree with you that ZIRP may be contractionary in some situations, as they rob the private sector of interest income.
Oct 5 2009 at 6:04am
It was kind of you to provide this simple explanation of recalculation theory. What I find missing is any indication of how your hypothesis can be made scientific, by which I mean identification of measurable and quantifiable indicators that could discriminate it from alternative hypotheses. Most importantly, how do you characterize and identify the nature of the reallocation going on. What exactly is it that need to be “calculated.”
In the last fifty years we have seen a millionfold speedup in the rate at which calculations can be made. If the business cycle really depends on calculation in any sense analogous to the usual meaning of the word, wouldn’t you expect some effect on the time a “recalculation” takes. You do mention the time it takes workers to be retrained, but if that’s the limiting time here, wouldn’t a better name for your hypothesis be “re-education”?
Instead you go directly to some policy prescriptions, which you baldly claim are “consistent with the reallocation” hypothesis. How so? If workers need retraining how do the policies you advocate facilitate it? It’s hardly clear what they have to do with “allocation” in any sense, except that (3) would have been likely to cause most of the world to advocate its savings to the mattresses.
You say: “Don’t focus on bailout out existing financial institutions. Those institutions are suited toward making mortgage loans that the economy no longer needs.” That makes it sound like you don’t read the papers. You seem to imagine that AIG, Goldman-Sachs and other large bailout beneficiaries are or were somehow specialized for the business of making mortgage loans (though of course Fannie and Freddie were).
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