Why Such a Deep Recession?
Several economists, not just Scott Sumner, have argued that the recession is too deep and too broad to be explained by the Recalculation Story. I think that there are many weaknesses in the Recalculation Story. It is far from a well established scientific thesis.
However, I would suggest that explaining the depth of the recession is a challenge for just about any macroeconomist. There is no well-established theory that can explain how we got to 10 percent unemployment.If you are a Yale Keynesian, you would have been able to tell a good story when the S&P 500 stock index was down near 800. But it has gone back up over 1000, which means that Tobin’s q is doing ok, which means that investment should be doing ok. It is not.
If you are what Greg Mankiw calls a macroeconomic “engineer,” meaning that you believe in macroeconometric models, then you have to explain why unemployment today is higher with the stimulus that what the models predicted without the stimulus. The standard macroeconometric models do not explain the depth of the recession.
Next, we have the theory that even a little deflation is a horrible thing. Mark Thoma points to an essay by Andy Harless, which takes that argument to its logical conclusion, namely, that the Fed was too tight under Alan Greenspan.
The Fed eventually popped the previous bubble – the tech bubble – not because it was a bubble but because the economy was nearing the overheating stage, and the inflation rate risked eventually rising back to levels of a decade earlier. In my opinion, the Fed was wrong to pop that bubble. The Fed should have let the economy overheat, for a while, and let the inflation rate rise.
…Low inflation is what got us into this mess.
In the end, Scott Sumner is saying the same thing, although he thinks that as recently as the fall of 2008 the Fed could have generated enough expectations of inflation to save the day.
I want to offer a bit of pushback against this evils-of-deflation thesis. How could an otherwise robust, adaptive economy go completely haywire because prices stay flat, or decline for a bit? Yes, I know the Keynesian story–the liquidity trap pulls savings out of productive assets and under the mattress. Did we observe that? No–at least not for long. Again, look at the recovery in the S&P 500.
The other part of the Keynesian story is sticky wages. But have we observed a sufficient rise in real wage rates to explain the horrendous job market? I am waiting for someone to spell out that story.
The Keynesian story at least has some microfoundations. Scott Sumner’s Y = expected MV/P story is just hand-waving. Does he want to default to the sticky-wage story?
Some pundits say “credit crunch,” but it appears to me that since the beginning of this year the signs point to lower credit demand rather than lack of credit supply–unless you want to blame the banks for their reduced willingness to make stupid, risky loans. In any case, “credit crunch” is not in the macroeconometric models or in the textbooks. If the main story of this recession is going to be “credit crunch,” then it is going to require at least as much theoretical and empirical back-filling as Recalculation.
I think where we are is this: every economist can tell a story of a sectoral recession in housing. No economist, from any school of macroeconomics, has a really convincing story of how that recession spread so widely.
One characteristic of this recession is that employment fell more dramatically than output. I think this requires the Garett Jones explanation, which is that the typical worker today is building organizational capital, not making widgets. This in turn begs the question of why so many organizations decided to cut back on building organizational capital at once.
One story you could tell is one of self-fulfilling expectations. Every executive says, “We are in for bad times, I need to cut costs in order to survive.” They all behave that way, and you get a deep recession. I can offer a lot of anecdotal evidence in support of this story, and it may be right. But it implies a sort of psychological fragility to the economy that I find a bit hard to credit. It’s bad enough to have to believe that our economic decision-makers can’t figure out how to handle a little bit of deflation. It’s even worse to believe that they are afraid of their own shadow.
If I had a convincing explanation for the depth of this recession, I would shout it from the rooftops. Instead, let me toss out a few ideas, in no particular order of importance or plausibility.
1. The huge transfer of wealth to failed banks sucked a lot of energy out of the economy. In other words, the bank bailouts that are credited with keeping things from getting worse are in fact what made things worse.
2. The bloated housing and financial sectors created broader distortions in the economy. If the value of New York City’s exports of financial services falls, then that has all sorts of effects. The city’s nontraded goods and services sector is adversely affected. Its imports from other parts of the U.S. and the rest of the world fall. And so on. All sorts of trading patterns need to change, and that requires considerable recalculation.
3. Part of the adjustment process in the economy involves physical relocation. The nature of the collapse in the housing market means that relocation costs go up, which reduces the economy’s capacity to adjust.
4. Since 2000, the economy has been in an innovation slump. The human genome project yielded less immediate benefits than expected. Progress in computer and communications technology has become evolutionary, not revolutionary. Nanotechnology is far too immature to create major new business opportunities.
Only when an innovation reaches the point where its economic impact can be felt, as happened with personal computers and the Internet in the 1990’s, will lots of new businesses be created. Remember that in 1987 Robert Solow quipped that “we see computers everywhere but in the productivity statistics.” That soon changed. Today, one could argue that we see genome decoding and nanotech research everywhere but in the productivity statistics.
The recent innovation slump was disguised by the housing boom. That is, if you take away the housing boom, you would have seen a steady increase in unemployment, due to the lack of new business formation. Instead, the housing boom caused unemployment to fall, and the crash caused unemployment to shoot up.
5. We ran into a “limits-to-growth” problem with energy. Tightness in the oil market means that we have to convert to less oil-intensive patterns of consumption growth and productions. Just as in the 1970’s, this creates big adjustment problems.
Of course, it is possible to have several of these problems at once.