Old classical macro plus reallocation
By Scott Sumner
My vision of macro has several components:
1. A production possibilities frontier, which gradually shifts out due to productivity and labor force growth. That’s the “old classical” part.
2. An AS/AD model that causes output to cycle above and below the PPF, due to monetary shocks (NGDP) plus sticky wages.
3. A “reallocation” problem when the economy needs to move quickly along the PPF. In that case, the economy will briefly dip inside the PPF, as resources in one sector cannot be costlessly reallocated to another sector:
The period from mid-2008 to mid-2009 is an excellent example of the second case, where tight money pushed the economy well inside the PPF, causing RGDP to fall by 3%. But what’s an example of the third case—reallocation?
It turns out that the period from the first quarter of 2006 to the second quarter of 2008 is a near perfect example of reallocation, showing all the trademark effects. Here are some data:
1. Housing starts fell by more than 50%, from a bit over 2.1 million (annual rate) to a bit over 1.0 million.
2. If the reallocation model is correct, then the decline in housing related industries should have been partially offset by a rise in non-housing related industries. And that’s what happened. RGDP growth average 1.27%/year over that 9 quarters, which was positive but somewhat below trend. Non-housing industries expanded.
3. Reallocation can be viewed as an adverse supply shock, so inflation should have been relatively high. And indeed the GDP deflator rose at a 2.45%/year rate, above the Fed’s target of 2%.
4. Total employment would probably have risen, but at a slower than normal rate. Unemployment would rise slightly. And indeed that’s what happened, as total employment rose and the unemployment rate crept up from 4.7% to 5.3%.
In fact, the economy was hit by a second reallocation shock at the tail end of this period, as oil prices skyrocketed in early 2008. So in addition to reallocating out of housing construction (and related activities), the economy had to reallocate away from energy intensive industries such as SUV and pick-up truck manufacturing. This 6 month period is when much of the rise in unemployment occurred. And yet despite all of that, RGDP held pretty stable.
Thus one of the biggest reallocations in modern history had only a modest impact on the business cycle, as other sectors picked up the slack. In contrast, the subsequent fall in NGDP (i.e. tight money) drove output lower in a broad cross-section of industries during 2008-09, pushing RGDP sharply lower and unemployment up to 10%.
In my view, the events of 2006-09 fit the model almost perfectly. Not sure why the Great Recession was viewed as a crisis for macroeconomics–maybe other economists have the wrong model.