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.
My simple guess is that leverage had a huge part. Both households, through their houses, and the financial sector--banks, GSEs, hedge funds, etc.--took on a lot of leverage. I think we have incomplete models of how leverage and "credit accelerators/decelerators" work.
Non-financial businesses were able to compete when credit was cheap, but with slightly tighter credit and a drop in demand, these marginal producers are wiped. All it takes in a highly leverage society is a small drop in assets to blow the business/household up.
"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'm no economists, but this is the theory that resonates best with my intuition. From my position in industry I certainly saw companies who were probably not in any real immediate danger panicking about the credit crunch in the fall of '08. The credit crunch focused attention on cash control, which inevitably translated very rapidly into layoffs (especially of people "building organizational capital" because they are easy to cut without hurting short term productive capacity). I personally have watched a few companies congratulate themselves on their quickly implemented cash saving policies (still in place in most cases), even as they put themselves in a position where they eventually dropped behind order fulfillment.
I think the economy is subject to a certain measure of mass hysteria. When an OEM panics over tight credit and reduces production as a means of cash control, that ripples through the entire supply chain.
No data to support it, but this is where I'd start looking.
If you want to figure out the causes of a major, economy wide slump it would seem prudent to first rigorously look at the (very) few portions of the economy that could potentially have such broad effects. The logical place to start is with interest rates as they have such a broad effect on the economy, and yet interest rates are widely ignored as economists rush to find evidence for their own pet theories. Why is this?
Bacon, you're kidding right? No one's talking about interest rates?
Anyway, I think this graph over at calculated risk is interesting and relevant to the discussion.
http://1.bp.blogspot.com/_pMscxxELHEg/S1B56MzqiVI/AAAAAAAAHRI/jLtFjrF4Csc/s1600-h/CapacityUtilizationDec.jpg
Businesses are afraid of the new regulations and taxes they are facing and so don't want to hire. The big recalculation (now - not last year) is not out of housing and finance, but fear that the federal government is going to run too much of the economy.
"self-fulfilling expectations"
Or maybe excuse theory. Rumours of recession give cover to employers who need a good reason to trim the fat. My employer dumped several people early, then turned right around and hired "better" people a couple of months later.
I lean toward a version of the self-fulfilling expectations story. I don't think this requires that expectations be capricious, though. Imagine an economy in which individuals forecast future income levels and growth as a model average between a high-level, high-growth regime and a low-level, low-growth regime. Under most circumstances the probability of the latter is extremely remote, even given frequent small shocks to the economy.
However, if a big shock comes along that affects highly leveraged industries, this could produce a sudden jump in the probability of shifting to the low regime. This causes a shift in consumer and investor behavior, which shifts us more strongly toward the low regime. If the original shock is big enough, the feedback could drive us toward the low equilibrium.
In this view, there was essentially one benefit to the bailouts: they calmed expectations enough that we are no longer in the feedback loop. However, it could still take time for the perceived probability of the low regime to fall back to previous levels, and thus for consumer and investor behavior to return to their previous patterns.
I essentially see this as a nested model of expectations, in which expectations are rational for any given regime, but expectations about which regime we are likely to be in are adaptive. Not that I have a formal model to put forward at this time. I think a lot of work in macroeconomics in the near future will need to focus on improving our models of expectation formation.
I think there are in fact two distinct phases to the recession. There was the recalculation portion that Arnold has been talking about for some time now and there is the phase that was caused by the very public panic of Bernanke, Paulson and Bush. As Cochrane put it in the New Yorker interview:
"The market crashed, to which I would say, we had the events last September in which the President gets on television and says the financial markets are near collapse. On what planet do markets not crash after that?"
It wasn't just all stop in the financial markets; it was all stop in the real economy too. Regime uncertainty to the extreme. And I think you can blame the lackluster recovery on the same thing. Who knows what a new employee will cost?
So, if Bush & Co. hadn't panicked in such a public fashion, would we have had a nasty recession that is less than what we've gotten instead? I think so. If the Obama administration wasn't intent on enacting the entire platform of the Democratic party in one year, would the recovery be better? I think so.
Arnold, As I said in a comment to one of your posts on the relocation story, there is huge literature on trade policy reform that addresses the many problems related to the reallocation of resources that this reform entails. Many GE models have attempted to assess the final allocation but there is also a literature that analyzes the dynamics of the reallocation process.
I cannot review the research on the trade policy reform implemented in Chile in the late 1970s, but I want to emphasize that one key element in explaining the slow recovery from the deep recession of 1975 was the uncertainty about government policies in general (it took 4 years to recover).
I believe that as your country is on the road to become a Banana Republic, uncertainty about government policies will slow down the recovery. Please don't underestimate the impact of the ineptitude and corruption of the Obama administration on the economy. And please don't tell me that Larry Summers, C. Romer, Bernanke and other great economists are close to Obama; at best, they can prevent the worse ideas of politicians to become policy, but that's not enough to eliminate uncertainty.
Joe Calhoun:
So, the bankruptcy of Lehman, the bailout of AIG the recievership of FNMA and FHLMC, the panic in money market funds would not have caused a less nasty recession if Bush et. al. simply said "It's all OK. Don't worry, folks? We don't need to do anything?"
You're kidding me, right? A calm, collected response like Bernancke's "subprime is contained" would only have kept unemployment below 8%, right?
raising the minimum wage can't help. growing government can't help.
Possibility 1 makes a lot of sense to me, and is something I haven't considered, 2 also resonates with me.
Deflation? Yeah, if you ignore fuel prices, which rose steadily last decade. That had a major impact on disposable incomes. Instead of looking for signs of deflation, we should consider the idea we suffered from stagflation for the past 10 years. We had a consumer driven economy. It's time to start looking at what was happening with them.
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