Is a broad lack of demand our Economy’s problem?: Recalculation vs. the data

The answer suggested in the post below is no.  He argues mostly that those who suggest we have a problem with people being in the wrong economic activity, not a lack of demand can’t explain why construction dropped for several year before the economy really hit the skids.  I think the housing story and people in the wrong jobs may still hold up.  My thinking is that there are transmission mechanisms from the falling construction to the broader economy that take effect with a long and distributed lags.  For example the drop in housing would impact furniture and other houseware sales but only after time.

There’s no question that Arnold Kling’s recalculation view is more intellectually appealing than the messy arguments about wage stickiness used by us ”GDP factory” proponents:

Regular readers know that I am trying to nudge them toward a different paradigm in macroeconomics. I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade. Even if there is only a small chance that this alternative paradigm is useful, I think it is a worthwhile exercise.

One reason for wanting to change the paradigm is that I believe that trying to describe economic activity using an aggregate production function is a mistake. When I use the derisive expression GDP factory, I am referring to the aggregate production function.

Yes, macroeconomics should be all about specialization and trade.  Except business cycle theory, which needs a special ad hoc sticky wage/price model.  Why?  Because the evidence simply doesn’t fit any other approach.  Here’s Kling on the construction bust:

I want to suggest that the output that is “lost” is output that people do not want. In 2008 and 2009, Americans do not want 2 million houses to be built. So I do not think that it is right to speak of a shortfall in output. Instead, we should say that the people who were building houses have not found a pattern of trade in which they can produce something that people want.

Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:

January 2006 — housing starts = 2.303 million, unemployment = 4.7%

April 2008 — housing starts = 1.008 million, unemployment = 4.9%

October 2009 — housing starts = 527,000, unemployment = 10.1%

So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs, which is what is supposed to happen if the Fed keeps NGDP growing at a slow but steady rate.  Then NGDP plummeted, and housing fell another 480,000.  Is this because people didn’t “want” those houses?  No.  They didn’t want 2.2 million new houses a year; that really was a societal screw-up (with many possible villains.)  Kling’s completely right about that.  But they probably do want about a million new houses a year as our population grows by 3 million per year and families average about 3.  The reason housing fell far below normal is because the severe fall in NGDP created a deep recession.  Unemployed factory and service workers aren’t going to buy new houses.

Most importantly, the huge run-up in unemployment did not occur when the big fall in housing construction occurred, but much later, when output in manufacturing and services also plummeted.

Here is Kling on the Great Depression:

I think that technological change can drive the marginal product of many workers close to zero (When I mention ZMP, I always feel I owe Tyler Cowen a footnote.) I suspect that this happened in agriculture in the U.S. in the late 1920’s and early 1930’s, dumping a lot of manual laborers into unemployment.

I don’t agree with this.  There had been a very long term secular decline in farm jobs going back for decades before the Depression.  Those workers gradually moved to the cities and were absorbed by growing manufacturing and service industries.  So what changed between the booming late 1920s when unemployment was about 3%, and the early 1930s when it rose to 25%?  The answer is manufacturing collapsed, as industrial production fell by roughly 50%.  It was factory workers losing jobs that explains the Great Contraction, not farm workers.  Yes, farm workers continued losing jobs, but there was no longer any place in the cities for them to find jobs.  Why not?  Because NGDP fell in half between mid 1929 and early 1933.

Here’s Kling on oil prices:

Could “pumping up demand” help in such a situation? Perhaps. But if the recalculation story is right, the higher demand could end up not doing much for employment. Instead, it might only do a lot to raise oil prices.

Of course more demand could raise nominal oil prices by boosting inflation.  But with CPI inflation running around 1% it’s more likely that Kling is referring to an increase in real, or relative, oil prices.  Could monetary stimulus boost real oil prices?  Absolutely.  But if and only if it raised expected levels of output and employment.  In other words, if and only if it was expected to work.

In my next post I’ll address Tyler Cowen’s ZMP workers argument.

Recalculation vs. the data
Fri, 14 Jan 2011 18:24:16 GMT


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