Criticisms of the recalculation argument

[tyler_cowen]

Originally posted on October 4, 2009.

Matt and Ryan Avent comment, and Matt Steinglass, I'll put some points under the fold...

1. Sectoral shock theories of unemployment have a long lineage, including search theory, David Lilien (1982), Fischer Black, work by Steve Davis and John Haltiwanger, Mortensen and Pissarides, plus some recent writing by Michael Mandel and much earlier Franklin Fisher's work on disequilibrium adjustment.  Avent and Yglesias suggest that Kling is making up his own macro but the innovation is simply to call the adjustment process "recalculation," to give it a more Austrian gloss.  Mortensen and Pissarides are sometimes mentioned in the context of future Nobel Prize winners.

Or try Brainard and Cutler (nowadays both Obama-linked), who note sectoral shifts are especially likely to account for unemployment episodes of long duration.  Here is a list of some of the relevant real shocks.

2. Ryan's summary of the argument involves several strawmen.  Various polemic phrases are used throughout his post, including "makes no sense" and "nuts."  When you read language like that, it often indicates the writer has not worked hard enough to imagine a sensible version of the idea he is criticizing.

3. Here are a few claims I do believe and in most cases I am on the record:

a. The AD shock today is very real, albeit overemphasized by many relative to sectoral shocks.

b. There is an optimum delay on the recalculation process.  An economy can't always do all the recalculation all at once and that is one way of thinking about why some bailouts have been necessary, plus automatic stabilizers.

c. Reemployment does not in general proceed in accordance with an optimum, especially during major shocks.  This follows from many (not all) of the models cited above.

d. The new, on-its-way optimum may well involve new government expenditures in various areas on a permanent basis; pick port security if you want one non-controversial example.

You can believe all those propositions, as I do, and still think that the recalculation argument means that, in absolute terms, significant parts of the current stimulus won't be very effective.  As James Hamilton has pointed out, a big chunk of the problem is something other than insufficient aggregate demand and so more stimulus doesn't translate necessarily into better outcomes.  In other words, we're spending lots of money for smaller "bang" than was advertised.

You might disagree with those conclusions, combined with propositions a-d, but they're not "nuts."  There's a disconnect between the emotional content of the polemic Avent wants to level and the information content in his post.

3. Matt suggests that some of the critiques do not apply to most of the stimulus.  He notes that aid to the states is a big chunk of the stimulus, as is tax cuts and increased transfer payments.  On the transfer payments, see my point 2d; you may or may not like them but most analysts conclude, following the Bush experience, that such programs aren't very good stimulus.  So the recalculation idea doesn't much apply there but the stimulus idea doesn't much apply either.

On aid to the states, the recalculation problem applies very directly (Matt says it doesn't but I don't see where in his post he gives a reason for that view).  You can think that some form of state-level aid is necessary, as I do, and still see the recalculation idea as explaining why a big state-level ouch is coming in about two years' time.  When (if?) the stimulus is not renewed, a painful sectoral reallocation will have to take place and right now we are only postponing that pain.  By the way, it would be nice if state governments played along by having a coherent long-run fiscal plan but right now at least half of them are not doing this, thereby worsening the forthcoming ouch.  Wait until you see what happens with state universities in two years' time.  Ouch, ouch, and triple ouch.

Overall the recalculation idea does apply to large chunks of the stimulus, albeit not all of it.

4. We should be especially skeptical of gdp measures when: a) governments care about those measures especially much, and b) we face trade-offs between temporary and permanent gains and we are choosing the temporary gains.  Fiscal theories of cyclical movements, as outlined by Rogoff and the like, deserve to make a comeback and I predict they will.  In fact you can add those theories to the list above at #1.

The bottom line is this: if you're trying to use the recalculation idea to explain why the fiscal stimulus should be zero, that in my view will fail.  If you're using the recalculation idea to explain why the stimulus has a lower rate of return than many people think, it hasn't much been dented by the recent criticisms.  After all, if the problem were just insufficient AD, a solution would be ready at hand.  But it isn't and it's not just because Obama isn't "tough enough" to propose a bigger stimulus.  It's a genuinely difficult problem to solve.

I may soon consider Scott Sumner's very good recent posts on real shocks and the business cycle.