I am really hustling in my entrepreneurial capacities lately, so I haven’t had the luxury of commenting on the back-and-forth Arnold Kling is having with his critics on his view of economic “recalculation.” Specifically, the argument is whether we add anything to our discussion of recessions and recoveries if we talk about the need to reallocate workers (and other resources) to different sectors, versus framing everything in an Aggregate Demand / Aggregate Supply framework.
At some point I may chime in on the specific disagreements, but for now let me use Kling as a springboard for the present post. He wrote:
As you may know, I have been recording chalk-talks for my high school economics class. I did macro first, and now I am working on micro (I am now quite a few lectures ahead of where we are currently in the course). After I did the basic factor demand story (wage equals marginal revenue product), I thought it might be ok to introduce PSST [Patterns of Sustainable Specialization and Trade]. The result is here. Think of it as an introduction to PSST for students who have gone through the rituals of introductory macro and just barely learned basic supply and demand in micro.
Anyway, what occurred to me while trying to do my talk was that there may be some intellectual swindling going on with AS and AD analysis. More below.
I started with the textbook model. There, the only problem in the economy is that the wage rate is too high. Thus, you get an excess supply of labor. Given the too-high wage, there is no excess supply in the goods market (firms are producing where marginal revenue equals marginal cost). But I have two issues with the textbook model.
1. It is nearly an abuse of language to call the problem a shortfall of aggregate demand. That makes it sound as if the problem is a lack of demand for goods, when in fact the problem is an above-market-clearing wage.
2. My verdict is that the textbook model does not hold up empirically. There are too many recessions on record where you do not see the real wage rising as the model predicts. This has nothing to do with whether you like PSST or not. As an empirical matter, if you are trying to explain every change in unemployment on the basis of a reverse movement in real wages, you cannot do it.
In my talk, I addressed these issues by drawing a goods market with excess supply using the standard picture…
OK, for one thing, unless Kling’s got these kids as students, I think this is probably way too hard for high schoolers.
If I may, here’s how I tried to tell what is the Austrian story (without calling it that), in my textbook aimed at junior high kids:
The Causes of Mass Unemployment
The single most significant aspect of the business cycle—in both political and human terms—is the mass unemployment that occurs during the bust or recession phase. Yet ironically—and perversely—the very government policies that most people recommend to “help” the plight of the unemployed actually prolong the recession and sow the seeds for the next unsustainable boom.
The artificial prosperity of the boom period was fueled by the government’s interventions pushing down the interest rate. The “false” price of borrowing credit led entrepreneurs to borrow more than there was true savings available. Remember from Lesson 12 that the pure market interest rate serves to ration the available savings among all the competing borrowers, and that the process isn’t simply about money. There are real, physical resources involved as well. If workers and materials are devoted to building a new car factory that will take two years to complete, then those resources are “locked up” in the project for at least two years until they begin to “bear fruit” in the form of new cars.
During the artificial boom, too many of these long-term projects are started, because the false interest rate is too permissive. But the mere printing up of new money hasn’t actually created more workers or other resources to go around. It’s still the case that if work begins on a new car factory, it absorbs resources that could have been used elsewhere. If, during the early stages of the boom, too many projects are started, then it is physically impossible for them all to reach completion. The sooner the central bank chickens out and lets interest rates return to their appropriate level, the better, because then the entrepreneurs catch their mistakes sooner and stop digging themselves deeper into their mistaken projects.
When the boom collapses and turns into a bust, there is a period of confusion where everyone in the market needs to reevaluate his or her situation, in light of the shocking realization that the plans made during the boom were mistaken—and in some cases, very badly mistaken. If we step back and think about the adjustment process, during which the economy returns to a sustainable growth path, it must go something like this: Those resources that were drawn into unprofitable projects or sectors during the boom period, now need to be redirected elsewhere. And that requirement includes labor resources, meaning that people who happen to be working at extremely unprofitable businesses (but which seemed profitable during the boom) need to lose their jobs once the bust occurs.
For example, if six months’ work has been done on a new car factory that will take another 18 months to complete, but for which (in light of the new information) there won’t be enough car buyers to support its operations, then obviously the correct thing to do is to stop building it immediately. From the point of view of the whole economy, it’s not “compassionate” for the government to, say, use tax dollars to subsidize the company that owns the factory, in order to prevent the construction workers from being laid off, and to “create” jobs in the factory making cars that no one wants to buy No, the correct thing to do is allow those workers and other resources (which can be salvaged) to flow into other projects or sectors that are actually profitable.
The problem with this “tough love” recommendation, of course, is that it takes time for the economy to rebalance itself after an artificial boom, especially if the boom has lasted years. Consequently, there could be a period of months or even longer for some of the displaced workers, where they can’t find a productive niche in the streamlined economy, in the wake of the bust. Rather than waiting for the “laissez-faire medicine” to work, many people would far prefer the government to step in and provide immediate relief.
Yet even here, it’s important to realize the actual function that a prolonged spell of large-scale unemployment serves. Remember the critical flaw with outright central planning, i.e., pure socialism: Without market prices and the profit-and-loss test, the central planner wouldn’t know how to make efficient use of the resources at his disposal. In the modern United States, for example, a would-be central planner would have no idea how many people “should” be brain surgeons, or construction workers, or school teachers, and let alone how many people within each of these broad totals should live in each particular city in the United States.
By the very same token, then, no person or even group of experts could possibly know the “right” way for the economy to adjust, in light of a collapsing boom. For example, consider the construction workers who built houses in Las Vegas during the great housing boom from the early 2000s through 2006. Clearly there were too many workers (and other resources such as lumber and nails) going into the Las Vegas housing industry during these years, and the “correct” thing to do would be for them to do something else with their labor time.
But what, specifically? Each construction worker in the Las Vegas area was a unique individual, with different skills, interests, and personal circumstances. The “correct” response of one worker may have been to get on a bus to Texas to take a job at an oil refinery. The correct response of another may have been to go back to graduate school and finish his Ph.D. in literature. And perhaps the correct response of a third worker would have been to take a huge pay cut flipping burgers in Vegas, waiting for the housing market to recover, because his wife held a great job as a personal assistant to a successful Vegas attorney.
Now that we have some idea of the scope of the problem, we see that the pure market economy is the best way to solve it. After the boom collapses, many workers realize that they can’t earn the same paychecks they had become accustomed to. That’s what it means to say the prosperity of the boom years was illusory—people really weren’t as rich as they thought. What happens then is that laid off workers begin looking for work, hoping to find a new job that offers a salary and other features comparable to their old job, and which doesn’t require them to move or (at least) to move to an area they detest.
It takes time for people to search for new positions. The longer an unemployed person searches, the better his new job is likely to be. However, the drawback of longer searches is that the unemployed person isn’t contributing anything directly to the economic system; he must live off of the output of others during his search.
Notice that all of these issues are given their due weight in the pure market economy. Each displaced worker is allowed the freedom to choose his or her new job, based on all the factors relevant to the individual; no government official decides where the worker “ought to go now.” At the same time, individuals bear the brunt of their delay in finding new work, because there are no government unemployment programs that (to put it bluntly) pay people not to find a new job.
As we have stressed throughout this book, economic analysis per se cannot decide which government policies are good and which are bad. But it can shed light on the results of particular policies, so that citizens and government officials can make informed decisions. In the case of mass unemployment, the issue is not simply a matter of cruelty versus compassion. By establishing a system of unemployment compensation, for example, the government reduces the earnings of employed workers, and makes it less attractive for profitable businesses to expand at the onset of the recession.
The government doesn’t create resources or wealth, it simply redistributes them. If there were no formal government scheme for unemployment insurance, individuals and businesses would still have the option of using their larger paychecks and profits (which would no longer be subject to contributions to the unemployment fund) to build up their savings in order to provide a cushion during times of economic hardship. Perhaps this free market cushion would in practice be smaller than the duration of unemployment checks established by the government, but again, what economics shows us is that there is a tradeoff involved. It is not a fact of engineering or chemistry to say how long unemployment relief should last; that is clearly an economic question.
For example, it would clearly be wasteful if the government established a rule saying that anyone laid off from his job could collect checks equal to 95% of his former salary, for up to 20 years, until he finds a new job. Even the most zealous advocates for the unemployed would admit that that hypothetical policy would be disastrous, and would in fact hurt workers (all things considered). But once we admit that there can be such a thing as unemployment benefits that are too “generous,” our knowledge of basic economics makes it hard to justify the government’s decision to provide benefits in excess of what would have occurred in a voluntary pure-market economy.
Finally, if the government were really interested in helping the unemployed, it would stop using the central bank to artificially suppress interest rates. If the government and public could resist the urge to meddle during a recession, and simply let the correct market prices redirect workers and resources to sustainable niches, there would be no need for further dislocations. Unfortunately, in practice the central bank often “cures” a recession simply by fueling the upswing of another unsustainable boom.