06 Oct 2009

Workers Would Rather Quit Than Be Laid Off

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That’s it, that’s all you need, to answer the Nobelist’s query. You don’t need to list papers on “factors of confidence and option value,” “sticky information,” etc. etc., except insofar as those opaque phrases mean, “Workers would rather quit than be laid off.” It also doesn’t really have anything to do with the timing.

Let me spell it out: Suppose we’ve got an economy in equilibrium, with unemployment at (say) 2.5%, with people quitting jobs and getting laid off in small numbers, due to normal changes of preferences, technology, etc.

Then someone starts printing up crisp new $100 bills nonstop. This guy begins advertising for new workers in his factory, and offers to pay qualified applicants double what they are currently making. Clearly, the number of people working at this factory is going to skyrocket over the months, as the guy continues to print up his new $100 bills.

Now Paul Krugman wants to know: Why doesn’t unemployment shoot up to 10%, as all these workers get sucked into employment at the counterfeiter’s factory?

The answer, of course, is that a few people who were previously unemployed take the jobs at the factory, and everybody else simply quit his old job, because of the higher wages. Unemployment actually falls down to about 0.3%, for a year or two.

But eventually something has to give. It can’t possibly be the case that printing up green pieces of paper makes the underlying economy more physically productive. People thought they were richer for a few years after the counterfeiting commenced, but actually they weren’t, in the aggregate. All that happened was a massive redistribution of wealth, and a consumption of capital as people were fooled into thinking their lifetime (real) earnings were now much higher.

At some point people realize the factory owner is running a counterfeit operation, and they pull the plug on it. The $100 bills stop flowing into the economy. Everyone at the factory gets laid off instantly, and all of the people who supplied materials to the factory see their business fall off by 50% (since the factory was such a large component of their sales). So they have to lay off a bunch of people.

The laid-off people are dazed. They can’t believe that they are expected to now take a job paying (in real terms) half of what they were making just yesterday. They decide to wait it out, sending out resumes in the hopes of getting a job that pays, say, 85% of what they are used to. Needless to say, the unemployment rate does not stay at 0.3%. In fact, it shoots above 2.5%, and stays at an abnormally high rate for many months.

Does Paul Krugman really not get that? Sure, maybe that story isn’t what happened in the US from 2002-2007, but there’s certainly not something logically remiss in the tale.

More important: Doesn’t Arnold Kling get this?! If so, why not bring it up when you’ve got poor befuddled bloggers who don’t see it?

(BTW for those who would prefer a more serious analysis, see my response to Krugman on this puzzle back in March.)

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