Classical economics and recession in many countries (wonkish)

by John Quiggin on April 27, 2012

Sharp tests of economic theories are rare and hard to find, particularly in macroeconomics. Any examination of particular episodes in economic history necessarily involves counterfactuals, and these provide room for endless dispute. As an obvious example, assessing the impact of the Obama Administration’s 2009 stimulus requires an estimate of how things would have gone without the stimulus, and that is obviously hard to do.

Similarly, arguments about unemployment in the US get bogged down in disputes over whether it is structural or demand-driven and the extent to which policies such as the extension of unemployment benefits to 99 weeks have contributed. 

There is, though, one way in which the current Great Recession/Lesser Depression provides a sharp test of a critical proposition in economics. All forms of classical economics involve, in one form or another, the claim that the causes of unemployment are to be found in labour markets, and not in  macroeconomic variables such as the level of aggregate demand. That’s equally true of the Say’s Law version of classical economics criticized by Keynes, the New Classical macroeconomics of Robert Lucas and the attempts by Real Business Cycle theorists like Kydland and Prescott to explain cyclical fluctuations in terms of labor market shocks.

The crucial problem for all these theories is that labor markets and the associated institutions operate mainly at the national level. Even within the EU, different countries have very different labor markets. So, it is essentially impossible for labor markets in many different countries to move together, except as the result of macroeconomic influences operating at an international level[1]. That means that the occurrence of a sharp and sustained increase in unemployment, taking place in many countries at once, is inconsistent with classical economics.

This point seems trivially obvious, but as far as I can tell hasn’t been made, or at least not clearly. Once it’s conceded, it seems impossible to avoid a view of the world that is basically Keynesian in its analysis of the macroeconomy.  It is possible to hold such a view and reject Keynesian policies on pragmatic grounds, as in Friedman’s critique of ‘fine-tuning’. But the longer and deeper the recession the harder it is to sustain this view.

This seems like a good time to plug the fact that a paperback edition of Zombie Economics will be out soon (May 6) with a brand-new chapter on Austerity, bits of which have been seen here. On 9 May, I’ll be launching an Australian edition, where the added material is a chapter on Economic Rationalism. And a week or two ago, I received some copies of the Italian edition

http://www.stampa.unibocconi.it/articolo.php?ida=9724&idr=6

 

 

 

 

 

 

 

 

 

fn1. Of course, you can cheat and label these macro influences “technology shocks”, then assume them to be internationally correlated. But in the ordinary meaning of technology, there is no plausible way in which economies as disparate as, say, the US and Greece can experience a common technology shock.

{ 46 comments }

1

david 04.27.12 at 10:24 am

International real business cycle theories do exist, playing on international flows to spread technological unemployment originating in one country around. Productivity falls, investment falls, money flows out, etc. Their intuition seems most useful when there really are very large changes in ‘technology’, e.g., very large natural disasters in small countries whose aggregate demand is largely regionally-determined anyway.

2

Martin 04.27.12 at 10:25 am

Dr. Quiggin, John,

I share your attitude, but I disagree with you when you say that this recession refutes Say’s Law. Say’s Law is not an impossibility theorem, it’s a framework to analyze the macro economy. Properly understood, it states that price rigidity and a shortage of supply can be the sole causes of failures of ‘aggregate demand’. The classics weren’t stupid, they lived in a period where you could experience several trade-cycles in a life-time. The view that Say’s Law is that excess demands always sum to zero is a zombie in the history of thought.

3

david 04.27.12 at 10:32 am

Addendum: you’re right that in IRBC it’s basically impossible for unemployment to be contagious, though – investment pursuing relative productivity can slosh around and affect in-country output, but not unemployment. But I suspect that an RBC advocate will just assert that the international flows are simply triggering policy stabilizers which then cause unemployment. Or something along those lines. If the obviousness of Mundell-Fleming didn’t dissuade them, it’s not like unemployment contagion will.

4

Michael Harris 04.27.12 at 10:41 am

I just wanted to leave the RBC joke I left on Noahpinion’s blog (here: http://noahpinionblog.blogspot.com.au/2012/04/neither-real-nor-business-nor-cycles.html).

Two macroeconomists are arguing in a bar.

The New Keynesian slams down a beer glass angrily and exclaims “You real business cycle people have set the profession back twenty years!”

“Ah,” says the other, “so you DO believe in technical regress after all.”

5

david 04.27.12 at 10:41 am

Martin @2 – that is not Say’s Law, which says that all excess demands are zero. That excess demands sum to zero is Walras’ Law. Regardless, whether or not Say actually held this view is irrelevant to the common definition.

6

Tim Worstall 04.27.12 at 10:57 am

All forms of classical economics involve, in one form or another, the claim that the causes of unemployment are to be found in labour markets, and not in macroeconomic variables such as the level of aggregate demand.

OK….

So, it is essentially impossible for labor markets in many different countries to move together, except as the result of macroeconomic influences operating at an international level[1].

OK…

Once it’s conceded, it seems impossible to avoid a view of the world that is basically Keynesian in its analysis of the macroeconomy.

Depends on what means by Keynesian doesn’t it? The politician’s version which says that unemployment means they get to spend more money on their pet projects?

Or a discussion of which macroeconomic variable it might be causing the problems?

Like, for example, a falling money supply is a really bad idea so when a tightly interconnected international financial system is going through a great deleveraging perhaps right now ain’t the time to increase capital requirements on banks?

And would (and I use the above only as an example, not a statement of truth) such a monetary argument be considered either kind of Keynesian?

7

david 04.27.12 at 11:00 am

Probably New Keynesian, but not old- or post-.

8

P O'Neill 04.27.12 at 12:29 pm

As Tim says, one story that would “work” (not saying I believe it) is to consider the financial system part of the technology — payment systems, balance sheet structures, bank operational models have all taken massive hits in the last 5 years. Put in adjustment frictions and there is a cross-border story (why it lasts 5 years is another matter). Another mechanism is falling asset values increasing labour supply. Again you need frictions to get the impact we’ve seen, but in principle it can be done.

9

SamChevre 04.27.12 at 12:51 pm

Is there anything in RBC theory that require that shocks be technology shocks? Because the sustained rise in oil prices looks like both a significant factor, and an international one.

10

Steve LaBonne 04.27.12 at 12:52 pm

Is there anything in RBC theory that require that shocks be technology shocks? Because the sustained rise in oil prices looks like both a significant factor, and an international one.

Not even within a parsec of a quantitatively adequate explanation for something of the scale and duration of the Great Recession.

11

Metatone 04.27.12 at 1:09 pm

Is the desire to subsidise banking all that consistent with a stance against funding “pet projects”?

Anyway, at any moment in time it is possible to decide to take actions to increase aggregate demand as a whole by making sure you increase more in some areas than you decrease in others.

A good example would be that you could decide to spend less on military hardware and buy more solar panels. So long as you spend more on solar panels than you cut from the military budget, then you will be increasing aggregate demand.

12

Steve LaBonne 04.27.12 at 1:31 pm

Is the desire to subsidise banking all that consistent with a stance against funding “pet projects”?

Silly rabbit. “Pet projects” are those that help ordinary people. Giving free money to rich malefactors is simply sound, conservative policy.

13

John Quiggin 04.27.12 at 1:48 pm

@Martin: As I mention in my book, Say didn’t believe Say’s Law. I’m quoting it as the centrepiece of the classical viewpoint refuted by Keynes rather than saying that all economists of the classical/pre-Keynesian period thought this way

14

Dave 04.27.12 at 2:17 pm

Will the new edition with the bit on austerity also be on Kindle, so that I don’t have to carry too many books in my bag?

15

JMH 04.27.12 at 3:40 pm

Hey,

I don’t understand what’s wrong with the ‘technology shock’ idea presented in fn1. Can someone write something unpacking that a bit further?

Yours,

JMH

16

Robert 04.27.12 at 4:54 pm

“It is possible to hold such a view and reject Keynesian policies on pragmatic grounds, as in Friedman’s critique of ‘fine-tuning’.”

Is Friedman’s critique cited more often than Kalecki’s article, “Political Aspects of Full Unemployment”? Friedman has been empirically refuted, while Kalecki’s insights becme more apparent all the time. For example, I think there’s recent work showing the economy booms more when Democrats are president but the rate of growth is higher in the last year of a Republican president.

Maybe citation patterns have something to do with mainstream economics being institutionally structured from having left-leaning economists get the attention they would otherwise merit.

17

Martin 04.27.12 at 6:20 pm

John: on p. 84 you quote the definition used by Keynes “supply creates its own demand” that’s rather Keynes’ viewpoint of the centerpiece of classical analysis rather than the centerpiece of classical analysis? As far as I know, heard and learned is that Keynes got that part wrong. Not that there is anything wrong with the Keynesian system as a consequence, Hicks’ IS-LM is pretty much the classical system with some modifications. I believe Hicks didn’t think it to be that different from Marshall?

david@2: Say’s Law is not that all excess demands are zero. How would a classical economists ever go explaining the existence of a shortage of a single good? No, rather the classical caricature is that a ‘general glut’ is impossible, meaning that all excess demands sum to zero.

Though see p. 208 of Two Hundred Years of Say’s Law, Walras Law is put on the same line as Say’s Principle and Say’s Law. (ie. all excess demands sum to zero).

18

Barry 04.27.12 at 6:45 pm

Noah Smith has some comments on ‘technology shocks’ and Real Business Cycle theory:

http://noahpinionblog.blogspot.com/2012/04/neither-real-nor-business-nor-cycles.html

19

Marshall 04.27.12 at 9:02 pm

Amazon claims to be shipping Zombie Economics in paper now.

20

david 04.27.12 at 9:06 pm

Martin @16

You can have a general glut (aka, prevalent excess supply) with Walras’ Law quite easily. Just shovel all that excess demand into a handful of goods of choice, leaving everything else in excess supply. Real money balances is a popular target. Oil was another possibility back in the price-controlled stagflation era.

I reiterate that what the classicals actually thought is irrelevant to the fact that Say’s Law now has Say’s name on it. So what if “a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value” doesn’t actually mean what it seems to mean? Here’s another law: Stigler’s Law of Eponymy.

21

Norwegian Guy 04.27.12 at 9:55 pm

Just a question about footnote 1: Is there really such a strong connection between “technology shocks”-theory and classical economics? For instance, a far as I know Carlota Perez isn’t considered a classical economist, and she’s not using her theories about techno-economic paradigm shifts to support right-wing policies like austerity and financial deregulation.

22

Walt 04.27.12 at 10:27 pm

The post-70s classical revival (known as RBC) explicitly argued that technology shocks caused the business cycle, yes.

23

david 04.27.12 at 10:27 pm

Norwegian Guy @21 – normally, yes. Well, a certain kind of macroeconomics, anyway; ‘classical’ is not quite the right word. The core intuitive problem runs like this: advocacy that business cycles are principally generated by exogenous factors conflicts with any other claim that something else, e.g., policy, can alter the character of said waves. It’s basic causal accounting: all the claimed contributory marginal causes must add up to one at some point, so more of one is less of the other. It doesn’t really matter whether you are claiming that the technology shocks are a random walk a la RBC or Schumpeter-style long waves a la Carlota Perez.

When the classicals were speculating on long waves, major economies did not generally run explicitly macroeconomic policies. A heterodox economist claiming today that the past century of business cycles, even in the face of starkly different policy reactions, is still long-wave in nature is claiming that said policy ‘thus far’ has not altered the business cycle. This is a methodological point that goes well deeper than politics – observe that Schumpeter is claimed by both the left-wing and right-wing economic heterodoxy.

24

John Quiggin 04.28.12 at 4:50 am

@16 Robert I cite Kalecki in my book chapter on austerity, but I think it’s a stretch to say he was opposed to Keynesian policies. Rather he argued that, precisely because they work too well in removing the fear of unemployment, they are likely to be resisted by the owners of capital. I think Friedman is the right person to cite in this context.

25

Emily 04.28.12 at 6:51 pm

I don’t entirely understand all your use of terminology. But isn’t classical economic thought, if I have the right end of the stick, inherently flawed because it imagines and produces a structural economy along vectoral lines – vis a vis expansionism – rather than circular/pythagorean continuities?

26

JW Mason 04.28.12 at 7:06 pm

So the new line seems to be that falling real wages in the UK mean that aggregate demand cannot be responsible for depressed output. I think the claim that involuntary unemployment necessarily means that wages are too high, would be a nice zombie for you to knock down in a sequel.

27

JW Mason 04.28.12 at 7:15 pm

Also, I wish there were a nice off-the-shelf argument to point people to, for why wage flexibility is not a solution to aggregate demand shortfalls. Is there?

28

Kevin Donoghue 04.28.12 at 7:46 pm

Keynes, GT Ch 19 discusses why wage flexibility may not be a solution to aggregate demand shortfalls; Tobin also wrote a paper about this and so did Summers and DeLong. But I’m sure you know that. Sadly there’s no way to force people to pay attention.

29

SusanC 04.28.12 at 8:35 pm

Ok, so I’m not an economist…

The current situation seems really puzzling if you try to view it in the framework of Say’s Law etc:

We have a lot of people who would like to exchange their labour for things they want (food, shelter, fuel, clothing…) but are unable to do so – they just aren’t getting any takers. (The exchange typically isn’t direct but instead mediated by money, of course). They aren’t getting any takers even if they drop the price of their labour significantly (i.e. are prepared to work more hours than they previously did to obtain the same amount of food etc.). In this light, we have a severe shortage of just about everything except labour.

The puzzle (at least, if you’re starting from Say’s Law) is why this surplus labour isn’t getting used to increase the supply of food, shelter, fuel, etc.

At an individual level [in an industrial society, rather than a hunter-gather one] there isn’t a lot you can do unilaterally if no-one is willing to hire you. Some people I know hunt for mushrooms in the woods for food (I’m told there’s an even better market for selling the hallucinogenic ones), but this is one of the rare few cases where something is unilaterally possible (and they can’t get anywhere near meeting all their food requirement that way). In general, you can’t do anything unilaterally because you don’t have the capital—the land to build a house on, the land to farm, the forest to cut wood, the coal mine/oil field to mine, etc.

Which then raises the question of why the organizations who do have the capital aren’t hiring.

30

J. Otto Pohl 04.28.12 at 9:03 pm

Susan:

I am not an economist either. So maybe I am completely off base. But, I am pretty sure organizations with capital are hiring. They are just not hiring as much as they were in high wage countries. If you have a PhD in history and are willing to work for $20,000 a year rather than $40,000 you can easily get a job in Africa. Wages in North America and Europe are simply too high compared to the rest of the world given the fact that the same productive factors including human capital of equal skill and education can be obtained elsewhere for much cheaper. But, resources are being extracted and goods produced. Wood is being cut in South East Asia, coal mined in China, oil pumped in Dubai, and houses built in Accra.

31

Greg vP 04.28.12 at 9:10 pm

Josh @ 27: It’s a fallacy of composition thing, like the paradox of thrift.

32

Watson Ladd 04.28.12 at 10:54 pm

J. Otto Pohl, that’s a good explanation for some fields and products. But as an explanation for the downturn it doesn’t make sense: even if Africa can make some goods cheaper then the US, Africa only sends those goods to the US in exchange for goods that Africa wants that the US can make. It also doesn’t explain the timing of the recession: Was Africa richer in 2006 then today?

33

Bruce Wilder 04.28.12 at 11:13 pm

SusanC @ 29 : The current situation seems really puzzling . . .

Indeed. You’ve made a nice start on a summary of the issues. As you observe, we are enmeshed in a social system of a division and specialization of labor (and everything else), and although somewhat de-centralized and distributed, the power any of us has to make a living can be sharply curtailed by a breakdown in the coordinating mechanisms.

I will object to one gambit you offer: “we have a severe shortage of just about everything except labour”

In some respects, it doesn’t seem to me that we have a severe shortage of anything (though global limits on resources may be shadowing us). The stores are full of stuff, and merchants eager as ever to sell their stuff. Labor is not alone in being idle; in the U.S., for example, there’s an excess of retail commercial space, among other resources “unemployed”. The rhetoric of “austerity” notwithstanding, we have not experienced a harvest failure.

I think you right, though, to observe that natural need is not enough, nor natural effort. You have to have money to make your demand for goods, effective. And, to get a money income, you have to have a place in the productive structure — a job in the simplest terms.

Imagine twin circular flows driving economic activity: money in one direction, and goods in the other. Once you lose your place in the twin circular flows, you lose money income and the means to produce and sell goods/services into the system.

The question is, to what extent is it possible for the individual to bid their way back into the circular flow. Will reducing wages and prices clear the market for labor and restore full-employment, full-production?

I think it is at least plausible to think not.

I don’t think there’s much scope for substitution between labor and capital, at least not in the most productive sectors of the economy. If the capital stock and structure of production has shrunk, there simply are not as many places for people to work productively. The remedy should be to expand the structure and add to the capital stock, so that there are more places to be productive.

The New Keynesians like to emphasize that wages are sticky downward, and that’s a problem, with the implication that more flexibility downward would make the macro-economy more efficient or stable. It seems plausible to me that the problem — our problem at the moment, in fact — can be that wages that appear to be sticky downward are, in fact, sticky upward in the sense that the macro-economy is stagnating because Capital, particularly Financial Capital, is taking too large a share of national income. People are not getting the “marginal product” of their labor, because wages are too low, and therefore they can not make fully effective their demand for what they produce. Financial capital substitutes debt to finance effective demand, but that debt drives a debt-cycle, when the capacity to take on new debt is constrained by stagnating wages and financial capital “investments” (e.g. usury) crowd out industrial capital investment in productive capital stock.

In the 1920s and 1930s in the U.S., potential productivity was rising very rapidly, due to rapid technological progress in agriculture and continuous process manufacturing, not to mention electrical goods, automobiles, telephones, radio, movies, etc. With effective aggregate demand devastated by the deflation of 1929-33, and unemployment at 25% (and part-time employment at 50%) in 1933, individual labor markets “naturally” put heavy pressure on wages in a downward direction. But, I think it would be reasonable to suppose that wages would have to rise substantially to achieve a fully productive full-employment equilibrium. (You could do what they do in many third-world countries, which is to consign lots of people to extremely low-productivity employment in market stalls or agricultural plots, but that isn’t my idea of “full-employment”.)

I don’t know how to make the argument more plausible. We are all trained to “believe” in market prices, so that it doesn’t seem right to imagine that, due to financial misadventure on an enormous scale, the bargaining in market generates market prices, which are now signalling moves down the wrong track or in the wrong direction.

34

Data Tutashkhia 04.28.12 at 11:30 pm

Which then raises the question of why the organizations who do have the capital aren’t hiring.

Because their goal is to make profits, not to satisfy the need. Crisis of over-production; you don’t need to be an economist: it’s trivial.

35

Emily 04.28.12 at 11:35 pm

Speaking of Zombies, did anyone happen to read the Harpers article on the invention of the Zombie tradition in Haiti? If I remember rightly, it was economic too, because the men and women who were enslaved to labour in plantations found the means to end their slavery, and those that fashioned themselves owners created Zombie lore so as to prevent the, might I say, “depreciation of value of human capital.”

36

Jim Rose 04.29.12 at 1:21 am

See Ohanian for ‘The Economic Crisis from a Neoclassical Perspective’. He finds that
the great recession differs substantially from other post-war U.S. recessions, and also from the 2008-2009 recession in other countries:
• lower labor input accounts for virtually all of the decline in income and output in the U.S while lower productivity accounts for much of other U.S. recessions and the 2007-2009 recessions in other countries.
• The existing classes of models, including financial market imperfections models, do not explain the U.S. recession. This is because the 2007-2009 recession is almost exclusively related to what appear to be labor market distortions, a topic about which current classes of financial imperfection models are largely silent.

Friedman tipped that the Euro-zone would not last past the first major recession.

The current discontents in the euro-zone show that overreactions by governments can prolong and deepen the downturn, turning it into a depression.

One-third of EU unemployed are now in Spain: Cahuc et al. estimated that Spanish unemployment would be 40% lower if Spain adopted the less strict French laws!

37

John Quiggin 04.29.12 at 1:42 am

“This is because the 2007-2009 recession is almost exclusively related to what appear to be labor market distortion”

As I pointed out in the OP, this claim requires labor distortions to bit simultaneously and sharply in many countries at once, despite the fact that their labor markets have almost nothing in common. If you’re willing to accept this kind of silliness, why not go for the Casey Mulligan line that it was all caused by markets rationally anticipating the election of the Obama Administration.

38

Jim Rose 04.29.12 at 2:31 am

John,my mistyping: it should read the 2007-2009 U.S. recession is almost exclusively related to what appear to be labor market distortions.

on your claim that “the claim that the causes of unemployment are to be found in labour markets, and not in macroeconomic variables such as the level of aggregate demand” hayek’s view is that cyclical unemployment is due to a discrepancy between the distribution of labour (and the other factors of production) between industries (and localities) and the distribution of demand among their products.

This discrepancy is caused by a distortion of the system of relative prices and wages and can be corrected only by the establishment in each sector of the economy of those prices and wages at which supply will equal demand.

39

Kevin Donoghue 04.29.12 at 7:40 am

Jim Rose to John Quiggin: I’ll see your Casey Mulligan and raise you a Hayek!

40

Guido Nius 04.29.12 at 11:10 am

The solution to Spain’s current problems surely is to increase their historically low levels of infrastructure development.

41

JW Mason 04.29.12 at 10:47 pm

lower labor input accounts for virtually all of the decline in income and output in the U.S while lower productivity accounts for much of other U.S. recessions and the 2007-2009 recessions in other countries.

Oh good lord. I wonder if Jim Rose even realizes that he is simply assuming that the economy is always at full employment?

42

Tim Worstall 04.30.12 at 7:22 am

“The solution to Spain’s current problems surely is to increase their historically low levels of infrastructure development.”

Sounds a little odd as they’re suffering the tail end of a housing and infrastructure boom.

http://www.calculatedriskblog.com/2011/06/ny-times-overbuilding-in-spain.html

43

Guido Nius 04.30.12 at 1:17 pm

No kidding, Tim.

44

MPAVictoria 04.30.12 at 2:51 pm

Jim I am still waiting to become a serf because of my country’s national healthcare system. Any news on when that is likely to occur? Or is waiting for a right wing economist to be correct about something kind of like waiting for Godot?

45

reason 05.02.12 at 9:09 am

Shouldn’t the Spanish simply agree to sell the rest of Mallorca to the Germans?

46

reason 05.02.12 at 9:11 am

(Hey only joking – as a response to Tim).

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