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Jim Manzi is not a professional economist, but he has been asking some very good questions about the confidence economists have in their models. In response, actual economist Karl Smith has defended the broad macroeconomic models that invite further "stimulus" from both the government and Federal Reserve.

Ironically, Smith claims to be a fan of free markets, but he believes that one critical "market failure" requires massive fiscal and monetary intervention: sticky prices and wages. Although I've critiqued this notion before, it's worth going into it in greater depth.

Smith: Why Do We Have Recessions?

In order to prescribe the right medicine for the economy, it's necessary to correctly diagnose the problem. Here is Smith's analysis:

I shouldn't speak for other academics but when I advise that stimulus be undertaken or that money be loosened it is not because I think that I have a model which accurately maps how said stimulus will impact the various sectors of the economy. … The basic [idea] both in the models and in my thinking is that for the most part markets work and that they will direct resources to whatever their best use is. Our task is to deal with particular market failures. In the case of recession the market failure is that we do not have perfectly flexible wages and prices. If we did there would be no recessions as we know them.

Let's pause to consider what Smith is saying here: In recessions "as we know them," what happens is that many people are unable to find work, and businesses are unable to sell as much as they had planned on producing. In other words, unemployment and spare capacity both shoot up. In terms of undergraduate supply-and-demand graphs, there would be a surplus (or glut) in the various labor and product markets.

But if all prices and wages instantly adjusted to the new situation, then these gluts should disappear. If there is 10 percent unemployment, then wage rates should fall, making workers more and more attractive to potential employers until unemployment returns to its normal level. Smith's argument here is exactly the one that Greg Mankiw used in his argument with me over negative interest rates.

Misallocated Resources, a Great Vacation, or Insufficient Aggregate Demand?

Smith further clarifies his diagnosis of what's ailing our economy by comparing three different explanations:

Many smart commentators still see recessions as either a calamity akin to a crop failure or as punishment for excesses. If that was what a recession was then the result should be our working harder to overcome the calamity or make up for our excesses. However, the key feature of an actual recession is that Aggregate Hours worked FALLS. That is, people work less, produce less, create less. This is not a solution to a calamity or overconsumption. In a world of perfectly clearing markets a fall in Aggregate Hours would represent a Great Vacation. That doesn't seem like the proper response to a calamity or previous irresponsibility. Thus our search for a market failure. When we work through our best guess at the source of this failure the answer tells me that: lower taxes, higher government spending and looser money would all serve to lean against this particular market failure.

Although he doesn't use the term, Smith is here attacking explanations such as the Austrian theory of the business cycle, which say a recession is an unfortunate necessity in order to reallocate workers and other resources into their proper niches after an unsustainable boom. (This idea is what Krugman has derided as the "hangover theory.")

Further, Smith's reference to a "Great Vacation" is a jab at "real business cycle" (RBC) theory, which is an equilibrium-always attempt to model recessions as perfectly rational responses to shocks in technology or other fundamentals.

To paraphrase, Smith rejects these diagnoses as silly. If the Austrians (and other "hangover theorists") were right, and the chickens have come home to roost because of our overconsumption during the housing bubble years, then the obvious prescription would be to work more and increase current output.

But that's not what's happening; large numbers of Americans are watching Let's Make a Deal rather than reporting to a factory five days a week. Because this can't possibly be a rational response to the problem — as described by the Austrians — then either the market is screwy, or the Austrians are wrong in their diagnosis. Either way, thinks Smith, we shouldn't sit back and let nature take its course, as the laissez-faire Austrians typically recommend. Instead there is a role for the government and Fed to help.

Support for the Austrians

Before tackling the issue of sticky wages head-on, let me first point out that there is plenty of evidence supporting the Austrian explanation (versus its Keynesian rival). In a previous article, I showed that Krugman's attempt to look at sectoral employment data blew up in his face; when the test is conducted properly, the numbers offer more support for the "reallocation-across-sectors" story than the "general-fall-in-demand" story.

Another huge problem with Smith's analysis is that he ignores the effects of prolonged unemployment benefits, TARP, the stimulus package, the health-insurance legislation, etc. Most Austrians opposed these measures and predicted that they would hamper recovery.

Let's take a step back and consider the big picture. Most economists — including Karl Smith, I would imagine — agree that outright central planning is an utter failure and would lead to a disastrous economy. Now then, looking at US economic history, when do we see the most sluggish recovery from a financial crisis? Now and during the 1930s.

Is it really such a stretch to suppose that when the US government (and Federal Reserve) brings the economy closer to outright socialism — as Hoover and FDR did in the 1930s, and as Bush, Obama, and Bernanke have done in our time — that those very interventions hamper the economy?

The "hangover" theory would look much more plausible if the government and Fed had followed (most) Austrians' advice and watched the housing bubble collapse. There would have been an awful 6–9 months, but I believe things would have bottomed out and true recovery would then have begun. By this point, the housing crash would have been an unpleasant — but distant — memory. We can't run controlled experiments in macroeconomics, but the Depression of 1920–1921 should give pause to those who explain the Great Depression on market failure.

Misallocation and Work

In this section, let's take Smith's objection head-on. He is simply mistaken when he claims that the optimal response to a calamity (or a period of excess) would be to work more.

In my "sushi" article, I laid out a simple yet internally consistent story — with actual numbers — to demonstrate how a misallocation of resources could give rise to a temporary period of higher output at the expense of distorting the capital structure. During the corrective period, key workers in the economy would need to replace the worn-out capital goods, while others stood around and did nothing. Thus, "unemployment" was the rational response until the economy recovered from the profligacy of the boom.

We see the same pattern in Mises's famous metaphor of a master builder. To illustrate the difference between generic overinvestment versus malinvestment, Mises asked his readers to imagine a man building a house. He has all the materials on site, including lumber, shingles, glass, workers, etc. (He can't buy more materials; this is all he has to work with.) The problem is that the blueprints assume there are more bricks than the man actually has at his disposal.

At some point, work on the house will have to stop. The blueprints call for the use of more physical resources than are on hand; it is literally impossible to finish the house as depicted on the blueprints.

Mises's point is that things will go better for the builder the sooner he discovers his mistake. If instead his subordinates use tarps to hide the dwindling supply of bricks — thinking they are "keeping the good times going" and the workers happily employed on their project — they are doing a great disservice.

Extending Mises's metaphor, we can see the problem with Smith's argument. When the builder realizes his error — for example, when he sees there are only 5,000 bricks remaining, even though his blueprint calls for 7,000 — what will his first response be? He will get out the bullhorn and announce to all the workers on site, "Stop!"

By assumption, the builder can't go to Home Depot and buy more materials: he has to finish the house with whatever is on site. When he realizes the original blueprint is unachievable, he needs to go back to the drawing board. He (or his architect) needs to look at the current state of the house, assess the remaining materials on hand, and then design the "best" house that is now physically possible. Obviously, the further along in the original blueprints the house had progressed, the fewer options the builder has. This is why continuing the boom period (in the real world, through artificially low interest rates) is so destructive: it paints the entrepreneurs into tighter and tighter corners.

But for our purposes in this article, notice that while the builder is revising the blueprints, everybody else on the site is out of work. For example, if some of the crew had been sawing down the lumber in order to assemble a gazebo in the backyard, they need to stop immediately in case those pieces of lumber are necessary in order to finish the second floor of the house, according to the revised blueprints.

Of course, the real economy is not one giant house, and there is no central planner analogous to our master builder. However, the analogy still does a great job illustrating Mises's theory of the business cycle. The unsustainable boom period draws workers and other resources into improper channels. Once the bubble pops, it takes some time for the market to readjust and reallocate workers and resources to more appropriate sectors. In the immediate aftermath of the popping, this process "looks like" recessions as we know them.

Flexible Wages Would No Doubt Be a "Market Failure"

Finally, we should note that "sticky wages" are not a market failure at all, but a quite appropriate response to the worker and employer's desire for predictability. In other words, it is not some arbitrary fluke that allows copper and gold prices to adjust by the second, while labor contracts tend to be for periods of a year or more.

Suppose things were the opposite, and that workers' wage rates could adjust every minute according to supply and demand. Someone making $20 per hour today, might make only $8 per hour tomorrow. In such an environment, workers would build up an enormous cushion of savings, because they would have to draw down their liquid assets to get them through periods of below-average wages. Very few workers would buy houses, but would instead rent apartments, ideally on month-to-month terms.

I have no doubt that if this were the norm, interventionists of various stripes would invent sophisticated mainstream models showing that such an outcome was "Pareto inefficient." If only the government would pass laws, requiring labor contracts to lock in wages for longer periods, then the enhanced predictability would increase the welfare of everyone in society.

Because they could count on their paychecks for a longer horizon, workers would reduce their antisocial "hoarding" of cash. Without such benevolent government intervention, the perfectly flexible wages of the cutthroat capitalist economy would be yet another example of market failure.

Conclusion

Like George W. Bush, Karl Smith thinks it is necessary to violate laissez-faire in order to save it. But in truth, our experience in the wake of the financial panic is consistent with the Austrian diagnosis. There is no "market failure" because some prices and wages are updated less frequently than others. If the government and Fed would stop intervening, the market would work just fine.