(This is my first post at Core economics, cross-posted with ClubTroppo)
There has been much talk in the last 12 months about the relationship between macro-economic theory and explanations of the current recession. Krugman essentially dismissed most current macro theory as being delusional about the workings of major recessions. His major argument (which goes back at least to Stiglitz in the mid 1990s) is that, within Real Business Cycle theories, major recessions are at their core viewed as mass holidays.
The ‘holiday’ view of recessions essentially arises from the fact that most macro-models take a perfect-market view of the aggregate economy and boil down the complicated machinery of GDP creation into a smooth production function which usually only includes Labour, Human capital, Physical capital, and Technology. As soon as you realise that the factories have not been bombed, that no-one has shot the workers or de-educated them and that people haven’t forgotten how to use the internet, then you are by necessity forced to say that any large reduction in production must have been because workers decided to go on holiday. Of course, you can redefine any of these ‘basic’ production factors to mean ‘the rest’ in which case you can tautologically say changes in it explain everything, but that kind of window dressing is ultimately useless.
In this blog I simply want to pose the question of which additional production factor we would have to think of to augment our models with, such that we get a more palatable story of what happens in major recessions, whilst still remaining within the confines of a production function view of the economy. Let’s look at what must roughly be true of this mystery production factor X:
– It must be easy to destroy X and hard to build up. If it wasn’t true that X was easy to destroy, then one couldn’t have a major reduction in GDP because the other production factors don’t really take a hit during recessions. If it was easy to build up again, then recessions should be over very quickly and one should be able to return the aggregate economy back to the path it was on previously. We know this is not true and that it has, for instance, been argued that the Great Recession of the 1930s really only ended in the Second World War (see here for support and here for a paper with a contrary view).
– X must have something to do with the utilisation of labour. This is because we know that the utilisation of labour quite closely follows the downturn and subsequent upturn, just as in this recession the GDP downturn was very quickly translated into losses of jobs and losses in labour participation. In the latest recession for instance, the US Department of Labor estimated the gross job losses totalled 7.4 million in the first quarter of 2008, whilst the US Department of Labor figures showed a loss of 533 000 jobs in the month following October 2008, the biggest drop since December 1974. For more, see here.
– X must have an element of a negative externality about it. If this weren’t true, then one would be forced to arrive at the absurd conclusion that people knowingly destroyed their own X and accepted the huge loss of income stream associated with it. There is no believable story that would make individuals inflict the kind of income loss that we see in recessions on themselves. Hence, to some degree, the reduction in X must be due to the actions of others and the destruction of the X of others might well be due to our actions. X must therefore be two-sided in that it is not something that would arise in a Robinson Crusoe economy.
– If we take the stylised story of this financial crisis at face value and accept that things like banks can be ‘too big and integrated to be allowed to fail’, then X has to have something to do with the other production factors being ‘integrated’. It must also be relatively easy to make up stories that tie the making or destructing of X to what happens in the financial sector.
– X must make internal sense as a production factor. This means it must cost resources to build up, that investments into it are in some sense visible (even if they are not yet measured by statistical agencies), and it must actually be associated with production. Hence things like ‘trust’ or ‘confidence’ do not qualify because they don’t actually directly involve the production and sale of goods. A lack of trust makes it hard to organise production and sales, but is not itself a production factor. Trust might be involved in the cost of building X, but it doesn’t make sense to call it a direct production factor in itself. In a pure command-and-control economy for instance one, in principle, needs no trust between people at all to have a reasonably high GDP. This of course does not preclude the possibility that the start of a recession is a dramatic change in things like trust which might affect the costs of making or breaking X.
Is it worth saving the production function approach at all, you might ask? Shouldnt we simply give it up as a bad job? I think it is worth saving, because the production function approach is the most obvious way to interpret GDP and growth regressions, and forms a logical basis for expanding the set of economic macro-variables the statistical agencies look for. It is also the easiest way to teach students about the macro-economy because it is nice and compact. What is hence wanted are reasonable candidates for ‘X’ and a model that convinces the profession it forms a palatable answer. We need an X to ‘save’ the production function approach to macro. Any ideas?