Grasping Reality on TypePad, by Brad DeLong

The Huffington Post simply shouldn't be publishing things like this. The Huffington Post should do better. It owes its readers. And we know that it can do better.

The kindest interpretation I can give what Washington University in St. Louis economist David K. Levine has written is that he is fundamentally confused between levels and derivatives.

David K. Levine:

David K. Levine: An Open Letter to Paul Krugman: Crises have been ubiquitous throughout history. While we can't forecast them we do know how to learn from them.... But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy - isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?

Oh boy. Let's see how far I can get with this...

Start with:

This chart shows what has happened to the civilian adult employment-to-population ratio. That ratio peaked at 63.4%[1] at the end of 2006. It was 59.2% as of mid-August and is probably 59.0% now--and if not now, soon.

A well-functioning labor market--one not deep in market failure--matches workers looking for jobs with jobs looking for workers. A well-working labor market will keep both the number of unemployed and the number of vacancies together in balance, and at relatively low values.

That is not what is happening now.

The number of vacancies--jobs for which employers are actively searching for workers but have not found any to hire yet--is very small. The number of unemployed--of people who want to hold jobs and are qualified to hold jobs--is very high. The result is that some 4% of the 18-65 population that in a normal time would have jobs is now jobless. This is a massive market failure: supply is not matched to demand. And the welfare costs of this elevated degree of market failure are very high: the excess people without jobs are not happy people taking great vacations. They are, rather, stressed out: give them their old jobs back for 3/4 of their old pay without consequences for their likely incomes in future years and they would be ecstatic.

David Levine says that the government should not do anything about this market failure. Right now "we are recovering," he writes. And he believes that because we are recovering activist governmental policies to deal with this collapse in the employment-to-population ratio are unwarranted.

Note, however, three things that "we are recovering" does not mean:

• It does not mean that macroeconomic market failures are small, or are rapidly being reduced to "normal" levels.
• It does not even mean that the magnitude of the macroeconomic market failures is falling--for every competent foreaster expects that the employment-to-population ratio will continue to decline, perhaps for a substantial time, even though it is highly likely that the NBER's final business cycle chronology will declare that we are now in a "recovery" phase of the business cycle..
• It does not mean that monetary and fiscal policy tools to compensate for, repair, or correct those macroeconomic failures have lost any of their juice or are no longer appropriate--they remain appropriate and necessary as long as the macroeconomic market failures remain elevated.

What "we are recovering" means is that:

• the magnitude of macroeconomic market failures--which are well-measured by the gap between the employment-to-population level and its normal level--are now no longer growing rapidly but instead only growing slowly. Things are still getting worse. But at least they are not getting worse rapidly.

As long as the gap between the current employment-to-population ratio and its normal level remains large, policies to compensate for, repair, or correct macroeconomic market failures are entirely appropriate.

For Levine to think that such policies should be abandoned just because macroeconomic market failures are no longer growing rapidly reflects a deep incomprehension of the discipline of economics. Things that Irving Fisher, Knut Wicksell, and in a later generation Milton Friedman knew very well indeed are things that David Levine simply does not understand.

Now there are deeper and more subtle questions for economists to to analyze right now. For example, in this situation:

1. How stimulative should monetary policy be when the employment-to-population ratio is as far below normal levels as it is now?
2. Can conventional monetary policy do the job--or do as much of the job as can be usefully done?
3. Under what circumstances should conventional monetary policy be supplemented?
4. And what policies should supplement it--quantitative easing, public purchase of risky assets, bank recapitalization, informal government guarantees, formal government guarantees, fiscal expansion, scattered nationalizations, full nationalization of the financial sector, or the acquisition of all financial and industrial assets by the government and the rational arrangement of economic affairs according to a common plan?

These are knotty and complicated questions about which competent economists can (and do!) argue, and about which competent economists can (and do!) disagree on matters of theory, on the weight of the empirical evidence, and of policy.

But you cannot have a fruitful discussion about any of those issues with David K. Levine. Someone so clueless that he thinks that the end of a period in which macroeconomic market failures are growing rapidly entails that the policies to compensate for, repair, and correct those market failures should be stopped right now is simply not in our galaxy.

[1] A level it attained without, mind you, a single sign that any worker was in any sense "fooled" into taking a job because of an erroneous misperception that his or her real wage was higher than it was in fact. See Krugman http://tinyurl.com/dl20090919a.