Dingbat Kabuki from the House Republicans
Liveblogging World War II: June 1, 1941

The Marx-Mellon-Schumpeter-Hoover-Hayek Axis Is Back!


Economics, politics, and distraction from productive activity: Since the recession began, Arnold Kling has been trumpeting a very non-traditional way of thinking about the economy. At first this went by the name of "recalculation," but Kling has now settled upon "PSST," which stands for "Patterns of Sustainable Specialization and Trade."... I'll let Kling sketch the idea in his own words:

Regular readers know that I am trying to nudge them toward a different paradigm in macroeconomics. I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade.... I believe that trying to describe economic activity using an aggregate production function is a mistake.... The advantage of the aggregate production function is that...it yields an aggregate supply curve. This allows macro to be presented using the familiar tools of supply and demand.... Instead, I think that the right tools to use for macro are the two-country, two-good models of international trade.... At full employment, both countries are taking advantage of specialization and trading with one another. When something happens to adversely affect the pattern of trade, some workers shift from market activities to non-market activities, mostly in the form of involuntary unemployment. Gradually, new patterns of specialization and trade emerge, and full employment returns. That is what I have been calling the Recalculation Story....

Every first-time econ student who has ever been presented with a macroeconomic aggregate probably has some variant of this reaction. Economies are just too complex to be modeled with this handful of variables! Then someone raises his hand and asks the Teaching Assistant if that isn't the case, and the Teaching Assistant shakes his head and says "Yeah, well, just try to model a complex system like that and see how far you get!" Because it is hard...

The teaching assistant's answer seems to me to be wrong. Modeling 140 million workers, 10 million firms, and 20 million commodities is really complex--that's why we don't do it, and don't have a big computer centrally-planning our economy. That is why we use the market system.

But when it comes to business-cycles--to recessions and depressions and downturns--we don't need to model 140 million workers, 10 million firms, and 20 million commodities: we only need to model two: (OK, four): currently-produced goods and services on the one hand, and (perhaps three types of) financial assets on the other. A business-cycle downturn comes when--for any of a number of possible reasons--there is an excess demand for financial assets and a corresponding deficient demand for currently-produced goods and services, which leads to rising inventories, falling sales, rising unemployment, falling incomes, and multiplies itself into general deficient demand for pretty much all currently-produced goods and services in the economy. The downturn comes to an end when incomes have fallen so far that households and businesses are so strapped that they cease trying to build up their stocks of financial assets, and the aggregate supply-aggregate demand balance comes to an end. The depressed state of the economy comes to an end when an excess supply of financial markets induces an excess demand for currently-produced goods and services that pushes inventories down, sales up, unemployment down, incomes up, and multiplies itself into general prosperity.

In the background the market system is trying as best as it can to find the best uses and production plans for 140 million workers, 10 million firms, and 20 million commodities given the state of aggregate demand. But that is not of the essence in understanding low capacity utilization and high unemployment. The aggregate demand shortfall is.

When you ask believers in "recalculation" what pattern of production and trade proved to be unsustainable in 2007, they answer: "building so many houses." When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing--silence. When you say that OK, there were $300 billion of excess houses at the start of 2007 but now construction has been so depressed for so long that there are $1 trillion fewer of houses than trend and why isn't the 2007 pattern of production and trade sustainable again, they answer once again with nothing--silence.

That annoys me.

It is possible to find in history economic catastrophes produced by the disruption of patterns of sustainable specialization and trade--the Bengal famine of 1942 comes immediately to mind. But there is literally no evidence at all that we have such a problem right now. Our problem right now is that demand is low because incomes are low, and incomes right now are low because demand is low, and demand is not rising because there is no excess supply of financial assets to goose people to spend more. If you want to argue that there is a disruption of patterns of sustainable specialization and trade, you need to point to such a disruption right now that is large enough to produce an 8% shortfall in spending. Nobody has. Nobody has because nobody can.

The other thing that annoys me is that this is presented as something new when it is actually something very old--and it is presented without acknowledgement of the arguments made against it in the 1930s and, indeed, in the 1840s when it was made before. Friedrich Hayek and Andrew Mellon claimed--and Mellon dragged Herbert Hoover along into policies of austerity, of tax increases and spending cuts during the Great Depression--that as a result of lax monetary policy in the 1920s the economy in 1930s had too much plant and equipment and too many workers employed making capital goods, and had to suffer from a "prolonged liquidation" in order to productively redeploy resources into the consumer goods industries where they really should be. Joseph Schumpeter cheered them on, claiming that without the boom-and-bust cycle the economy would die, for it was its "respiration." But if Hayek were correct we should see depressions both when the economy is switching resources from capital to consumer goods and when the economy is switching resources form consumer to capital goods, and we don't: while an economy making too little in the way of consumption goods is ripe for a downturn, an economy making too little in the way of capital goods is ripe for a boom.

And a century earlier Marx had the original story: because workers earned less than they produced, full employment could only be maintained if capitalists purchased the excess, but capitalists would do so only if they believed the boom would continue and they could keep making money by expanding their operations, but expanding operations meant that the gap between what workers produced and what they earned would grow, and so full employment required that capitalists not just anticipate that growth would continue but that growth would continue at an increasing rate--and somebody capitalists would lose their confidence that the rate of growth would keep increasing, and then would come the depression. The depression would continue, Marx thought, until the waste and destruction of the depression had gone on for long enough that capitalists concluded that the economy was once again short of capital, and that they could safely and profitably expand their operations again.

It was not an implausible theory--for 1848.

But it was a wrong theory.

And it is an especially wrong theory now: We have worked off our housing overhang. We have worked off our housing overhang fourfold. We are now $1 trillion short of houses in the United States. But where is our robust recovery?