October 5, 2009

Bubbles, Unemployment and Fiscal Stimulus

Paul Krugman, is trying to fight for the usefulness of fiscal stimulus in mitigating unemployment.
Ryan Avent has some fairly harsh words for Arnold Kling’s recalculation theory of business cycles. Tyler Cowen, predictably, thinks Ryan is too snide.

But what none of the participants in the debate seem to realize is that Arnold is basically reinventing 1934 macroeconomics.


It’s all there: mass unemployment is necessary, because you have to shift resources away from sectors that got too big, stimulus is a bad thing because it slows the necessary adjustment. And now as then, the whole notion falls apart when you ask why, say, a housing boom — which requires shifting resources into housing — doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.
Both booms and busts involve shifting of resources between sectors. This much is self evident. It would be stupid to try to deny that. This doesn't mean that the unemployment should not be alleviated at all.

Krugman unfortunately makes a complete fool of himself in the last paragraph. Of course booms don't involve unemployment. In a boom, the driving force of inter-sectoral adjustment is a surge in demand. In a bust, the cause is a collapse of demand.

In a boom, the workforce moves behind the pull of opportunity. This was clearly visible in the flow of newly minted real estate brokers who were encouraged to leave their prior jobs in search of bubble-induced income. In a bust, the realignment is caused by a push-type phenomenon. (Or is it a kick?)

This is such an elementary thing that I can only wonder what Mr. Krugman has been smoking while writing that last paragraph.

To clarify, my own view is that increasing unemployment can hardly be completely avoided in a major bust of a bubble, but that government projects can (and should) be brought forward to mitigate it, if only to make use of the suddenly cheap labor and raw materials. Busts clearly have effects on people who were not directly involved in the bubble and an uncontrolled collapse is bad for everybody.

Equally, I believe that fiscal measures might even be appropriate in controlling the growth of a bubble. Additional small taxes on house-flippers (say for houses bought and sold within 12 months) could have helped slow down the development of the housing bubble. Additionally, it could have provided a larger cushion for the inevitable fiscal collapse.

In both ends of the boom-bust cycle, monetary policy should be the primary means ahead of fiscal measures. In this sense, the QE policies should go even further, as there is a lot of credit that is (and should be) paid down.

This collapsing credit can be replaced with base money even if the money multiplier has collapsed to unity. Instead of "mopping up the liquiduidity", central banks should bring back meaningful cash reserve requirements (to all bank-like entities) after the economy has recovered from the excess of credit. This would naturally will be fought against tooth and nail by the financial sector.

1 comment:

Qönttä said...

Krugman unfortunately makes a complete fool of himself in the last paragraph.

He didn't get the Nobel prize for these columns, indeed. He writes them quickly and without academic scrutiny. Sometimes even facts do not match.

I know from hands-on business experience that many jobs should not exist at all if the economic theories were correct. Many companies do not produce big enough profits to have the right to exist according to the myths of market economy.

And it is clear that my neighborhood has 30%-50% more groceries than is necessary.

Thus the point of view that the number of jobs is somehow strictly dictated by the market economy is science fiction.

An economist can draft a macroeconomic model which models the number of jobs based on macroeconomic variables. So what. In another time and place the parameters of the model are different proving that the model is inadequate.

People do know that many of them have a job which is not really needed by anyone, but of course they seldom admit it themselves.