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.

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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.

Individual Advantages as a Cause of Systemic Weakness, a Parallel in Biodiversity

BBC News reports of a study that comes to a conclusion that increased nutrients decrease biodiversity by letting the fastest growing plants grab all the sunlight, while slower growing species suffocate. In a more nutrient-constrained environment, plants that use nutrients efficiently succeed alongside plants that make effective use of light. (Hat tip to Yves Smith)

I think this is a more general game-theoretic phenomenon: the higher the number of binding constraints there are in a system, the higher the number of successful strategies. The individual constraints can be seen as objectives for a multi-objective optimization problem, thus controlling the degrees of freedom in the world of Pareto-optimal solutions.

I have been thinking of the role that this phenomenon has had on the financial world. Before 1980's, the financial world was comfortably resting on limits of liquidity, in the form of binding reserve requirements, and leverage, in the form of binding limits of bank capital.

After removing the important constraint of reserve requirements, especially after 1994, when retail sweep programs were allowed, leverage has been the only major remaining limit, and was thus taken to the maximum.

After the weakening of even that limit, by changes in rules and active avoidance of regulations, actual solvency is now the only remaining factor to limit the growth of financial institutions. This is not a good limiting factor for a system built mostly of institutions that are “too big to fail”.