Category Archives: PSST and Macro

Puzzling Statistics from the GDP Factory

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Scott Sumner writes,

This 4 and 1/2 years of sub-2% growth (on average) occurred during a period of rapidly falling unemployment, and above trend employment growth

The implications for productivity growth are terrible. Supposedly, firms got rid of their ZMP workers during the recession. Are we saying that subsequently they were hired back???

Again, I do not trust data that treats the entire economy as a GDP factory. If I had to bet, I would go with the Goldman Sachs view that inflation is over-stated, which means that real GDP growth has been under-stated.

Claiming Higher Productivity Growth: Some Implications

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James Pethokoukis cites, without providing a link, a recent claim by Goldman Sachs economists.

If our ballpark estimate of a 0.7pp understatement of annual GDP growth is close to the mark, the measured growth pace over the past five years of 2.2% might correspond to a true growth pace of almost 3%. This would be closer to the pace one would expect given the pace of improvement in most labor market indicators over the past five years.

They think that inflation is overstated, and therefore real output and productivity are understated. The official estimates face several well-known problems, including:

1. For some products and services, quality change is difficult to measure. The statisticians’ estimates of quality improvement tend to be biased in the direction of zero. I’ll bet, for example, that if you were to look into medical care data in the GDP accounts in detail, you would find a lot instances in which quality improvements are mis-classified as cost increases, and almost no cases of the opposite.

2. The process of aggregation is problematic, because people shift their consumption in response to price changes. If college tuition goes up and people switch to using YouTube, it is not clear how to measure the change in real consumption of education services.

3. The nature of inputs changes. To any business, the differences in skills and characteristics of workers matter. In the aggregate productivity statistics, an hour of labor is an hour of labor. There are similar problems with aggregating capital and aggregating output.

You know I don’t like anything that smacks of treating the economy as a homogeneous GDP factory. But if you do think in those terms, then I am inclined to agree with the Goldman folks. The aggregate measures show the GDP factory becoming more and more profitable, even with rather slow growth in revenue (nominal GDP). To get that, you need productivity growth to be better than wage growth. And, yes, that means that an implication of the Goldman view (and mine) is that the people who complain that labor is not getting its fair share would have more fuel to feed their complaints.

It means that real interest rates have been higher than they appeared to be. So does that mean that the zero bound was more binding than we thought? But we got higher growth than we thought??? I think that, on balance, this is bad for people who harp on the zero bound, but my biases have always been against that viewpoint.

Meanwhile, righties, it also means that people who think that there must be inflation going on somewhere, because the Fed is such a wicked institution, are not correct. I expect to get a lot of push-back on that. For those of you who want to use asset prices as your measure of Fed profligacy, you may have a point, but that is a different story as far as I am concerned. For those of you who are new to this blog, I subscribe to a “consensual hallucination” theory of low to moderate inflation. That is, people just operate as if prices are going to keep doing what they have been doing. On the other hand, I subscribe to the fiscal theory of hyperinflation. You get big hyperinflation when, and only when, the government is deficit-spending so much that it can no longer finance its deficits with low-cost borrowing.

Price Stickiness is Only One Coordination Failure

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Steven Randy Waldman writes,

For both firms and individuals, resistance to downward price adjustment is often rational, even when at a macroeconomic level universal downward adjustment would be desirable (perhaps because the central bank and/or state have failed to accommodate the expected path of nominal incomes, perhaps because nominal exchange rates are rigidly misaligned). If we could wave a magic wand and have wages, prices, and especially debts all simultaneously scale downward, that might be awesome. But, unfortunately, we can’t.

I think both Tyler Cowen and Mark Thoma pointed to this post. Read the whole thing.

The problem with the macroeconomic perspective is that when you think of the economy as a GDP factory, then the only reason you can think of for it not to operate at capacity is that the ratio of M to P is too low. Instead, if you think in terms of PSST, you can think of all sorts of reasons for coordination failure.

The chains of production are really long and complex. Somebody has a job doing “business development” for a company trying to make money out of an app. That job is so far from producing widgets that it is ridiculous.

In addition, pretty much everything we buy is discretionary. The seller of almost any product or service could wake up tomorrow and find the demand for that product or service poised to fall off. Need I cite landline telephones, retail music stores, or taxi drivers?

In the PSST story, the rigidities that matter are the burdens of trying to start a new business and the reluctance of people to relocate and to change occupations. The ratio of M to P just doesn’t amount to a hill of beans in an economy that depends on deep, complex coordination in the market process.

Kirzner vs. Samuelson

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David Glasner writes,

In Kirzner’s view, the divergence between Mises and Hayek on the one hand and the neoclassical mainstream on the other was that Mises and Hayek went further in developing the subjectivist paradigm underlying the marginal-utility theory of value introduced by Jevons, Menger, and Walras in opposition to the physicalist, real-cost, theory of value inherited from Smith, Ricardo, Mill, and other economists of the classical school.

…as the neoclassical research program evolved, the subjective character of the underlying theory was increasingly de-emphasized, a de-emphasis that was probably driven by two factors: 1) the profoundly paradoxical nature of the idea that value determines cost, not the reverse, and b) the mathematicization of economics …The false impression was created that economics was an objective science like physics, and that economics should aim to create objective and deterministic scientific representations (models) of complex economic systems that could then yield quantitatively precise predictions, in the same way that physics produced models of planetary motion yielding quantitatively precise predictions.

neoclassical economists who developed this deterministic version of economic theory, a version wonderfully expounded in Samuelson Foundations of Economic Analysis…

Pointer from Mark Thoma (!).Read the whole post, which refers to this lecture by Israel Kirzner. (Kirzner starts about 17 minutes in)

The Samuelson tradition keeps wanting to treat production technology as known and costs as objective. It is long on math and short on philosophy. For an exploration of subjective cost, see James Buchanan’s Cost and Choice. For an analysis of the ideological implications of subjective cost, see my essay.

Provocative Sentences

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From Steven Kates.

You could tell the true economists from the ones who knew little of value about how an economy worked by whether they understood and accepted that demand for commodities is not demand for labor. In classical times, just about every macroeconomist today would have been described as a fraud.

He quotes John Stuart Mill’s fourth principle of capital:

What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour.

Here, you can find more discussion by Kates.

Joseph Stiglitz Tells a PSST Story

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He wrote,

For the past several years, Bruce Greenwald and I have been engaged in research on an alternative theory of the Depression—and an alternative analysis of what is ailing the economy today. This explanation sees the financial crisis of the 1930s as a consequence not so much of a financial implosion but of the economy’s underlying weakness. The breakdown of the banking system didn’t culminate until 1933, long after the Depression began and long after unemployment had started to soar. By 1931 unemployment was already around 16 percent, and it reached 23 percent in 1932. Shantytown “Hoovervilles” were springing up everywhere. The underlying cause was a structural change in the real economy: the widespread decline in agricultural prices and incomes, caused by what is ordinarily a “good thing”—greater productivity.

At the beginning of the Depression, more than a fifth of all Americans worked on farms. Between 1929 and 1932, these people saw their incomes cut by somewhere between one-third and two-thirds, compounding problems that farmers had faced for years. Agriculture had been a victim of its own success. In 1900, it took a large portion of the U.S. population to produce enough food for the country as a whole. Then came a revolution in agriculture that would gain pace throughout the century—better seeds, better fertilizer, better farming practices, along with widespread mechanization. Today, 2 percent of Americans produce more food than we can consume.

I did not notice this article when it first came out. Instead, I was motivated to look for it when I saw that Stiglitz’s new book is a collection of reprinted articles. I looked for this article because of what I found in David Rotman’s article in Technology Review,

In his new book, The Great Divide, the Columbia University economist Joseph Stiglitz suggests that the Great Depression, too, can be traced to technological change: he says its underlying cause was not, as is typically argued, disastrous government financial policies and a broken banking system but the shift from an agricultural economy to a manufacturing one. Stiglitz describes how the advent of mechanization and improved farming practices quickly transformed the United States from a country that needed many farmers to one that needed relatively few. It took the manufacturing boom fueled by World War II to finally help workers through the transition. Today, writes Stiglitz, we’re caught in another painful transition, from a manufacturing economy to a service-based one.

This is a PSST story. However, unlike me, Stiglitz thinks that more government spending is a solution for unemployment caused by structural change. Put people to work producing useless munitions, and next thing you know the structural problem is solved. Instead, my view is that between 1929 and 1946 a whole lot of workers with obsolete skills (not just in farming–some types of manufacturing were disappearing, also) aged out of the labor force. The workers that entered the labor force were better educated, and they ended up working the expanding white-collar sector.

I think that the main contribution of World War II was to put people in motion. Soldiers who had gone overseas did not go back to places where there were no jobs. Instead, they went to where there was opportunity. Women and African-Americans were more mobile during the war than they had been previously.

Axel Leijonhufvud on the Financial Sector and Recalculation

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Leijonhufvud offers a view of the role of finance in macroeconomics, particularly in producing deep recessions.

But financial systems can become fragile. When this is the case, one default can trigger an avalanche of defaults. Most avalanches are small and self-limiting. But in extreme cases they can take down very large portions of the web of contracts. A major collapse of the web will be associated with a breakdown in the economic organization of a country and widespread unemployment of labor and other resources. But it is more serious than that. A default avalanche leaves a myriad of broken promises in its wake. Social relations are disrupted by distrust and recriminations all around. . .

A financial crash reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again. Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. If we had done so this time, it would simply have led us into another Great Depression.

What I believe he is arguing is that choices have to be made concerning who gets paid and who does not. You cannot expect justice to be fair–you just want it to be swift.

I like the “web of contracts” description of the role of the financial sector. It is an idea worth coming back to. It ties in both with Leijonhufvud’s classic work on the “corridors” interpretation of Keynes (see my discussion, but also explore other sources) as well as with PSST and recalculation.

Axel Leijonhufvud vs. Genghis Khan

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Leijonhufvud writes,

For the past 60 or 70 years, macroeconomics was dominated first by “Keynesian” theory—or, I should say, by what was widely thought to be Keynesian theory—then by Monetarism and most recently by Dynamic Stochastic General Equilibrium (DSGE) theory—an evolutionary sequence of theories that ended up in a fool’s paradise conducive to much mathematical elaboration, and thus very congenial to modern economists. Intertemporal equilibrium models incorporating no financial markets did not offer much help in understanding the events of recent years.

In other words, Stan Fischer and Olivier Blanchard were no better than their Dark Age counterparts from Minnesota.

Non-marketable Outputs and Executive Compensation

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I have suggested that one can think of firms as taking marketable inputs and producing non-marketable outputs. These non-marketable outputs ultimately contribute to marketable outputs. It is the non-marketable outputs that bind the firm together. If instead all outputs were marketable, then you could unbundle the firm and arrive at marketable output using market transactions among many firms.

I have also suggested that non-marketable outputs have an indeterminate value. This in turn makes the compensation paid to workers indeterminate.

Apply this to CEOs or other top executives. A CEO produces non-marketable output. The CEO’s “output” consists of key decisions with regard to strategy and personnel. It also includes intangible effects on employees, customers, and other firms.

Non-marketable output is, by definition, mostly valuable within the firm. The value of firm X’s CEO to firm X is likely to be quite a bit higher than the value of firm X’s CEO to firm Y. Thus, the CEO’s opportunity cost easily could be low relative to the value that the CEO provides. Whereas for low-level positions, it is plausible that competition serves to narrow the range of potential compensation, the same is not true at the level of CEO. It would seem that the range of indeterminacy in CEO pay ought to be especially high.

Observers on the left have argued that the rise in CEO pay in recent decades reflects changes in social norms rather than an increase in CEO productivity. Although there may be other explanations, I would think that the range of indeterminacy is sufficiently high that one should not dismiss the social-norms story out of hand.

Non-marketable Outputs

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A non-marketable output is something that has relatively little value outside of one firm. One company’s tax return won’t help any other firm file its return. A half-finished Chevy is not of much use to Toyota.

1. I claim that a typical firm buys marketable outputs, produces non-marketable outputs, and turns at least some of these non-marketable outputs into marketable outputs.

2. I can imagine a firm that produces only non-marketable outputs because it works only for a single buyer. However, there is a sense in which the firm and its buyer can be treated as a single entity.

3. Non-marketable outputs are what determine the configuration of firms. Suppose that there are ten stages of production. If at each stage the output is marketable, then there might exist firms at each stage of production. On the other hand, if only the final stage is marketable, then there will be just one firm.

4. The value of a non-marketable output is indeterminate. It has to be worth at least as much as the cost of the inputs required to produce it, and it cannot be worth more than the entire marketable output of the firm. But that leaves a wide range. Consequently, workers engaged in the production of non-marketable output do not have a well-defined marginal revenue product.

5. I conjecture that the larger the firm, the higher the proportion of non-marketable output relative to total output. If all you are doing is buying marketable outputs and selling marketable outputs, then you can be a tiny firm, like somebody who sells on e-Bay. On the other hand, if you manufacture airplanes, then most of your effort goes into producing unfinished airplanes, so you need a large firm.

Compare the old-fashioned general store to Wal-Mart. Wal-Mart has important non-marketable output in its supply chain, consisting of logistical systems and contracts with sellers. That supply chain might be worth something to an old-fashioned general store, and you can imagine a different Wal-Mart acting solely as a wholesaler/distributor. However, the supply chain is worth even more when it is integrated with large, strategically-located retail outlets, namely Wal-Mart stores.

6. I conjecture that non-marketable output tends to become increasingly important as the economy becomes more complex. That in turn would suggest that the trend would be for firms to get larger.

7. Some important creative destruction takes place in the arena of non-marketable outputs. Uber and taxi companies both offer on-demand rides. But Uber replaces the taxi company’s non-marketable output, its dispatching system, with something different. Amazon and traditional sellers both offer books. But Amazon replaces the non-marketable outputs of the traditional sellers (inventory management, product display, and customer fulfillment) with something else.

Note that Amazon found that a lot of its infrastructure proved to be marketable. Other companies rent server space from Amazon or sell products using Amazon.