Scott Sumner and Tyler Cowen have given you theirs. Here is mine.
1. Ditch the concepts of aggregate supply and aggregate demand. Thinking of the economy as if it were a single business, what I call the GDP factory, is misleading. Also, there are two versions of aggregate supply, and no one can keep them straight. Version I treats the GDP factory as operating in a world without prices, or with fixed prices. Version II treats the GDP factory as operating with a sticky nominal wage, so that the profitability of output increases with price.
2. Instead, think of all recessions as adjustment problems. We are in a specialized economy, and at any point in time some people are employed in ways that do not earn a profit. These jobs are unsustainable, and the workers will be let go. Sometimes, the dislocation is temporary, and they can go back to their old jobs. But often the dislocation is permanent.
3. Arriving at sustainable patterns of specialization and trade requires two types of adjustment: static adjustment and dynamic adjustment.
4. Static adjustment means solving for the price vector that clears all markets. What I called Version II is an example of a static adjustment problem–getting “the” real wage to adjust the right level. This problem might exist, but I think it is at most one of many adjustment problems.
5. Dynamic adjustment means entrepreneurial trial-and-error to come up with businesses that employ otherwise-idle workers at a profit. Mathematical models are mostly focused on static adjustment problems, but I think primarily in terms of dynamic adjustment problems.
6. Adjustment is how we get out of a mess. How do we get into messes? To some extent, each unhappy economy is unhappy in its own way. But some elements that one tends to find include Minsky-Kindleberger manias and crashes, sudden changes in credit conditions, sharp movements in important relative prices (oil, home prices), and permanent shifts in the skill structure of work.
7. Kindleberger has a useful concept, which he calls “displacement,” which causes a large shift in wealth. For example, after a war, the winning side can feel wealthier. A bundle of technological innovations or new trading opportunities can have the same effect. The sense of increased wealth that arises from displacement can evolve into a mania. A decade after the end of the first World War, the U.S. experienced a mania. A decade after the end of the Cold War, the U.S. experienced first an Internet mania and then a housing mania.
8. Manias can create unsustainable patterns of specialization and trade and postpone the adjustment to deeper structural change. The mania of the 1920s helped to temporarily disguise the impact of the adjustment to the tractor, the truck, and the electric motor. Many jobs involving manual labor in factories and farms were becoming unsustainable. Ultimately, many of the new jobs were in wholesale and retail trade, but these jobs typically required a high school education. An important part of the adjustment process was that by 1950 a generation of poorly-educated workers had aged out of the labor force. Meanwhile, the U.S. experienced the Great Depression of the 1930s.
9. Similarly, the housing mania of the early 2000s helped to temporarily disguise the impact of the adjustment to the changes brought about by the Internet and globalization. Once again, the composition of the work force appears to be undergoing a shift, as signified by the low rate of labor force participation.
Simple thought. Expand safety net, but make it “means tested” so that it discourages individuals entering into work force. Obamacare is classic but by no means only example.
Any surprise if as a result you end up with a decline in labor force participation rate.
Then increase regulation, thereby lowering productivity growth.
To top it off attack banks, thereby reducing lending activity.
What you expect if these policies were enacted coming out of a recession? A sub par recovery, right? Why do you need any other explanation.
I believe that Scott Sumner has often made comparisons, across both countries and time, among the US, Canada, Australia, UK, Japan, and Europe, connecting differences in their recoveries and recessions to differences in monetary policies. Can you make similar connections, showing how differences in ability to adjust explain differences in recoveries and recessions? For example, have Australian and Canadian policies in recent years been more amenable to facilitating adjustments necessary to arrive at sustainable patterns of specialization and trade? Has Abe made Japan better at adjustment compared to his predecessors?
Regards the “the economy is not just a GDP factory” thing, (I agree), it might be well for macroeconomists to reconsider “costs” in opportunity cost terms, rather than “counts of Federal Reserve Coupons” terms.
The opportunity cost construct is the stuff of economics. The “counts of Federal Reserve Coupons” construct is only the stuff of accountants.
So I agree with all of what AK says, because it confirms my existing beleifs. But here is what my devil’s advocate says.
During a “mania”, people consume more of everything. They do not endure cheerful austerity while they thriftily wait for their (mal-)investments to pay off. While this is going on, the existing pattern of specialisation and trade (PST) is capable of producing all those consumed goods and services.
This consumption-production balance happens regardless of the financing details. But when the mania ends, people suddenly stop consuming as much. How is this possible without a there being a lot of unemployed resources, which could be brought back on line by simply replicating last week’s PST?
What, other than those financing details, made the old PST “unsustainable”, and so why not just twiddle the numbers to cancel the effect?
Confirmation bias for me too.
Your devil’s advocate sounds like the rock star economist who’s happy to kick the can down the road and say that in the long run he’ll be dead, so just let the kids deal with the structural change that we’re banking and compounding.
China and other countries definitely had some mania, when they had unlimited opportunity to export, and their prices would always be good due to cheap labor.
Taiwan had this too, for a while.
Its a very interesting cultural phenomena when all of society seems really happy as the growth engine is just humming along.
It is a minor point. But if the question is How do we get into messes? then “sudden changes in credit conditions” is not the right answer. The sudden change in credit conditions *IS* the mess. What gets us into the mess is the long, slow, gradual increase in the reliance on credit, until private debt reaches a crisis level.
http://newarthurianeconomics.blogspot.com/2015/11/frameworks.html
Shouldn’t you add to number 2 that capital goods are specialized too ( not just a lump of K) and that they can become idled for a time or stranded and worth only their scrap value?