Three Big Ideas (Part 2)


…is a controversial concept, and the answer to the question of whether or not it really is a “thing” will have implications in the ongoing competition between “Classical” and “Keynesian” type theories. (More on that later, of course.) For this first, simple explanation, think of “memory foam.” The question is: does the economy ‘forget’ a downturn after it bounces back to its original path of growth (classical equilibrium model), or does it retain a more or less permanent impression–a new, lower path–going forward (hysteresis, not necessarily accepted by all “New Keynesians” at this point).

The policy tradeoff between the unemployment rate and the rate of inflation (expressed by the “Phillips Curve”) is widely accepted by the economics profession. There are a variety of mechanisms invoked for this relationship, but they result in virtually the same model, where a policy that lowers inflation leads to higher unemployment. Here is one easy intuition: imagine a factory owner is facing a higher sales price for her product (due perhaps to increased demand in the marketplace). She will want to ramp up production, which in the short run will require more workers. (Investments in machinery–including robots–are long-run, not short-run, factors.) As the labor market tightens, it may become necessary to offer more money (wage inflation). This feeds the inflationary pressure on the general price level while lowering the unemployment rate. Now imagine the exact opposite process when demand is dropping: things go on sale (sometimes permanently) while the demand for labor drops. This is a period of “disinflation”, where wages and prices drop while economic output shrinks.

Notice how I have described a microeconomic mechanism while (with a slight of hand) extending it to the entire economy. This is called “giving macroeconomics a micro foundation.” There are many ways to go about this, since economics suffers from the problem (familiar to all scientists) that the data are underdetermined by theory. Which is to say, there are any number of theories that could explain the same result. An alternative theory explains inflation and unemployment rates through “imperfect information” about future price levels, but gets to the same result.

Let’s not play dumb here. It is easy to imagine that a short run variation in demand can lead to quick adjustment to the labor force under normal conditions, and therefore a lot of resilience in supply. We see it happening when a business gives its part-time staff more hours to work when a busy season is underway, then cuts back when things slow down again. But everything could change when the slowdown is deep and long lasting. Imagine the business has to close “temporarily.” People will look for other jobs and may not be available when it is time to re-open. When industries lay off hundreds of thousands of workers for several years at a time, it is unlikely that those same workers (along with their skills) will be readily available if and when the economy gets better.

The classical (non-hysteresis) theory depends on the “natural-rate hypothesis,” where the economy taken as a whole has a certain “potential” at any given moment, a sort of maximum output level where all resources (especially human) are fully utilized. Even at this level of output there will be a “non-accelerating inflation rate of unemployment” (NAIRU), because some people are always between jobs for a variety of reasons. However, the rate of unemployment is not as simple a thing as one might think, since it is a ratio of the number of people who haven’t yet found a job to the number who want a job at any given point in time. It turns out that the workforce participation rate (against which the unemployment rate is calculated) actually changes all the time.

We will see that Larry Summers presents data from the past few decades to show that there do seem to be more or less permanent changes to the workforce with every economic downturn. I will do some of my own drilling into the vagaries of measuring unemployment as well.

Next time: Secular Stagnation