Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Saturday, December 28, 2013

The most obvious source of cyclical asymmetry is not a nominal rigidity

I've long been interested in the apparent cyclical asymmetry in business fluctuations. So it's nice to see Paul Krugman publicize the issue here: On the Asymmetry of Booms and Slumps. His post, in turn, was motivated this one, by Antonio Fatas: Four Missing Ingredients in Macroeconomic Models. Fatas writes:
1. The business cycle is not symmetric. Most macroeconomic models start with the idea that fluctuations are caused by a succession of events that are both positive and negative (on average they are equal to zero). Not only this is a wrong representation of economic shocks but it also leads to the perception that stabilization policy cannot do much. Interestingly, it was Milton Friedman who put forward the "plucking" model of business cycles as an alternative to the notion that fluctuations are symmetric. In Friedman's model output can only be below potential or maximum. If we were to rely on asymmetric models of the business cycle, our views on potential output and the natural rate of unemployment would be radically different. We would not be rewriting history to claim that in 2007 GDP was above potential in most OECD economies and we would not be arguing that the natural unemployment rate in Souther Europe is very close to its actual.
Let me dissect the passage above.

1. "The business cycle is not symmetric." Agreed.
2. "Most macro models assume a symmetric impulse mechanism." Agreed.
3. "Not only is this a wrong representations of economic shocks..."

Not sure what to make of this claim. I think it's sensible to assume that the shocks are symmetric (unless there is compelling evidence to suggest otherwise). The asymmetry in question is more likely to be the byproduct of human interaction -- the economy's propagation mechanism.

4. "...but it also leads to the perception that stabilization policy cannot do much."

I'm also not sure what to make of this statement. Economists know that we cannot make any inferences about the desirability of policy interventions solely on the basis of the statistical properties of time-series data. And in any case, there are plenty of symmetric models suggesting beneficial policy interventions.

5. "If we were to rely on asymmetric models of the business cycle, our views on potential output and the NRU would be radically different."

I'm afraid that Fatas is placing the cart before the horse here. There is no logical basis for that proposition (in fact, I provide a counterexample below): see comment above.

6. "We would not be rewriting history to claim that in 2007 GDP was above potential..."

I hear people make this claim all the time. Typically, they are the same people who claim that the last recession was caused by a bursting asset-price bubble -- of an overheated real estate sector -- of a booming construction (and related) sectors--of over-accumulated capital--and over-accumulated debt. But now, apparently, these same people want to interpret the episode leading up to the crash as the economy just humming along at "potential." Strange.

In any case, on to Krugman's pet idea that asymmetry is explained by DNWR (downward nominal wage rigidity). Maybe there's something to this idea, but my own view is that any such effect is not likely to be very important. Why is this?

I've explained why before here, but let me summarize the argument here. I claim that economists who rely on sticky wage theories are unwitting slaves of Marshall's scissors--static supply and demand curves. If unemployment exists, it must be because reality does not correspond with scissor-intersection: markets do not clear.

But Marshall's scissors are meant to describe what happens in an anonymous spot market for goods like wheat or oil. The labor market is a market for relationships. Relationships are durable. Relationships are a form of capital. We have to move away from Marshall's scissors to understand these relationships (search theory is one way to do this). The economic surplus generated by a productive relationship is divided through a bilateral or multilateral bargaining process that specifies (among other things) how wages are to evolve through time over the life of the relationship. The spot wage (the wage that an econometrician might observe in a data set) plays no allocative role in the relationship. Stickiness in the spot wage does not matter.

That's the theory, anyway. But then, there is also some evidence: Evaluating the Economic Significance of Downward Nominal Wage Rigidity (Michael Elsby) and here: The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle (Beaudry and DiNardo).

Well then, if not a nominal rigidity, what might account for the asymmetry in the unemployment rate?


As it turns out, the sharp rise in unemployment followed by a slow decline follows as a natural property of labor market search models, something that I showed here (the example I alluded to above).

The basic idea is very simple. As I explained above, the labor market is a market for productive relationships. It takes time to build up relationship capital. It takes no time at all to destroy relationship capital. (It takes time to build a nice sandcastle, but an instant for some jerk to kick it down.)

We see the same sort of phenomenon in population dynamics--the so-called "heat wave effect." That is, mortality rates spike up during a spell of bad weather, causing a sudden decline in the population. There is no corresponding spike up in the population during a spell of good weather for obvious reasons (unless you believe in zombies returning suddenly to life).

***

PS. Some related papers where a shock destroys (reshuffles) match capital and takes time to recover: Adaptive Capital, Information Depreciation, and Schumpeterian Growth (Jones and Newman) and Distributional Dynamics Following a Technological Revolution (Andolfatto and Smith). 

10 comments:

  1. David,
    The link to your paper links to the Jones one instead.

    ReplyDelete
  2. Good post.

    But what is the shock? Why not a fall in AD, plus sticky (non-spot) prices and wages? Why does it get easier for buyers to find sellers, and harder for sellers to find buyers, in a recession? Does that not suggest a monetary nature of the shock? Because it is easier to sell money and harder to buy money, in a recession.

    ReplyDelete
    Replies
    1. Not ruling that out, Nick. Just not sure it *necessarily* suggest a "monetary shock and sticky prices."

      For example, a "bad news shock" (lowers the expected after-tax return to investing in physical and human capital) would "look like" a negative AD shock. Now suppose some investment includes marketing, distribution, etc. Contraction in these activities leads to thinner markets, making it harder for buyers and sellers to match. Nothing "monetary" in this story. We have to sort out which of these (and other) competing interpretations make the most sense. I'm not ready to hang my hat on any one explanation.

      Delete
    2. David: "Contraction in these activities leads to thinner markets, making it harder for buyers and sellers to match."

      That makes good theoretical sense, but I'm saying I don't think it fits the data. In a recession, sellers of money (buyers of labour and other goods) usually report it is easier to find a match. It is buyers of money (sellers of labour and other goods) who usually report it is harder to find a match.

      It's that asymmetry in ease of finding a match that us old Marshallian scissors guys describe as "excess supply".

      Delete
    3. Nick, the ratio of "buyers" to "sellers" has a name in search theory: it is the market-tightness variable. As the ratio changes, one side will find it easier to match, the other side less so.

      In any case, don't get me wrong. I like the story you tell. I just don't think it's the only possible story.

      Delete
    4. Yep. I want to put the two together somehow. And dump Calvo's fairy!

      Delete
  3. Oh! your post is mind blowing. I like it. Thanks a lot for your great sharing.

    kablo tv

    ReplyDelete