Lectures on Macroeconomics

by Arnold Kling

Note: These lectures were delivered as a series of blog posts on Econlog, starting on November 8, 2008 and continuing through January 11, 2009.

1. Introduction

These lectures will cover macroeconomics as I think it should be taught, not the way it is normally taught. The focus is not on model-building. The focus is on the two most troubling questions in macro.

1.How is it that financial markets affect the real economy?
2.How is it that an economic slump involves unemployment?

This lecture will be focused on the second question. However, I will not get to the answer in this lecture. The focus of this first lecture will be on ordinary labor market dynamics, both in theory and in practice.

To a non-economist, the answers to the two fundamental questions may seem obvious. The answer to the first question is that when the stock market goes down, that tells everyone that times are bad, so consumers and businesses tighten their belts. The answer to the second question is that when times are bad, people cannot find work, until somebody can figure out a way to create jobs.

To a first approximation, the non-economist's answers violate fundamental economic logic. That does not mean that those answers are wrong. However, the economist cannot simply give those answers and leave it at that. Even if the non-economist's intuition is right (and I am not saying that it is), we need to reconcile it with microeconomic analysis that we know works well in other contexts.

Take the issue of unemployment. Thirty years ago, Lester Thurow was fond of trotting out a tale of a basketball coach asked by a player, "Why is the basketball round?"

"Son, you've asked two questions," Thurow's fictional coach replies. "First, 'why?'" That is a very deep question, one which the great philosophers have struggled with for years. I cannot help there."

"Second, you've asked, 'Is the basketball round?' The answer to that is yes."

Thurow took the basketball coach's approach to the question of why there is unemployment. Do not ask why, just take it as given that there is unemployment. That might work for Thurow, but it does not work for us. If macroeconomic theory is to be of any use at all, it must include an explanation for unemployment.

From a traditional economic perspective, unemployment looks like a labor surplus. Surpluses and shortages are corrected by the pricing mechanism. So, if there are surplus workers, then a simple drop in wages should solve the problem. Bring wages down and you reduce labor supply, increase labor demand, and get rid of the labor surplus. There cannot be any unemployment, at least if the wage-adjustment mechanism works properly.

The classical economic logic may be easier to understand if we think about the reverse of a labor surplus--a labor shortage. What would happen if there were a shortage of, say, computer network administrators? (I picked network administrators because I want to stay away from other occupations, such as nursing, where regulations impede the operation of the laws of supply and demand.)

If there were a shortage of network administrators, I would expect the salaries of network administrators to rise. That would cause some firms to look for ways to economize on their use of network administrators. Perhaps they would outsource the function to service providers. Perhaps they would select computer systems that require lower levels of manual administration.

Another effect of higher salaries would be to draw more people into network administration. People who happen to be working in other jobs but who have experience in network administration might return to the field. Others might take training courses that would allow them to qualify for job openings.

The American economy is dynamic. People often quit jobs, take new jobs, or drop out of the labor force to retrain themselves. When the aggregate unemployment rate is 5 percent, the typical person who is out of work finds a new job within one or two months. Of course, there will be a significant minority of unemployed workers whose unemployment spells last much longer than that.

Each month, there are millions of new quits and millions of new hires. The monthly change in employment is equal to the net difference between the two. If there are 3.1 million new hires and 3.2 million new quits, then unemployment goes up by 100,000. These net figures-- monthly changes in the number of unemployed--tend to be plus or minus 200,000 in any month. That is really quite low relative to the gross flows in and out of unemployment.
For further reading on labor market dynamics in practice, I recommend Steven J. Davis, R. Jason Faberman and John Haltiwanger. Some excerpts (note that most of their period of analysis is 1990-2005, and today's labor market may be working differently):

for every dozen or so filled jobs at a point in time, on average one job disappears in the following three months. In a growing economy, a somewhat larger number of new jobs are created at new and expanding establishments.

...job flow rates are three times larger in construction than in manufacturing, and worker flow rates are three times larger in leisure and hospitality than in manufacturing.

...in the third quarter of 2001, 31 percent of establishments contracted during the quarter and so contributed to job destruction. Another 26 percent expanded and so contributed to job creation. Most job destruction, 68 percent, occurred at establishments that contracted by 10 percent or more during the quarter. Perhaps more surprising, 63 percent of job creation occurred at establishments that expanded by 10 percent or more. In fact, the prevalence of such large employment changes is the norm in both booms and busts. Hence, most job destruction cannot be interpreted as the product of modest contractions achieved by normal rates of worker attrition. Neither can most job creation be seen as the outcome of modest establishment-level growth rates. That is, although most establishments experience little or no employment change within a quarter, job flows mainly reflect lumpy employment changes at the establishment level

Because unemployment escape rates are high, spikes in job destruction and layoffs lead to short-lived rises in the unemployment rate unless the spike itself is long-lived. The unemployment escape rate is also highly procyclical, and movements in the unemployment escape rate account for most of the time variation in the unemployment rate

2. Misconceptions about Labor Markets

I continue to focus on the issue of unemployment. In this lecture, I want to emphasize two things. One is the problems with popular intuition that jobs are scarce. The other is the wide variety of jobs, and hence labor markets, in a modern economy.

If you're paying $12, $13, $14 an hour for factory workers and you can move your factory South of the border, pay a dollar an hour for labor, hire young -- let's assume you've been in business for a long time and you've got a mature work force -- pay a dollar an hour for your labor, have no health care -- that's the most expensive single element in making a car -- have no environmental controls, no pollution controls and no retirement, and you don't care about anything but making money, there will be a giant sucking sound going south.
--Ross Perot, October 15, 1992

Ross Perot's famous warning that the North American Free Trade Agreement (NAFTA) would produce a "giant sucking sound" still rings in our ears. The implication was that free trade with Mexico would cause significant job losses in the United States. Despite Perot's warnings, President Clinton signed the agreement in January of 1994. Subsequently, employment in the United States increased steadily and dramatically, with the share of the working-age population employed reaching an all-time historical high in 2000.

The issue of whether trade costs jobs--or whether jobs are intrinsically scarce at all--is one that divides economists from non-economists. Bryan Caplan puts it,

The public often literally believes that labor is better to use than conserve. Saving labor, producing more goods with fewer man-hours, is widely perceived not as progress but as a danger. I call this the make-work bias, a tendency to underestimate the economic benefits of conserving labor. Where noneconomists see the destruction of jobs, economists see the essence of economic growth: the production of more with less.

Caplan has analyzed surveys of economists and non-economists in order to pinpoint differences. A persistent worry of non-economists is that better efficiency will cost jobs. This worry becomes particularly acute when the source of efficiency is trade, which registers with the public as "foreigners stealing our jobs."

Suppose that there were a central planner for an economy. People have unlimited wants. That is, consumers will always prefer having more goods and services available to having less. The central planner would never prescribe that some people not work. That is, the planner would never say, "We get enough from China. You can go home." Nor would the planner say, "Since we can now produce the same output with fewer workers, we will have some workers remain idle forever."

Instead, a central planner would find a use for all workers. The planner will move labor out of sectors where productivity growth exceeds demand growth and into sectors where demand growth exceeds productivity growth.

In the case of international trade, David D. Friedman in Hidden Order: The Logic of Everyday Life offers the illustration of growing cars in wheat fields. That is, instead of building cars in manufacturing plants, we can grow wheat, ship it overseas, and have the ships come back with cars. The car-growing process may require fewer auto workers, but those workers can be given other work to do.

In practice, central planners do not organize economies very well. There is often a lot of disguised unemployment in such economies, because people have little incentive to seek productive jobs.

In a market economy, prices and wages perform the function that in theory could be done by a central planner. When the economy needs to shift employment from manufacturing to health care (because productivity growth exceeds demand growth in the former but not the latter), wages will fall in manufacturing and rise in health care. When the U.S. economy needs to shift employment from customer call centers (which can be outsourced to India) to accounting, wages will rise in accounting and fall in domestic customer call centers.

As we saw in the previous lecture, millions of jobs are lost each month. But each month, millions of jobs also are gained. Some firms expand rapidly, and some firms cut back rapidly. The net differences between total monthly hires and total monthly separations are small.

In the 1990's, labor market policies in Europe were often geared toward stopping job losses. Ideas included a limited work week or penalizing firms for firing workers. The net result was higher unemployment and a lower share of the working-age population employed than in the United States. It turns out that the anti-job-loss policies make workers expensive to employ. As a result, they reduce new hires by more than they reduce job losses.

The fallacy is to confuse gross job losses with net job losses. A nation can have a large number of gross job losses without any net job loss, as long as additions to employment in expanding companies are at least as large as reductions in employment at contracting companies.

The overall key point is that the common intuition that jobs are scarce is dangerously wrong in many contexts. It leads to a fear of productivity gains. It leads to a particularly strong fear of the productivity gains that come from trade and comparative advantage. It leads to a faith in anti-job-loss policies that is counterproductive.

And yet, there is one context in which economists talk about job scarcity in the same terms as an ordinary layman guilty of make-work bias. That context is macroeconomics. When they talk macro, professional economists speak of the need to create jobs. Economists will grade Presidents on how many jobs are gained or lost during their administrations, rather than on, say, productivity growth during their tenure in office.

I worry that mainstream Keynesian macroeconomics is little more than fancy camouflage for make-work bias. That is, it allows economists to strike a sympathetic chord with non-economists, while maintaining an air of professional sophistication.

On the other hand, I worry that classical economics is vulnerable to appearing irrelevant in the face of episodes such as the Great Depression, the recession of 1980-1982, or the recession that looms at the end of 2008. We need a narrative of episodes of severe unemployment that does not embody crude make-work bias but does not deny the existence of large amounts of involuntary unemployment.

I suspect that a key to thinking usefully about macroeconomics is to shift from thinking in terms of a singular labor market to thinking about plural labor markets. One of the reasons I resist mathematical model-building is to avoid the temptation to specify the labor market, as if there were only one. My guess is that thinking in terms of one labor market puts you off track.

Think in terms of many labor markets, constantly in flux. Demand shifts across sectors, across firms, and across occupations. Even if the demand for accountants or computer programmers is rising on a secular trend, there will be failing firms that fire accountants and programmers.

Substitution mechanisms matter. It may be impossible for the same worker to walk off an assembly line one day and join a physical therapy practice the next. But the same change can be effected if an assembly-line worker reaches retirement age and is not replaced while a freshly-certified physical therapist reports to work for the first time the following day.

Some industries move quickly to add and subtract workers. In retail trade, firms hire for seasonal needs. There are always new stores opening and failing stores closing.

Other industries move more slowly. In manufacturing, the decision to add capacity or to take capacity off line is made cautiously. In law firms, investment banks, and other companies that employ highly-skilled workers, the decision to lay off an experienced professional is not taken lightly.

The economy is radically different today than it was in the 1930's, when the majority of the work force did manual labor. It is also different from the 1950's, when autos and steel were so significant that General Motors' Charles Wilson famously said that "What.s good for GM is good for the country, and vice-versa."

For further reading, I suggest browsing through the U.S. Department of Labor's Standard Occupational Classification web site. Particularly fascinating are Katherine Abraham's historical overview and the proposed structure for 2010, which highlights changes relative to 2000.

3. Unemployment as an Adjustment Problem

In this lecture, I get to the punch line and offer my explanation of unemployment. Markets are constantly in adjustment, with the number of people in different occupations changing. Usually, the task of adjustment and adaptation goes remarkably smoothly. Occasionally, however, markets are overwhelmed by the amount of adjustment required within a relatively short period of time. When the adjustment mechanism is overwhelmed, we have a recession.

Thank you for your time
Oh, you've been so much more than kind
You can keep the dime
--Jim Croce, Operator (That's Not the Way it Feels), 1972

Jim Croce's classic song conveyed the pathos of coming to terms with a broken relationship. Forty years later, it also conveys the pathos of the end of a bygone era.

The protagonist in the song is evidently in a phone booth, and the lyrics are the words that he speaks to the telephone operator. There are still telephone booths, but when was the last time that you used one? There may still be human operators who can connect calls, but when was the last time that you spoke with one?

It is safe to conjecture that, compared with forty years ago, we need fewer people to install and maintain telephone booths and fewer people to act as telephone operators. Instead of phone booths, we need cell phones and cell phone towers. Instead of operators, we have computerized systems for connecting calls and automated voice-response systems for looking up phone numbers. (To be sure, even by 1972 most calls were automatically connected without an operator.)

A dynamic economy requires constant adjustments in the labor force. New types of jobs emerge--consider that none of the job titles associated with web site development could have existed prior to 1994. Other jobs disappear.

Usually, these adjustments take place remarkably smoothly. In 2003, I wrote an essay called Manufacturing a Crisis, in which I presented the following data:
YearTotal Nonfarm EmploymentManufacturing Production WorkersPercent
195248.9 million12.8 million26 %
196255.7 million12.0 million22 %
197273.8 million13.5 million18 %
198289.7 million12.3 million14 %
1992108.7 million12.0 million11 %
2002130.4 million10.8 million8 %

For 2007, the figures are 137.6 million for total employment and 10.0 million for manufacturing production workers, respectively.

It should be noted that over this long history of falling employment, total U.S. manufacturing output was rising. Productivity increases have been larger then the declines in employment.

The fact that there are 3.5 million fewer manufacturing production workers today than in 1972 does not mean that there are 3.5 million former manufacturing production workers now standing around idle or in need of government retraining. It seems safe to presume that more than 3.5 million manufacturing production workers in 1972 have reached retirement age since then. Many of the retirees have not been replaced. However, there are many people, perhaps millions, working as manufacturing production workers who were not doing so in 1972.

Economists who notice job displacement tend to leap to the conclusion that we need government retraining programs. They forget that the natural process of retirement and new entry into the labor force tends to take care of the marginal adjustments in occupational choice. No, not every manufacturing production worker can retire at once, but they do not all have to. Many of them have to change firms or change industries, but the overall process of adjustment among occupations is reasonably gradual.

When workers are unemployed because of job displacement, economists call this structural unemployment. This is one of three types of unemployment described in traditional macro textbooks.

Another type is frictional unemployment, presumably named for the natural "friction" that exists as people leave jobs to seek new jobs. Someone might quit because they are fed up or want to move to a new city. Or someone might be laid off by one firm in a market where jobs are readily available at other firms, but it takes time to find a suitable opening and make a choice.

Finally, there is cyclical unemployment. For example, when the U.S. economy was more heavily dominated by manufacturing, the big auto companies and steel companies would occasionally find themselves with excess inventory. They would put workers on temporary layoff until supply and demand are in better balance. Because these industries were so large relative to the overall economy, the layoffs of their workers caused demand to fall in other sectors, so that employment also fell elsewhere. Eventually, however, the inventory correction would be over, manufacturers would recall their workers, and the economic decline would reverse. Alan Blinder, among others, has observed that most of the recessions in the U.S. economy between the end of World War II and 1980 could be described as "inventory recessions."

One way to think about cyclical unemployment is that it represents a system overload in the adjustment mechanism in labor markets. There is too much adjustment required in too little time, resulting in excess unemployment. This excess unemployment tends to amplify because of multiplier effects--workers out of a job are going to spend less, and this will reduce labor demand elsewhere.

Ordinarily, the need for adjustment is sufficiently gradual that lateral movements (workers changing jobs but not changing careers), retirements, and new entry into the labor force can meet the needs of a dynamic economy and maintain full employment. A recession takes place when the adjustments required are large and the economy is sluggish about making them.

With an inventory recession, the market is saying that we need less heavy manufacturing output and more of something else. However, workers laid off by manufacturers do not go to work producing something else, because they instead wait to be recalled by their old jobs. In a typical inventory cycle, most workers in fact do get recalled.

Sometimes, however, major shifts in employment are called for. For example, the development of automobiles, trucks, and paved roads in the 1920's brought about a restructuring of production. Farm produce could travel farther, which took away the economic advantages of dense urban areas surrounded by farms. Eventually, we would see in the 1950's the configuration of suburban housing, shopping malls, fast-food restaurants, major grocery stores stocked by out-of-town produce, and other familiar features of the mobility-driven economy.

However, in the 1930's, the adjustment process got stuck. The jobs that were added in the 1920's in boom industries such as electrification were cut back when the stock market crashed. Bank failures, monetary contraction, and deflation made matters worse, in ways that will be explained in a subsequent lecture. The financial turmoil caused further job cuts. In addition, the turmoil meant that industries that otherwise would have been expanding were instead struggling. The workers displaced by the transportation revolution and by layoffs in the boom-bust segment of the economy could not find work elsewhere. They reduced their spending, and multiplier effects kicked in.

Between 1925 and 1955, the U.S. economy achieved a massive transition. Suburbs replaced close-in rural communities. Farm labor contracted and service employment expanded. Unfortunately, this transition was not smooth. The veterans of World War II built a new economy, because the one that their parents had known in the 1920's stopped functioning during the Great Depression.

The nature of labor has changed since the 1930's. A much larger proportion of our labor force has specialized skills, and a smaller proportion are general laborers. The increased levels of specialization and training will have mixed effects. On the plus side, not everyone is tied to key manufacturing industries. An inventory correction in automobiles does not affect nearly as large a percentage of the work force as it did fifty years ago.

On the other hand, major adjustments may be more painful for highly trained individuals. If we need more health care management personnel and fewer mortgage securities traders, that adjustment process may not be as simple as moving a farm laborer into a factory.

I suspect that the modern labor force poses different problems for policy during a recession. With an inventory recession, a generic fiscal stimulus might serve to shorten the duration of the downturn. However, when the economy is in the process of expanding some sectors and contracting others, and when the expansions and contractions involve workers with different skill sets, generic stimulus may not be able to affect the dynamics of the process very much. I intend to talk more about policy issues in the next lecture.

Further reading: Much of the transition from landline to cellular telephones took place between 1990 and 2004, as recounted by Christopher C. Carbone in a n article published by the Bureau of Labor Statistics. A few data points from the article:

--from January 1990 to August 1993, total employment in telecommunications fell by 43,000, even though wireless communications firms added 25,000 workers over that period.

--From the beginning of 1996 to March of 2001, total employment in telecom increased by 352,000 jobs, as landline telecom services built capacity to market Internet services and to handle the increased data load, while cell phone services continued to expand.

--From March of 2001 through the end of 2004, total employment in telecom fell by 300,000. It turned out that the capacity build-out had gone too far, too quickly. Some of this was the Internet bubble, but much of it reflected the failure to take into account reduced demand for landline phone calls with the growth of cellular.

4. Why Wage Cuts are Rarely Seen

This lecture covers an important issue: why do firms adjust by cutting workers rather than by cutting wages?

So far, I have been pushing an explanation for unemployment that relies on issues with adjustment. There is heterogeneity in the labor market. Demand rises for some occupations and falls for others. Some industries expand, while others contract. Within industries, some firms are successful, while others fail. The overall effect is that individual workers frequently change jobs; moreover, the occupational mix changes as some workers exit the labor force (when they retire, for example) and other workers enter the labor force.

The picture I have of a macroeconomic recession is one in which the need for these adjustments becomes overwhelming. The gains and losses in employment, which usually offset one another, get out of balance. Declines in certain sectors are too large and/or too rapid, so that aggregate employment declines. Moreover, this decline in employment has multiplier effects, as those who are unemployed cut spending.

A question is: why do worker cutbacks take the form of job losses, rather than wage cuts? There are many possible answers.

My first thought is that most of the time wage cuts are inappropriate. The overall trend is for productivity and living standards to rise. On average, salaries are increasing. One can see, particularly in longitudinal studies, a strong tendency for people to move on a rising escalator of income. (Longitudinal studies examine the same people over time. In contrast, many people wrongly conclude that incomes are stagnating when they examine snapshots of the distribution of income at different points in time, using Census data for example. One might find that the bottom 10 percent of the income distribution in 2000 is not far from the bottom 10 percent in 1980. However, many people at the bottom in 1980 moved up, and they were replaced by new workers and immigrants.)

For the most part, the market tells workers that they can expect to maintain or improve their standard of living. Doing so may require a willingness to adapt by changing firms, changing cities, or changing occupations. Overall, however, it is not normal to have to accept a permanent wage cut.

If the long-run trend of wages is upward, then as a manager you know that cutting wages at your firm means cutting them relative to other potential opportunities for your work force. If wages are not falling generally, then an absolute wage cut at your firm means that you are reducing wages relative to the market. Your workers are likely to bleed away, and the workers you lose first are likely to be your best workers. Better to choose which workers to lose and to lay them off.

In other words, keeping the same work force and cutting wages is typically not an option. The choice is between cutting the work force directly or having your work force decline in response to a wage cut. You probably are better off making direct cuts. Most of the time, cutting wages is a bad policy.

In addition, economists have considered a number of sociological reasons for maintaining wages. For example, wage cuts may demoralize workers and therefore harm productivity.

In any case, I find it plausible that under most circumstances wage cuts are not a good way for a firm to cope with adversity. Still, from a macroeconomic perspective, there are rare circumstances in which wage cuts are called for.

For example, if there is general deflation, then cuts in nominal wages are needed in order to keep wages from rising relative to prices and productivity. This may have been an issue during the Great Depression. One would expect that if real wages were too high, employment would fall and productivity would rise as firms attempt to economize on expensive labor. This seems to be what happened.

In addition, if there is a major sectoral decline that is too big for the rest of the economy to absorb, it might be better for wages to fall for a while in that sector in order to help maintain employment. In the long run, a decline in demand for cars relative to physical therapists should lead to fewer auto assemblers and more physical therapists. In the short run, an unusually large decline in auto demand (due, say, to permanently higher oil prices) might best be met with lower wages in the auto industry, which could bring down prices and enable firms to sell more cars than they would otherwise.

Even if the macroeconomic rationales for wage cuts may on occasion be legitimate, such cuts may be very difficult to implement. How is a worker to tell the difference between an appropriate, macro-determined wage cut and a raw deal?

In fact, the inability of workers to see through the reasons for wage cuts is at the heart of why workers are paid fixed-dollar salaries to begin with. Economists have long noted that there would be fewer employment fluctuations if workers instead were paid a share of corporate revenues or profits. In theory, if worker were paid in the form of the output of firms, there would never be layoffs!

As a worker, shifting some of my income from fixed-dollar wages to a share of corporate profits is adverse for two reasons. First, it makes my income riskier and dependent on things beyond my control. I may do my job perfectly well, but the company makes strategic errors, leading to no profits and little or no pay for me. Second, it imposes an information cost on me. I have to be able to audit the corporation's accounting statements to make sure that the reported profits on which they base my pay are not misleading--perhaps the real profits are being disguised and held in a form that benefits shareholders but not me.

So here is my story for explaining why we observe swings in unemployment rather than short-term wage adjustments. Under normal circumstances, most labor market transitions are toward jobs with higher pay and/or more desirable non-wage characteristics. Millions of these transitions take place each month. Therefore, a wage cut is a destructive, unsustainable policy that will alienate the firm's work force and cause its best employees to leave.

There are occasions where, from a macroeconomic perspective, a cut in wages, in either a large sector or across the board, would help to avert a surge in unemployment. However, there is no credible way for any firm to tell its employees, "You are getting a wage cut, but don't worry. It's just for macroeconomic reasons."

If this view is correct, then in times of high unemployment macroeconomic policy should aim to boost prices, presumably by expanding the money supply. Printing money should help to avert a general deflation. With sectoral imbalances, printing money should cause prices to rise in high-demand sectors, effectively reducing real wages in low-demand sectors and maintaining full employment in the latter.

Note that if sectoral imbalances are a problem, and creating general inflation in order to reduce real wages in weak sectors is the solution, then there is a Phillips Curve--a trade-off between inflation and unemployment. This model of the Phillips Curve was articulated particularly clearly by James Tobin in his address as President of the American Economic Association.

Note, however, that the Phillips Curve trade-off does not necessarily exist every instant. In order for inflation to reduce unemployment, there has to be a sectoral imbalance that is too large to be resolved by normal market forces. That may not always be the case. In fact, it may only rarely be the case.

Further reading: Martin Weitzman's book, The Share Economy, describes the macroeconomic advantages of having worker pay that varies with corporate performance. An excerpt from James Tobin's address can be found here.

5. The Dotcom Recession

So far, I have focused on unemployment as a problem of adjustment. In this essay, I review the history of the Dotcom recession, and I focus on the index of aggregate hours worked as an indicator of macroeconomic performance. According to this indicator, the Dotcom recession was quite severe. This in turn raises interesting questions about other indicators and about the policy history.

Below is a table showing the index of hours worked in the nonfarm business sector for the three deepest post-war recessions, starting with the pre-recession peak and moving forward eight quarters (two years) at a time.

Oil RecessionVolcker RecessionDotcom Recession
Pre-recession Peak1973 Q41979 Q42000 Q2
Hours Index at Peak77.987.2121.9
2 years Past Peak75.086.3116.3
4 Years Past Peak80.988.6116.5
6 Years Past Peak87.294.6121.1

Using this measure, the Dotcom recession seems to have been much worse than the previous two, particularly in terms of length. It was not until the fourth quarter of 2006, 6-1/2 years after the peak, that the hours index edged above its peak level. It stayed above the earlier peak for four quarters, and has since slipped back below.

The reason that most people do not look at the Dotcom recession as being a severe one is that the flagship indicators, GDP growth and the unemployment rate, were better behaved during the Dotcom recession. GDP growth was reasonably robust, because productivity growth was high. The unemployment rate remained low, because labor force participation fell.

Overall, my sense is that the Dotcom recession saw a change in the composition of the labor force that favored higher productivity. For example, from the second quarter of 2000 to the second quarter of 2006, the number of employed persons aged 25 and older with a high school degree went from 36.7 million to 36.9 million, essentially no change. Over that same period, the number of employed persons aged 25 and older with a college degree went from 36.0 million to 41.3 million, an increase of more than 14 percent.

Interestingly, the labor force participation rate of college graduates declined by more than that of those with just a high school degree. The participation rate of the latter declined from 64.4 percent to 63.4 percent, while the participation rate of the college graduates fell from 79.8 percent to 77.6 percent.

My interpretation:

1. The work force became weighted more toward the college educated. Presumably, those who aged out of the labor force and retired were disproportionately less educated than those who joined the labor force.

2. A relatively high proportion of the college-educated dropped out of or failed to enter the labor force, as indicated by the decline in their labor force participation rate. This decline presumably reflected a more difficult job market during the Dotcom recession.

3. Nonetheless, the composition of employed persons shifted markedly toward more employment of those with a college education. This may account for some of the strong productivity gains. However, I should point out that the more educated labor force tends to have occupations where hours and output are both harder to measure than the classic factory job. Both the numerator and the denominator of output per hour are less reliable.

4. Perhaps what makes the Dotcom recession unusual is the behavior near the peak. It could be that there was an unsustainably high level of employment as a result of Internet companies taking on large numbers of workers in spite of having little or no revenues. In a more realistic job market, more people choose to remain out of the labor force.

5. The severity of the Dotcom recession as measured by the hours index makes it difficult to criticize the monetary policy of 2001-2004 from a conventional Keynesian perspective. If you were to use hours worked rather than the unemployment rate as an indicator of labor market conditions, then you certainly would argue for a policy of monetary easing.

However, in terms of these lectures, to discuss monetary policy is to get ahead of our story somewhat. So far, I have hinted that when there are severe structural imbalances that require wage cuts, expansionary monetary policy might serve to produce the required adjustments by raising prices relative to wages. However, it seems far-fetched to suggest that what we needed from 2000-2006 was inflation in order to cut the real salaries of college graduates so that employers would retain them. The period of 2000-2006 would seem to me to be long enough for a lot of labor market adjustments to work out on their own. If college graduates were not participating in the labor force in 2006 to the extent that they did in 2000, I am reluctant to attribute this shift to inadequate macroeconomic stimulus.

In fact, I am extremely cautious about any conventional macro stimulus theory, given the complexity of labor market dynamics these days. But, again, that is getting ahead of the story.

6. Labor Markets in the Post-Industrial Economy

The main theme of this lecture is economic policy and labor market adjustment. My conjecture is that in our post-industrial economy, conventional Keynesian policies do not operate as they do in an industrial economy.

Another issue is that the natural impetus of the political process is to impede adjustment. Therefore, in a post-industrial economy, the presumption that government ought to do something about unemployment can be dangerous. The government may be more likely to do something wrong than to do something right.

Commenting on an earlier lecture, Matt Yglesias wrote a blog post entitled Fight Recession by Causing Inflation?

If I'm reading him right, that's what Arnold Kling is calling for here. Not just a shift in emphasis away from inflation-fighting and toward expansion, but specifically an effort to create inflation to allow real wages to fall in lieu of mass layoffs. I'll file that under "provocative."

In the Great Depression in the United States, I am pretty confident that monetary inflation would have been a good idea. So, without any apologies, I officially call for inflationary monetary policy in 1930.

Speaking of the Great Depression, Amity Shlaes passes along a note from Lee Ohanian with some relevant facts.

In 1939, total hours worked per working age person - including the hours of those on government payrolls - were 21 percent below 1929 level....

Why was there so little recovery in employment? Because wages in many sectors of the economy were far too high. For example, manufacturing wages relative to trend were about 16 percent above trend in 1939.

First, note that Ohanian uses a measure of employment--hours worked per working-age person--that is quite similar to the one that I referred to in my last lecture. My thinking with that kind of measure is that it is better than the unemployment rate because it gets rid of labor force participation rate changes. Hours are a better indicator than total employment because employment is affected by "labor hoarding"--at the end of a boom businesses are slow to fire unnecessary workers.

Second, if Ohanian is correct that real wages were too high, and if inflation would have lowered real wages, then his data support the view that more inflation would have helped to alleviate the Great Depression.

Of course, the point that is important to Shlaes is that the employment measure calculated by Ohanian shows that the New Deal did not bring about anything close to a full recovery to the 1929 peak. I would argue that the U.S. economy has yet to fully recover from the Dotcom recession that began in 2000, based on a similar indicator of labor capacity utilization.

Notwithstanding my views on the Depression, I do not think that inflation is the universal solution to every adjustment problem in labor markets. Let us look at the most severe recessions since the 1930's--the oil recession of 1974-75, the Volcker recession of 1980-1982, and the Dotcom recession.

With the oil recession, the economy needed to adjust to higher oil prices. Government impeded the adjustment by using rationing, including the infamous queues at gasoline stations, rather than prices. Otherwise, there was plenty of inflation in the late 1970's, and I see little evidence that this helped with labor market adjustment.

What the late-1970's inflation gave us was the appointment of Paul Volcker as Federal Reserve Chairman, and what ensued was his eponymous recession. The Fed raised interest rates, leading to cutbacks in the interest-sensitive sectors of the economy such as housing.

The subsequent recovery was not accompanied by inflation. Instead, the Volcker recession produced a twenty-year trend of disinflation. Interest rates came down only with a lag, so that ex post, real interest rates were high. However, part of the reason that rates came down slowly was that expectations about inflation only declined slowly, so that ex ante real rates were generally lower than they were ex post. (If the interest rate is 8 percent, and everyone expects 5 percent inflation, then the expected real interest rate is 3 percent. If inflation actually turns out to be 4 percent, then the realized real interest rate is 4 percent.)

I should point out that housing is sensitive to nominal rates as well as to real rates. That is because high rates on fixed-rate, amortizing mortgages produce payment shock to borrowers. Regardless of what is happening to inflation, it is harder to make the payments on a 10 percent mortgage than a 6 percent mortgage.

(Suppose that we equate the real interest rate for both borrowers at 4 percent. That is, the 10 percent mortgage is accompanied by 6 percent home price appreciation and income growth, and the 6 percent mortgage is accompanied by 2 percent appreciation and income growth. In that case, in the early years of the mortgage, the high-rate borrower will have a higher payment/income burden and accumulate more equity than a low-rate borrower.)

Because the Volcker recession was caused by high interest rates, the cure was simply to let interest rates drift back down, once the Fed Chairman was satisfied that we were on a disinflationary path. Otherwise, there was no real macroeconomic policy involved. As rates eased down, some people returned to work in the interest-sensitive sectors related to housing, business investment, and consumer durables. A drop in oil prices helped the rest of the economy.

During the long recovery (from the mid-1980's to 2000, we had only one, relatively mild, recession, the "economy, stupid" of 1992), the required labor market adjustments were gradual. Over this period we continued to phase out (through retirement) cohorts of less-educated workers while bringing into the labor force cohorts of more-educated workers. Personal computers spread rapidly, at first causing Robert Solow to famously complain (in 1987) that they were "everywhere but in the productivity statistics." However, by the latter part of the 1990's, it was clear that productivity growth was rising, and many economists concluded that computers were at least partly responsible.

The Dotcom recession is the one that I think is most relevant to circumstances today. It was a post-industrial recession, by which I mean that the main driver was not an inventory correction among manufacturers of consumer durable goods. There were major job losses in the service sector, and these were not temporary layoffs.

I would argue that standard Keynesian remedies were tried. Government spending rose and taxes were cut. Interest rates were kept low, with short-term real rates below zero (meaning that inflation was higher than the interest rate).

With all of this stimulus, what do we have to show for it, other than a housing bubble? As the table in my previous lecture showed, the Dotcom recession seemed much worse than the other two major recessions, particularly in terms of its duration. Of course, we do not know what would have happened had fiscal and monetary policy been to provide a weaker stimulus, or none at all.

My tentative judgment is that the Keynesian remedies are less appropriate to the post-industrial economy. Fiscal and monetary policy may be good for kick-starting the durable goods sectors, but the Dotcom crash required more complex adjustments, involving a more educated labor force.

From 2002 through 2007, the economy fell short of providing the employment opportunities for highly-educated workers that the Internet bubble was able to generate. Meanwhile, we overheated the traditional housing and consumer durables sectors. Some of the demand for consumer durables was met by foreign producers, as our imports shot up. One could argue that the demand for housing also was met partly by foreign labor, in the form of illegal immigrants.

Another sector that overheated in this period was the financial sector. The mortgage origination, securities-trading, and risk-disguising industries ballooned. These excess financial services employees now need to find other lines of work. I cannot see how a Keynesian policy of creating inflation to reduce real wages can help with that.

When the market tells an industry to shrink, the natural response of those in that industry is to sound the alarm. "This would be a disaster," they say. "If X is allowed to fail, then that will affect Y and Z as well."

It is true that most important industries are connected to other industries. Can you name a major industry that is completely isolated, so that it could suffer a catastrophe without affecting any other industry? Perhaps there is such an industry, but offhand it is easier for me to think of examples of industries that have important interconnections than to come up with an example of an industry that is fire-walled off from the rest of the economy.

Listening to the plea not to let industry X fail is probably a bad idea. A dynamic economy is one in which human and physical capital are chasing new opportunities, not holding onto lost causes. Politically, on the other hand, I can see where a bailout is a winning policy. The threatened industry is organized and visible. The alternative uses of capital are diffuse and unseen.

The economy needs to adjust as market conditions change. Instead, the political process encourages denial. It is natural to seek to prop up declining firms, but the result is something like Japan's lost decade(s), where "zombie banks" misallocated capital in a massive way.

We have created the expectation that government can ensure high rates of labor utilization. In an industrial economy, where there is a lot of low-skilled labor and economic activity is heavily concentrated in a few key sectors, inflationary policies may in fact have some effect in terms of bringing real wages into better balance, either across sectors or in the economy as a whole.

My guess, however, is that in a post-industrial economy, the necessary adjustments are too subtle and complex to be helped much by inflation-producing macroeconomic stimulus. The problem is not to bring about a general reduction in real wages, or even a reduction in real wages in a key sector. In today's economy, an enormous variety of career changes, business start-ups, and business failures will be needed in order to bring labor markets into balance.

In theory, wise technocrats could help guide workers in declining industries to appropriate re-training and career development. In practice, technocrats are not that wise. But it is much worse than that. Instead of giving the technocrats the mission of making the adjustment process more efficient, politicians will give them the mission of delaying the adjustment process and resisting the signals coming from the market. Thus, the expectation that government should help could have an ironic effect: the more that the public asks government to relieve the distress in labor markets, the longer it may take for labor markets to adjust.

7. The Imperial Origins of Money

With this lecture, I start to look at the second great puzzle of macroeconomics. How does the financial sector affect the real economy? Before one can answer that question one needs to examine the fundamental role of money and credit. In this lecture, I suggest that they are closely linked to government power.

I have a very skewed view of economic history.

Imagine yourself in the environment, which existed until about 300 years ago, in which the overwhelming challenge was to obtain food. Not many people can make a living in art, science, education, or software development, because people need to eat. So you have to be engaged in primary food production. That means you need land, and you can't live close to a lot of people. There are not many people to trade with. There is very little surplus to trade. Maybe every six months or so you have a festival where you get together with people from miles around, get drunk, and swap a few bowls, to give future archaeologists something to get excited about.

If you're really sophisticated and disciplined, maybe you organize an army that conquers lots of farmers. They pay taxes (in the form of food), you use the taxes to feed soldiers and slaves. The latter build cities. Some of the children of the elite soldiers, knowing that their parents will feed them, go into art, science, software development, and so on, which gets the future archaeologists even more pumped up.

I don't think of pre-modern economies as market economies, in the sense of people voluntarily specializing in production for sale. Instead, I see individuals focused on subsistence, and organized groups focused on war, financed by plunder.

A standard textbook starts by assuming a market economy, explains how money makes such an economy more effective, and then incidentally introduces a role for government in regulating money and banking.

My skewed view is the opposite. For me, money and credit start out as tools of government, and they get incidentally adopted by the market.

Imagine that you're a warlord leading a band of soldiers. Your business model is that your soliders prey on farmers, taking plunder and tribute. To help motivate your soldiers, you promise them a share of the booty.

When the band of warriors is small, the promises can be verbal and informal. However, in order to organize a large army, you need formal, written contracts. Lacking lawyers and xerox machines, you make little carvings on metal, hand them out to soldiers, and say, "After the battle, turn this in to the clerk and we'll give you a share of captured slaves and grain and stuff."

In this simple model, governments exist to make war or to subjugate populations. The warlords sometimes pay their warriors on credit, using coins or other means. The warrior knows that the warlord will redeem the coins for booty.

Eventually, the coins can start to circulate in a secondary market. As warriors start to accumulate slaves and goods, they sometimes trade with one another. Every once in a while, instead of exchanging a slave for a few bottles of wine, you might exchange the slave for some coins.

Keep in mind that the standard view is that a market needs money as a medium of exchange. Suppose that the person selling grain wants shoes, the person selling shoes wants wine, the person selling wine wants olive oil, and the person selling olive oil wants grain. There is no two-way trade that works (we say there is no "double-coincidence of wants"), but a four-way trade is clearly possible. Using money as a medium of exchange makes it a lot easier for this complex trade to take place.

In the standard view, if you did not have a market economy, with lots of specialized production and consumption, then you would not need money. If people are just living on subsistence or making occasional bilateral trades, money would not emerge.

In the skewed view, money can exist even without a market economy. A big-time warlord needs to be able to procure soldiers on credit, and the warlord issues credit instruments that act as money. Maybe if the warlord builds a really big organization and accumulates a lot of plunder and tribute (think of the Roman empire), you start to see markets where different types of plunder are exchanged, and money serves as a medium of exchange along the modern textbook lines.

Money's value reflected the military power of the warlord. A really strong warlord's coins would be widely accepted. A shaky warlord might have trouble getting his coins accepted. You can imagine that there are strong positive feedback loops. A rising warlord has a more powerful currency, which buys more soldiers, who deliver more plunder, which strengthens the warlord, which makes his currency more in demand, and so forth. When the warlord falters, the process goes into reverse. A warlord needs a good financial operation as well as a good military operation.

If somebody is good at accumulating money but not so skilled with a sword, he can form a symbiotic relationship with a warlord. The warlord needs the money maven to help finance expeditions, and the money maven wants the warlord to protect his wealth. Hanging over this relationship is the threat that the warlord will steal the money maven's wealth or that the money maven will switch sides and bankroll the warlord's enemies. One can imagine a variety of incentive mechanisms that would be devised to sustain the relationship, including land grants by warlords to money mavens, marriages arranged among children of money mavens and children of warlords, and so on.

I can imagine that until quite modern times, the typical person had only occasional contact with money or credit. Instead, money and credit were instruments of rulers and the warriors needed to sustain rule.

It could be that for the typical person, the use of money was coerced. A farmer might be ordered to accept money for grain. With the exchange rate of money for grain dictated by the wardlord rather than determined in a fair market, this would be a convenient form of taxation.

The government need not use a particular grain-for-coin price to take advantage of seignorage. An alternative approach would be to require that taxes be paid in coins. That would force the farmer to acquire coins, trading grain for coins at whatever price the market generates.

From the skewed perspective, one would expect to find finance and government power closely linked. In the world at large, military strength should correlate with the acceptance of a government's financial instruments. Within a country, the wealthy need political power in order to preserve their financial position, and governmental leaders need financial resources in order to preserve their political power.

According to the skewed view, there was never a state of nature in which financial institutions roamed free in the wild, to be later tamed by regulators. Instead, financial institutions were fundamentally institutions of government. Entrepreneurial finance is a modern development, and its separation from government may always be tentative.

The early United States, in this as in other things, seems exceptional. Our frontier society was resistant to government and engaged in some experiments with banking that was quite independent of the Federal government. Eventually, the Federal government consolidated its hold in the United States, and "free banking" was no more. (I am not an expert in this history of free banking, but I suspect that at the state level there were lots of ties between banks and government during the "free banking" era.)

In the contemporary situation, we want to find a neat dividing line between government and finance. However, this is proving difficult. From the skewed perspective, it comes as no surprise that we are having a hard time creating a financial architecture that clearly separates the roles of government and private institutions.

8. Government Money and Private Quasi-Money

This lecture looks at private monetary instruments and their relationship to government monetary instruments.

In the previous lecture, I suggested that there is a close connection between money and government. Historian Niall Ferguson has drawn this connection in The Cash Nexus and The Ascent of Money.

Note how unusual it is for government to exist without issuing money and for money to exist without a central government. Examples of the latter might include the seashell economies of primitive tribes or the cigarette economies among prisoners. But both are very small, limited, incomplete economic systems.

Prisoners are not producing goods for trade with one another. They are receiving gifts and rations. Also, they operate under strict rules and supervision, even though they have not formed a government. The prison economy is not representative of society at large.

Tribes that use seashells and similar media of exchange seem to me to engage in trade for ceremonial purposes, such as weddings. I don't think of them as organizing their economies around trade and monetary exchange.

For government to exist without printing money is just as unusual. In theory, another country, call it A, could outsource its monetary system by using dollars or euros as money. There are two problems with taking this approach.

First, the money supply depends a great deal on what goes on with international transactions. If foreign investors take a liking to A's investment prospects, they will flood A with money. Conversely, if investors decide to take their funds out of A, the money supply in A will contract sharply. Not being able to control when your money supply is growing or shrinking dramatically is a problem.

(There is a well-known proposition in international macroeconomics that if you are a small country with a fixed exchange rate and no controls on foreign exchange, you have little or no control over your own money supply. If foreign investors like your investment projects, they will bid up your currency, and to offset that you have to print money. Conversely, if investors are fleeing your country, then in order to maintain the value of your currency you will have to take money out of circulation. A small country with a fixed exchange rate is only one step removed from outsourcing its monetary system to a foreign currency.)

Second, a country that outsources its monetary system will be giving away its seignorage. When the demand for money increases, people are effectively paying a "tax" to the authority that prints the money. For example, if the amount of money in circulation rises by $1 million but prices do not change, then that increment of $1 million acts like a tax. The value of the tax is equal to the value of what the government obtains for the additional $1 million, minus the cost of printing the $1 million. If country A produces its own money, then country A collects the tax. On the other hand, if country A uses dollars, then an increase in the demand for money in country A effectively creates a tax on country A's residents that goes to the U.S. government.

So, for all practical purposes, we do not see money without government or government without money. Let us consider another possibility--private money existing along with government money..

There are some interesting examples of financial instruments that act like money, even though they are not created by government. For example, thirty years ago, if you were going to travel overseas for more than a few days, you might have obtained Travelers' Checks, most commonly from American Express. You might withdraw, say, $1000 in cash from your bank and exchange this for $1000 in Travelers' Checks. In your country of destination, every once in a while you would go to a bank and exchange some of these Travelers' Checks for local currency, in order to pay for hotel bills, meals, and other expenses.

The advantage of Travelers' Checks over paper dollars is that they required your signature to be used. If they were lost or stolen you would not have forfeited your funds. Instead, you could obtain new Checks at an American Express office in the country that you were visiting.

Suppose that you spent only $800 on your trip. When you returned, you could come back to your bank and exchange the remaining $200 for cash, to re-deposit into your account. Between the time that you buy the Checks and the time that all of them have been used, the issuer of the Checks has earned interest on your money. In addition, sometimes the issuer would charge a fee of, say, one percent of the face value of the Checks.

It is interesting to think about what had to happen in order for American Express to build this business. Foreign banks had to be willing to accept the Checks. This meant that American Express had to have offices in foreign countries that were known and trusted by the local banks. Those banks also had to trust that American Express was financially sound, so that the local bank would not honor a Check and then find that American Express did not have the funds to back the Check.

Nowadays, credit cards and ATM cards have replaced travelers' checks. With current communication systems and computer databases, it is relatively inexpensive for banks and merchants in one country to verify a bank account or credit card account belonging to a person from a different country. As a form of substitute money, credit cards have expanded and Travelers' Checks have declined.

Another interesting form of substitute money is frequent flyer miles (FFM). FFM are issued by airlines and backed by their services. That is, FFM can be redeemed for tickets on flights, for upgrades to first class, or for other services. Many credit cards offer rebates in the form of FFM. Some hotel chains also offer rebates in the form of FFM. It is my understanding, however, that FFM in general are not readily transferable across individuals--I cannot get your FFM nor can you get mine.

There are a number of ways in which airlines can devalue FFM. An airline can restrict the availability of seats that are eligible for FFM. An airline can increase the number of FFM needed to purchase a seat. Or the airline could go out of business, potentially rendering customers' FFM worthless (although often in an airline merger the new owner will honor FFM issued by the defunct carrier).

I wonder why an airline does not decide to allow individuals to exchange FFM with other individuals. If this would cause FFM to be redeemed more frequently, then the airline could offset that by raising the number of FFM needed to purchase a ticket. Perhaps what the airlines are doing is engaging in price discrimination. The "frequent redeemers" get good deals, subsidized by those of us who rarely redeem our FFM. If we could exchange, then those of us who are rare redeemers would sell our FFM to frequent redeemers, taking away the price discrimination. I guess that's why the airlines don't allow transfers.

I have to admit that the whole phenomenon of FFM makes very little sense to me. Basically, I hate every airline except Southwest, so I regard the prospect of taking an extra trip on another airline as a punishment, not as a reward.

The point that I am making with Travelers' Checks and frequent flyer miles is that private currency is possible. Technically, I think if I printed up blue pieces of paper with my picture on them, called them money, and convinced merchants to accept them, I might be in violation of some law. But in practice, a lot of instruments that come close to that are quite legal. The fact is that the cost of bringing an alternative financial instrument up to the status of pseudo-money is very high, for reasons having to with gaining acceptance, not legal prohibition. The monopoly that a government enjoys in creating currency that is accepted within its own country seems quite secure.

When one country's money is really distrusted by its residents, the solution is never for a private entity within that country to develop a money substitute with more widespread acceptance. Instead, residents will attempt to hold their wealth in foreign currency. They may even prefer to accept foreign currency in ordinary transactions.

Within any one country, the trust that people put in government money usually represents an upper bound on the trust that they put in any financial instruments issued within that country. As far as I know, there are no instances in which you will find people saying, "Country X's currency is almost worthless, but they have a bank whose liabilities are a really safe investment."

Again, I see a close connection between confidence in government and confidence in money. Where people are confident in one, they tend to be confident in the other.

There is also a correlation between military hegemony and monetary hegemony. You tend to find that where a country's armed forces are feared, its currency is accepted. For countries whose armed forces are not feared, acceptance of currency is ultimately at the discretion of the hegemon. Perhaps the currency of Cuba is no worse than that of Argentina, but the fact that the United States is willing to honor the latter but not the former has a broad impact.

Private financial instruments that serve as money tend to come from the United States. This suggests that companies like American Express and the airlines are riding on the U.S. government's credibility. In fact, I think that financial institutions and financial instruments can be viewed as consisting of layers, in which one institution rides on the credibility of another, which rides on the credibility of another, and so on. Resting on the bottom of all of these layers is the credibility of the government. This idea will be developed further in a subsequent lecture.

9. The Financial Sector and the Nonfinancial Sector

The nonfinancial sector wants to hold risk-free short-term assets and issue risky long-term liabilities. To accommodate this, the financial sector does the opposite. If the financial sector suddenly contracts, the nonfinancial sector gets stuck with an asset mix that is riskier and more long-term than it wants and a liability mix that is less risky and shorter term than it wants. The reaction to this unwanted mix can cause a recession. That is how the financial sector affects the real economy.

Think of an economy where investment projects consist of fruit trees. It takes time for them to mature, and they are subject to risk, such as the risk of disease.

Other things equal, consumers would rather have riskless, short-term assets than shares in fruit trees. As a consumer, you might need money in a hurry. Or, you might not be able to deal with the loss of wealth that would come from disease ravaging fruit trees in your investment portfolio. Entrepreneurs, meanwhile, need long-term capital to back their fruit tree investments.

Ultimately, the market has to resolve the conflict between what Keynes saw as the propensity to hoard of consumers and what he called the animal spirits of the entrepreneurs. In the absence of financial intermediation, the growers of fruit trees have to persuade consumers to buy shares of stock in their enterprises. If consumers require a high expected return on these shares, then only a few fruit trees will be able to satisfy them. If they were willing to accept a lower expected return, then many more fruit trees would be profitable to plant.

Let us say that, given that consumers are wary of taking risk, the supply and demand for fruit tree investments are in balance when 100 fruit trees are planted. If fewer were planted, the expected returns would be so high that consumer would be willing to buy more shares in fruit trees. If more were planted, the expected returns would be so low that consumers would not be willing to hold shares in fruit trees.

Next, along comes a financial intermediary, which we will call a bank. Somehow (we'll explain the magic shortly), the bank holds fruit trees as assets and issues short-term, risk-free liabilities (demand deposits, also known as checking accounts). Consumers are much happier with demand deposits than fruit tree shares, so they put up a lot more wealth than they would if they had to invest in fruit trees directly. The bank invests this additional wealth in fruit trees, which causes the required return on fruit trees to go down. This results in more fruit trees being planted.

With a bank, let us say that the entrepreneurs are able to plant 500 fruit trees. Before the bank came along, there were 100 fruit trees, with the shares in the fruit trees making up the liabilities of the entrepreneurs and the assets of the consumers. With the bank, there are 500 fruit trees, with the shares in the fruit trees making up the liabilities of the entrepreneurs and the assets of the bank. Consumers' assets are demand deposits, which are the liabilities of the bank.

If consumers "see through" the bank, they will realize that their ultimate assets consist of shares in 500 fruit trees. They were not willing to hold that many shares before there was a bank, but now indirectly that is what they do hold.

How is the bank able to pull off this sleight-of-hand? On both sides of its balance sheet, the bank is using some combination of diversification, customer selection, and behavior modification.

Diversification means that the bank is counting on risks to be imperfectly correlated. For example, as a consumer, you have a risk that you will need your money to deal with a short-term crisis in your family, such as a medical emergency. The bank knows that, on average, only a fraction of its customers will be confronting emergencies. Perhaps on a typical day, 1 percent of customers need to withdraw their funds. On a really, really bad day, 10 percent of customers need to withdraw. So the bank decides to hold 10 percent of its deposits in a cash reserve, leaving the other 90 percent to invest in shares in fruit trees.

It is as if the consumers have gotten together and formed a mutual insurance company, under which they help each other out. When one consumer needs emergency funds, the others make the money available. Sooner or later, anyone is bound to have an emergency, but the emergencies do not all happen at once.

The bank could select its customers carefully. It might not want to have depositors who live hand-to-mouth and have a lot of money emergencies.

Diversification also works on the investment side. Suppose that fruit tree risk consists of "market risk" (the chance that every tree will be struck by disease) and "idiosyncratic risk" (risk that is specific to each fruit tree). For example, market risk could be 1 percent, meaning that there is a 1 percent chance that a disease will come along that damages every tree. Idiosyncratic risk might mean that each tree has a 20 percent chance of being struck by a disease that will not affect any other trees.

If you could only invest in one tree, then the risk of a damaged tree would be 1 percent plus 20 percent equals 21 percent, adding together market risk plus idiosyncratic risk. On the other hand, if you invest in two trees, then the chances of both trees falling to idiosyncratic risk is (0.2)(0.2) = 4 percent, so your risk of being totally wiped out is 1 percent + 4 percent = 5 percent. As the bank invests in more and more trees, the idiosyncratic risk gets smaller and smaller. Thus, the bank's assets, while not completely risk-free, get to be quite safe. Moreover, the bank can protect depositors against the nondiversifiable market risk by holding capital.

Another strategy for the bank is underwriting, which is customer selection on the asset side. Individuals find it very costly to examine the prospects for each fruit tree, so they have to take a very conservative view of investing in fruit trees. The bank has an experienced, professional staff to examine trees. (Or, if you will, think of a bank that makes mortgage loans, using a professional staff to evaluate the borrower's ability to repay and to appraise the home.; or think of business loans, with the staff evaluating the financial prospects of the business.) The skills and experience of its underwriting staff enable the bank to obtain shares in trees that have higher returns and lower risk than the trees that the average uninformed consumer could find to invest in.

Finally, the bank can use behavior modification. If it foresees a lot of demand for liquidity by its consumers, it can try to work with entrepreneurs to improve the short-term cash flows from the trees. On the consumer side, the bank can increase the penalties for sudden cash withdrawals and increase the rewards for consumers who maintain a high minimum balance in their accounts.

With all of these tools at its disposal--diversification, underwriting, and behavior modification--the bank works pretty well most of the time. When it works well, consumers develop confidence in the bank, and it is able to get by with greater leverage, meaning lower cash reserves and less capital.

Unfortunately, stuff happens. The bank may suffer a solvency shock, because of a really bad disease outbreak. Or, the bank may suffer a liquidity shock, because of an unusually high rate of withdrawals. It is easy imagine a slight solvency shock leading to a liquidity shock, because depositors may believe that the last one to withdraw will find that the bank is out of money.

If stuff happens, then the financial sector (the bank) will contract suddenly and sharply. This means that we no longer want 500 fruit trees, owned by a bank. Instead, the market tries to get down to a lot fewer fruit trees. Tobin's q, which is the price of a fruit tree relative to the cost of planting a fruit tree, goes way down. That tells entrepreneurs to stop planting fruit trees.

Reconfiguring the economy to plant fewer fruit trees and instead to do something else is a long, painful process. While fruit tree planters look for other jobs, they cut back on consumption, creating multiplier effects. The economy goes into recession. Eventually, after enough wage reductions and enough workers have changed occupations, the economy returns to full employment. But that can take a long time.

What can government policy do about this? That is a good topic for a later lecture.

10. Money or Credit?

A long-standing controversy in monetary theory and macroeconomics involves the question, "Is it money, or is it credit?" In most of the macro theory of the past thirty years, the focus is on money. This is nice because you get to write down M and stick it into equations. Thinking about credit does not lend itself to equations. But if equations are the proverbial lamp post, and we've lost our watch somewhere else, then we should dare to look elsewhere than under the lamp post.

Suppose we have a butcher, a baker, and a candlestick maker.

The butcher says to the baker, "I'd like a cake. I'll pay you for it when I get paid for my hamburger, which should be soon."

The baker says to the candlestick maker, "I'd like a candlestick. I'll pay you for it when I get paid for my cake, which should be soon."

The candlestick maker says to the butcher, "I'd like some hamburger. I'll pay you for it when I get paid for my candlestick, which should be soon."

If they are all willing to extend credit to one another, you can see how this economy will work. The baker will bake a cake and sell it to the butcher, etc. Everybody gets what they want, and everybody gets paid.

In general, though, trade does not take place this way. Instead, trade is facilitated by an institution that is trusted by all parties. That institution might be currency. Or it might be banks.

Suppose we have an economy that has come to depend on banks for supplying trade credit. You can see that if the banks are very generous, lots of businesses can operate on the basis of accounts receivable. Maybe some of these businesses even operate unsoundly--perhaps their capital expansion plans are based on overly optimistic assumptions.

Suppose it turns out that the baker bought too many ovens, issued bonds to pay for them, and it turns out that he cannot repay the bonds. His bank no longer wants to advance him funds against receivables, because the bank is afraid that the receivables might not actually materialize or, if they do materialize, the bondholders will claim them. So the baker's bank credit dries up.

You can see that if bank credit dries up for a lot of businesses, economic activity can decline. The butcher can no longer get bread, the baker can no longer get candlesticks, and the candlestick maker can no longer get hamburger.

What are the policy implications? If the banks are still lending but the baker has too many ovens, then it seems as though the best thing to do is just let the baker and his creditors suffer. The economy's capital needs to be re-deployed, and there is nothing to be done about it. People are not as wealthy as they thought they were.

If the baker has not over-extended, but bank credit dries up for no good reason, then government can improve the outcome by stepping in to replace the banks. If the government provides credit, or it induces the banks to expand credit, economic activity can be restored.

In real life, a slowdown in credit can reflect both factors. That is, borrowers may have over-extended, and there are adjustments and wealth losses to be endured. But in addition, banks may have become exceedingly cautious, denying credit in ways that produce a needless contraction in economic activity. The ideal government policy then involves letting failed firms fall by the wayside while promoting credit expansion for viable economic activity. But how does the government know what is viable economic activity and what is the desperate flailing of insolvent firms?

The challenge is difficult enough for a government that is motivated solely by economic considerations. In practice, one can be certain that the political bias will favor bailouts of failed firms. This is the opposite of the correct economic approach, since it keeps capital misallocated.

11. Leijonhufvud and the Corridor

This lecture discusses what I think of as the Leijonhufvud interpretation of macroeconomics as an attempt to characterize an economy that is far from classical equilibrium.

How do we reconcile macroeconomics, which uses ratios, with microeconomics, which does not?

Macroeconomics often deals in ratios. For example, the simple Keynesian multiplier equation is:

Y = A/(1-c)

where Y is total national income, A is "autonomous" demand (including investment) and c is the marginal propensity to consume.

From a microeconomic perspective, making predictions using simple ratios is typically wrong. For example, if you think that the ratio of food production to land is fixed, you will predict that soon we will see people starving. In the 1970's, environmentalists made many incorrect predictions based on this sort of ratio analysis. They saw "limits to growth" based on fixed quantities of natural resources.

Simple ratios do not take into account prices, adaptation, and technological change. If a natural resource becomes scarce, its price will rise, and the economy will adapt. Over time, entrepreneurs are developing new recipes that use resources (including labor) more efficiently.

One of the problems that I have with the quantity theory of money is that it is a ratio-based theory. If the quantity of money were to gradually become scarce, would people not be able to create money substitutes? In practice, that sort of thing does happen, which is why velocity is not a constant. Of course, if you print money fast enough, I do believe that you can reach the point where substitution effects are relatively minor, and you will see strong correlations between the money supply and the price level.

Axel Leijonhufvud (henceforth AL) suggests that when the economy is close to equilibrium ("inside the corridor," he might say), trade and employment can be maintained by small price adjustments and simple adaptations by consumers and producers. However, outside the corridor, the standard adaptive mechanisms do not work sufficiently well to maintain full employment.

In this interview (from 2002), AL says,

When I talked about situations where the system is not recovering rapidly by itself due to effective demand failures, there are basically two of them that we can find in [Keynes'] General Theory. First, a fresh act of saving is not an effective demand for future goods. Second, the wishes of the unemployed for consumer goods do not constitute an effective demand. But there is a third effective demand failure that can be very important. This is when the financial system is in a state where for most entrepreneurs it is not possible to exert an effective demand for today's factors of production by offering future goods. That is, it is not possible to make a deal by saying: 'I have this investment project that will pay off in the future and I want to trade that prospect for the factors of production today necessary to produce those future goods'. And that's where we end up if the financial system is totally clogged up with bad loans. That has been and still is the Japanese situation.

The first type of effective demand failure is a shortage of "animal spirits." No matter how much people want to save, entrepreneurs don't have projects that they want to pursue. The result is that instead of an increase in investment, we see a decline in output.

The second type of effective demand failure is what I think of as the standard multiplier effect. When people lose their jobs, they cut back on consumption.

The third type of effective demand failure is a credit crunch. Entrepreneurs want to engage in projects with reasonable risk-return trade-offs, but banks are busy shoring up their own balance sheets.

I think that in the United States today, we do not have a shortage of "animal spirits." We have a credit crunch. But we have something else, not included in AL's list. We have savers suddenly wanting a lower ratio of risky assets to risk-free assets. This is somewhat akin to Keynes' liquidity preference. It reinforces the credit crunch.

However, the main issue for this lecture is the "corridor" theory. Think of the economy as a kite. Under normal circumstances, it flutters around but stays aloft. However, a sudden, sharp change in the wind might send it into a tree or hurtling into the ground.

I am not sure we know how to distinguish wind shifts that the kite can withstand from wind shifts that will bring it hurtling down. A housing crash, particularly when so many decisions had been made under the assumption that house prices would never fall, might constitute such a major wind shift. But was it really such an enormous wind shift? If you had known that a large correction in home prices was in store, would you have predicted such a large overall macroeconomic impact? Why was the popping of the housing bubble more of a wind shift than the popping of the dotcom bubble?

I am not sure that we know how to pull the kite out of a dive. Pulling out of the dive means continuing to make appropriate adjustments to relative shifts in supply and demand while somehow stopping or offsetting adjustments that are counterproductive, such as multiplier effects. There is a widespread view that printing money and/or increasing the Federal deficit are policies that can do this. However, it is always worth stopping to think about whether that view is correct. What I think of as the Japan problem (and what many of us fear is taking place in the U.S.) is one where policy works to inhibit necessary adjustments.

Another aspect of the "corridor" theory or the kite theory is the role of beliefs. When people believe they are wealthy, in some sense this causes them to be wealthy. As long as none of Bernard Madoff's investors knew that he was running a Ponzi scheme, they were able to treat their funds with him as real wealth. Until the respective bubbles burst, the owners of dotcom stocks and of mortgage-backed securities could treat those assets as real wealth.

One way to look at fiscal stimulus is that its effectiveness depends on beliefs. Think of deficit spending as a Madoff scheme. As long as people view their holdings of our government bonds as real wealth, a larger deficit will be stimulative. If instead people were to see government bonds as deferred taxes, the stimulative effect would be less. If investors were to come to believe that the U.S. is a banana republic, the stimulus effect would be nonexistent, or even negative.

With the "corridor" theory, one can say that when the economy is inside the corridor, you should forget about macroeconomics. Normal adjustment mechanisms, including responses to relative prices, take care of solving economic problems. However, when the economy gets pushed outside the corridor, normal adjustment mechanisms are ineffective or even counterproductive. At that point, one can describe the economy in terms of ratios, such as the Keynesian multiplier. If such multipliers are to be trusted, then fiscal and monetary stimulus can offset some of the otherwise counterproductive adjustments.

12. Herd Behavior, Procrastination, and Business Cycles

This lecture speculates on some possible behavioral economics of booms and recessions. The idea is that herd behavior (buying at the top, selling at the bottom) is a form of procrastination.

As I write this, on January 1st, 2009, the U.S. economy is in recession. There is evidence that consumers have cut back on their purchases of automobiles and other durable goods. They have cut back on their purchases of jewelry and other discretionary purchases. As a result, prices on these goods have been marked down.

One might think that it would be rational for consumers to shift some of their purchases to times like this. That is, it would be rational at the margin to buy more during a recession and to buy less during a boom. Yet we know that the opposite is what happens. It appears that:

--consumers cut back especially on durable goods purchases during a recession, when such goods are cheap

--the typical investor buys more stock near the peak than near the trough

--the typical firm hires more labor near the peak of a cycle, when labor is expensive, than near the trough of the cycle, when labor is cheap

Let us call this phenomenon herding, because people behave as a herd in a way that is contrary to their interests as individuals. A rational economic agent tries to buy low and sell high. The herd does it the other way around.

There are two reasons for economists to be interested in herding. One reason is that it poses a puzzle about behavior, since herding seems inconsistent with rational decision-making. Second, herding accentuates business cycles. If instead people behaved more countercyclically, the cycles would be dampened.

As a specific example, consider the real estate boom and bust. In 2005 and 2006, fewer people should have been trying to buy real estate and more people should have been trying to sell. Today, we seem to have the opposite, with many people foregoing opportunities to buy and many people anxious to sell, even though prices are low.

As of January 1st, 2009, is it a good time to buy real estate? To most people, the answer is, "No. Wait until prices decline further." This reasoning may prove correct, in the sense that prices may very well decline further. However, I predict that the average person who reasons this way will end up buying real estate at prices that are considerably higher than they are today. Instead of buying at the bottom, they will miss the bottom and instead buy at some point well into the next upswing.

People confuse perfect market timing with feasible market timing. When prices are high, they think to themselves, "If I get out now, I may miss out on more profits. I'll keep putting money in." Implicitly, they are assuming that they will be able to time the market better by waiting. They are afraid that if they sell now, they will have failed to time the market perfectly. They do not take account of the fact that perfect market timing is not really feasible.

Similarly, when prices are low, they think to themselves, "If I get in now, prices may fall further. I'll wait until they go lower." Again, they are acting as if they can time the market perfectly.

In a famous lecture, Procrastination and Obedience, George Akerlof argued that a lot of irrational behavior could be explained by procrastination. You don't quit smoking today, because you know you can quit smoking tomorrow. What you fail to account for is the fact that tomorrow you will once again think that postponing quitting smoking by another day is a good idea.

I think that herding behavior takes place for the same reason. People realize that prices are too high, but they put off selling until tomorrow. Or, people realize that prices are too low, but they put off buying until tomorrow.

The problem is that nobody can predict when the herd will turn, and when it does it turns so quickly that the procrastinators lose. For example, a retailer's executives may worry that they have expanded too quickly, but they put off closing marginal stores until too late. Instead, the firm waits, the boom ends, and the firm finds itself selling excess inventory and stores in the midst of a recession, just as everyone else is trying to do the same thing.

At some point, the herd will once again buy U.S. stocks. When that happens, more people will be late than early.

What the foregoing assumes is a model in which asset prices fluctuate wildly relative to a "true mean." It suggests that if you as an investor have a reasonable estimate of the true mean and sufficient patience, you can do well. Invest more in the stock market when prices are below their long-run mean and invest less when prices are above their long-run mean. Ex post, this model always works. That is, if you take some model of average stock prices, estimate it on historical data, and then use that model to determine buy and sell decisions, you can go back and show that you would have done very well. The challenge is coming up with the right model of the true mean ex ante. Your model of the true mean that fits past data really well (think of Shiller's model that looks at the ratio of stock prices to the past ten years of earnings) could end up not being the right model in the future.

From a macroeconomic perspective, the key decisions that may be subject to herding are labor demand by firms and spending on durable goods by consumers. (Investment by firms could also be subject to herding.)

On the margin, it is smarter for a firm to hire during a recession, when good workers are readily available, than to hire during a boom, when the quality of available workers is lower. Similarly, during a boom, it would be smart to be reluctant to hire workers and eager to shed workers, because at the margin worker quality is likely to be low. However, what we get is herding behavior--firms tend to hire too much at the peak, and they all tend to lay workers off at the same time.

Similarly, consumers--even those who are safely employed--do not buy durable goods in a recession, when they are cheap. Instead, they procrastinate, and they make more of their purchases during a boom, when durables are expensive.

To the extent that procrastination and herding are important, there is a theoretical justification for countercyclical government policy. However, there is an even stronger justification for ordinary individuals to behave countercyclically.

Do not assume that just because government might behave countercyclically that it in fact will behave that way. It would not surprise me if it turns out that most of the spending in the soon-to-be-enacted stimulus package ends up taking place after the recession has bottomed out.

13. Multipliers and Model Estimates

Having reached the unlucky number of 13, it is fitting to talk about multipliers and model estimates.

For much of this lecture, we are going to leave the world of economics behind. We are going to start out in the world of what Greg Mankiw calls the macroeconomic engineer.

Below is a table that gives the output of a hypothetical "model run." It forecasts for 12 quarters (think of this as starting in the first quarter of 2009 and ending in the the last quarter of 2011) the value of GDP in a baseline scenario (b) and in a scenario (s) in which government spending (G) is higher by 100 every quarter.


Let me try to explain what is going on. This economy has a full-employment level of GDP of 1200, but in the baseline scenario it is sliding into recession. If nothing is done, it will pull out of the recession at the very end of the 12-quarter simulation period.

The alternative scenario has government spending go up by 100 from its baseline of 200 in every single quarter. That is, the fiscal stimulus is maintained at a constant rate for all twelve quarters. The multiplier is defined here as the difference in GDP divided by the difference in G in each period. For example, in the first period, GDP is higher by 100 (1100 in the alternative scenario minus 1000 in the baseline), and G is also higher by 100, so that the multiplier is 100/100 = 1.0.

In the example, the multiplier builds up over time, and then it declines. It builds up because of, well, the multiplier. As total spending goes up (and government spending does add to total spending), income goes up. And as income goes up, spending goes up. The process feeds on itself. The exact nature of the process is hidden inside my model, which might have hundreds of equations. Honestly, it doesn't have any equations, and I am making the numbers up, but you get the idea.

The multiplier is zero at the end ("the long run"), because in the long run the economy will come back to its full-employment equilibrium, anyway. So, in the long run the increase in government spending does nothing but crowd out an equal amount of private spending.

This brings up a question. Why doesn't the government just increase spending for a few quarters, and then drop it back to the baseline level? It could do that. It makes the meaning of the multiplier less clear. If the alternative scenario has G follow a path of 300, 300, 280, 260, 240, 220, 200, and then 200 the rest of the way, what should we use as our measure of the difference in government spending between the alternative scenario and the baseline case?

How we construct the alternative scenario is a matter of taste. I prefer the permanent increase in government spending, because it can be used to illustrate the way that the multiplier varies over time for the same increase in spending.

Overall, the term "multiplier" should best be treated as shorthand. The more precise terminology would be "response of GDP to a given alternative path of government spending."

I said that in the baseline scenario, the economy returns to full employment on its own in 12 quarters. Most macroeconomic models have the property that the return to full employment comes about, although the length of time may vary. If a model instead has a tendency to deviate from full employment forever, the model is said to be "not well behaved," which is not a good thing. However, if you go back to Lecture 11 on Leijonhuvfud, you will find that his view is that the economy is only well behaved when it is close to full employment. Far from full employment, it can be badly behaved, and if you buy that, you would not want to impose good behavior on your engineering model when it gets far from full employment.

These models, you see, are a combination of empirical estimates and imposed structure. The empirical estimates are derived from past data, often using a statistical technique known as regression. The structure is based on what the human in charge of the model thinks is reasonable based on theory.

Greg Mankiw's essay, alluded to earlier, makes the point that academic macroeconomists approve of neither the empirical method nor the structural constraints used by model practitioners. I don't believe that any major economic journal has published a paper based on a conventional macro-econometric model in the past twenty-five years. You might just as well try to get into the American Economic Review by submitting porn.

There are academic macroeconomists (CEA chairperson designee Christina Romer is one) who have come up with ways to estimate multipliers and still get past the censors at economics journals. This requires really clever technique to conform to the latest methodological standards of propriety. Whether the resulting estimates have any redeeming social value is open to question.

In my opinion, the multiplier (or, more precisely, the response of the economy to a change in the path of government spending) is far from a constant. It should vary over time, for both cyclical and structural reasons.

The cyclical issues concern the state of the economy. I have alluded to the idea that the economy is likely to behave differently when it is close to full employment than when it is far away. That seems relatively noncontroversial. However large the multiplier might be at the bottom of a recession, one would expect it to be lower when the economy is close to full employment. Near full employment, one expects to see more crowding out and more inflation as a result of fiscal stimulus.

In addition, there is the behavior of monetary policy. Fiscal stimulus that runs into a headwind of rising interest rates would be expected to be less expansionary than fiscal stimulus that is accompanied by monetary policy that maintains steady interest rates.

Also, there is the Minsky effect. Hyman Minsky argued that if corporate balance sheets are weak, investment depends on profits. In that case, government deficits generate profits that will strengthen those balance sheets, which will remove a major constraint business investment. Thus, the multiplier will be larger at a time when balance sheet constraints are operative than at a time when firms are not constrained to begin with.

The structural issue concerns fundamental characteristics of the economy. For example, in a small economy, an increase in government spending can "leak out" into spending on foreign goods. In an economy where government debt is less trusted than that of the United States, an increase in government spending could cause adverse financial effects. There are those of us who are not convinced that the United States itself is immune from adverse financial effects.

Another structural issue that I have discussed in previous lectures is the nature of the unemployment that exists. The standard recession of the post-war United States found the economy with excess inventories of durable goods, and most of the unemployed were production workers temporarily laid off from manufacturing facilities. More recently, it seems to me that a lot of our imbalances are structural. In financial services, most of the people who are leaving jobs related to mortgage origination and securitization are not coming back. In autos, some of the decline in production is cyclical, but worldwide there is too much capacity in the industry, so that many unemployed auto workers are also not coming back.

I doubt that I would want to apply the same multiplier analysis to structural unemployment that I would to cyclical unemployment. To my knowledge, neither the old-fashioned macro engineers nor the modern academics have addressed this issue.

Finally, I should point out that the basic logic of the multiplier is at the same time both simple and devoid of economics. The idea is that more spending leads to more income, and more income leads to more spending.

To understand why this is devoid of economics, ask yourself when the process stops. When do people stop earning more income and spending more income? One way to answer is to say that people aim for a balance among labor, leisure, consumption, and saving. In classical economics, people find that balance by responding to market signals. Our belief in the multiplier is a belief that (a) the market is unable to provide that balance and (b) that an increase in government spending can help them to find that balance. For some economists, that faith is so strong that they take seriously an exercise like the "model run" that I made up in the table above.

My own view is that, as of early 2009, there may be enough cyclical unemployment developing to warrant a modest attempt at fiscal stimulus. Also, I suspect that the Minsky effect may be operative, which may make fiscal stimulus particularly effective at reducing cyclical unemployment and perhaps even speeding up structural adjustment, as firms use profits to finance expansion. However, in general, I think that structural adjustment will take a long time, and creating a big fiscal imbalance will cause more problems than it will solve.

14. A Recession as an Information Problem

This lecture looks at a recession as an information problem. It is a synthesis of a number of the ideas mentioned in previous lectures.

The market solves a complex information problem. The economist who emphasizes this the most is Hayek. He (and Mises) made the point that no central planner can acquire the information needed to adjust resources to meet economic needs.

The information problem includes making sure that your grocery store has enough milk but not too much. However, it also includes allocating long-term investment between, say, pharmaceutical research and new microbreweries.

As a follower of Hayek, I believe that government will do a poor job at solving this information problem. However, that does not mean that I think that markets will do a perfect job of solving this information problem. A tiresome rhetorical tactic of anti-free-market economists is to say that when markets fail to solve information problems this discredits markets.

Instead, recall what I wrote.

Masonomics says, "Markets fail. Use markets."

My view is that markets fail all the time at solving information problems. By the same token, market innovation seeks to arrive at better solutions. Thirty years ago, large inventory buildups could occur at retail stores without other participants in the supply chain being aware of the problem. It took months to unwind these unwanted inventory buildups. Today, thanks to market innovation, such information problems are less severe.

I also reject what I call the naive Austrian view, which is that the only information problem that markets cannot solve is that of seeing through the distortions caused by government money. Yes, the monetary authorities can mess things up. But there are also many naturally-occurring information problems that markets have difficulty solving. I do not believe that markets would work perfectly if only there were no government.

On the other hand, I do not believe that government intervention is called for whenever the market trips over an information problem. Government does not have an automatic advantage in solving information problems. On the contrary, the Hayekian view suggests that government is at a disadvantage in solving information problems.

I view a recession as a special case of an information problem. A recession arises because individuals, investors, and entrepreneurs realize that they have committed resources to unprofitable projects. Currently in the United States, too many resources were committed to housing and mortgage securitization. Perhaps this information error was caused in part by monetary policy. Perhaps it was caused in part by other government distortions. Perhaps it was mostly a naturally-occurring information failure caused by speculative fever and poor judgment. It does not matter to me whether the cause was government or the market. There was an information failure, and now the economy needs to make a sudden, sharp adjustment. We have unnecessary resources in the construction and finance sectors.

The problem is to figure out where the resources should go. Which other sectors have the greatest marginal use for these resources? This problem eventually will be solved by the market. However, in the short run, the problem is so severe that the market is overwhelmed. Many of the adjustments that are taking place, rather than absorbing unemployed resources, are generating reductions in economic activity in other sectors. This is the problem that Leijonhufvud describes. The market may solve information problems quite well near full employment, but it staggers and stutters when there is a crisis.

Government can promote the use of unemployed resources in a recession. The government can borrow money from savers and give it to spenders, whose purchases will lead firms to absorb unemployed resources. The spenders could be individual consumers, or they could be government technocrats managing programs.

However, it is misleading to suppose that a government transfer from savers to spenders necessarily puts the economy on a better path. Instead, such a transfer may keep resources from getting to where they need to go in the long run.

If the spenders make decisions that are compatible with the long-run path for the economy, then this fiscal stimulus will be helpful. However, if the spenders cause resources to be committed to projects that ultimately are unsustainable, then any relief is only temporary.

Politically, the temptation is to try to fight the signals that the market is sending. If the housing market is headed down, the political impetus is to prop it up. If there is too much capacity in automobile manufacturing or financial services, the political impetus is to try to prop up those industries. To the extent that spending is focused on these political goals, it will be counterproductive. Rather than helping the market find its way to sustainable full employment, the prop-up strategy instead serves to impede the necessary adjustment.

Another way that government can cause harm is by creating uncertainty. In recent months, policymakers have contributed to uncertainty in many ways. Alarmist rhetoric that leaders used to motivate Congress to pass major legislation. Sudden, unpredictable changes in tactics for handling financial institutions. Frequent revisions of the rules for mortgage borrowers and lenders. Many questions about the future financial condition of the U.S. government, given the new path of deficits.

It is true that markets have been overwhelmed by today's information problems, and consequently resources are unemployed. However, the ultimate solution of where resources belong is not known by government officials any more than it is known by private investors. A large "fiscal stimulus" is, ultimately, a major transfer of power away from the trial-and-error process of entrepreneurial markets and instead toward the bureaucratic planning process. It is not clear to me that technocrats have suddenly acquired the wisdom that would justify such a transfer. In fact, while they may have an air of certitude, they may know even less than usual about the best future direction for economic resources. It could be that, relative to central planning, private trial-and-error is as advantageous in a recession as in a boom.