Is current unemployment all about aggregate demand?

Christie Romer basically says yes, Arnold Kling dissents.

I don't expect Romer to turn a speech into an academic debate and in this sense I don't fault her.  Nonetheless I did not find her account very persuasive.

I would start with the fact that output has bounced back more robustly than employment has.  AD theories per se do not explain that differential.  One simple possibility is that better management and better measurement have allowed us to identify (and fire) hundreds of thousands of low-wage people who just weren't producing much of value.  That's a real shock, even if it does not qualify as a sectoral shift in the traditional sense.

It's also the case that the rate of new job creation has been especially low.  Yet the nominal wages on those jobs-to-be are not constrained by previous contracts or agreements.  Tell stories as you may, but it's hard for me to see that as exclusively an AD problem.

I wonder what is the behavioral postulate for how long all these unemployed workers are all staring jobs in the face yet persistently stubborn about their appropriate nominal wage.  I'm all for behavioral economics, but I don't buy the necessary story here.

I don't want to oversell the minimum wage hike + unemployment compensation extension + means-testing hypothesis here, but surely it deserves a mention as one relevant factor.  Those are real factors too.

I also see that wages, and the job market, are more flexible today than in a long time, with so much service sector employment, so much flex-time and part-time, and such a low rate of unionization.  In most AD theories that implies the job market bounces back relatively quickly yet that is not what we observe.

A separate question is what Romer believes the major AD shock to have been.  She clearly repudiates the Scott Sumner story that monetary policy was too tight.  Is it all from the collapsed bubble in the housing market?  Keep in mind those are paper values and that the real services from the country's housing stock haven't declined.  Again, you can tell behavioral stories about the asymmetric perception of losses vs. future gains (for many people, buying a future home is now much cheaper, though perhaps they don't notice the positive wealth effect), but is that going to drive the whole cycle?

To be sure, AD is a major factor in this recession but it is not the entire story by any means.  In major recessions usually it is AD and AS forces together.

Most of all, the Romer essay convinces me that current economic policymakers — not to mention many bloggers — should not be so certain they understand what is going on.

Addendum: I sometimes have the feeling that commentators on the left reject the "real shocks" hypothesis because they think it implies government can't do much to make things better.  That doesn't follow.  Most of what government does, for better or worse, is an attempt to solve a real rather than a nominal problem.  It might imply "intervention is less effective" but it also (possibly) can imply "intervention is more necessary."


One shock to the economy was the auto industry. Jobs that are lost forever in areas were few new jobs exist.

A second shock is construction. Excess supply of housing and few people wanting to invest in housing improvements, that now often have a negative expected return on investment, dampens demand for workers.

Third shock is the view that in the near future we will see a dramatic increase in taxes. Plus inflation expectations seem up in the air.

Fourth shock is tourism and travel are down. Energy costs and job uncertainty slow travel.

Fifth the mis-managment of the California economy has a drain on the national economy.

Sixth state and local budgets are a mess.

Seventh the Federal government is controlled by politicians hostile to business.

Eighth is the increased cost of hiring new workers through changes in the health care system, minimum wage, etc

Ninth is the impact of energy policies that mean that high energy costs are coming in the near future - which historically means a dip in the economy.

Tenth the impact of the almost certain VAT tax to pay for a growing government.

Taken together this makes the recent market gains look like they are based on a pollyannaish world view

A separate question is what Romer believes the major AD shock to have been...Is it all from the collapsed bubble in the housing market?

I don't know about all, but surely the loss of the HELOC ATM would surely be the major factor behind any huge drop in AD, no? These HELOC's were based on fantasy, not real value. The "real services from the country's housing stock haven't declined", but those "real services" did not support the amount of demand credit that existed under the bubble. Take away those massive credit lines, and you've got one big loss in aggregate demand.

The bad news is that this AD shock is not amenable to either fiscal or monetary correction - we can't pretend it didn't happen and just "return to normal" - there was no "normal" - now is the normal - the loss in AD is a fact, and we must learn to live with it.

What about all the recent models of demand shocks? E.g. financial accelerator models (Bernanke and Gertler; Kiyotaki and Moore; Gertler and Kiyotaki; Curdia and Woodford). Or Guorio's model of time varying disaster risk (right now we're worried about a new depression, which drives down the real rate)?

Can't there just be a precautionary saving effect? There is genuinely a lot of uncertainty out there -- political risk, volcano risk, etc. That drives consumption demand down. In the presence of startup costs for investment, it will also drive investment demand down.

I'm not sure why your only proposal for an AD shock is housing...

The long debate over health care reform probably dampened hiring to a degree. Whether you agree with the reform or not, the debate create considerable uncertainty for employers.

Tyler wrote: "It might imply "intervention is less effective" but it also (possibly) can imply "intervention is more necessary.""

This is possibly correct if what Tyler means by "intervention" is government massively de-regulating. I'm not sure if this is what Tyler means, but if it is I say: Bravo! For it is massive governmental interference with a spectrum of markets that has relative prices so out of whack that resources can't help but be misallocated and mal-invested.

All this talk of AD, and AS, is by definition so AGGREGATED that looks completely past the "structural" problems that are the direct consequence with governmental distortions of relative prices.

My vote for Zeil's comments. Amplify it a bit more by examining the growth of household debt (excluding government) from 60% of GDP in 2000 to 102% of GDP in 2008. Some mighty deleveraging has to take place, reducing aggregate demand.

Sorry to break the news.

I am with zell here also. Note that Texas which had stricter rules on home equity loans has been less affected by the mortgage crisis than most other states.

danC --

the first link didn't work. the second link is still just a series of correlations, though Carroll at least makes some attempt to use instruments. I'm not clicking any more links on the housing MPC.

Posts like this, along with the occasional post on time management practices, are why I read MR.

Real GDP as of 2009q4 is below what it was in 2007q2 and only started recovering in the third quarter of last year. There appears to be a gap of about $800 billion between actual and potential GDP. Concentrating on flow rather than stock measures obscures this fact.

I see the academic question here: why don't workers just suck it up and accept lower wages in exchange for immediate employment? But the policy issue is that GDP is still far below where it needs to be and that we need sustained, rapid growth of real GDP. This rapid growth in turn will almost certainly create jobs and help the labor market return to normal.

To the extent there are structural hurdles to job growth, these same hurdles seem to have been there during the last recession. There is a long term declining trend in the labor force participation rate among men. Is there any good explanation for these patterns of jobless growth and increasing numbers of discouraged male workers?

I think Romer is continuing in the tradition of Keynes in her emphasis. The question is not why things are so bad but simply what can be done to make them better. And her answer is fiscal policy to stimulate aggregate demand, create jobs and move both the labor market and GDP to where they should be.

DanC -- if the prices of all houses rise, then there is no increase in anybody's real wealth. You have to live in a house. It's true that your house is more valuable, but that effect is exactly offset by the future increase in the amount you have to pay for shelter. The PIH has nothing to do with this. The housing bubble did not increase anybody's wealth by one cent.

@Ian Dew-Becker - In theory it's true that no real value was created during the housing bubble, but lots of individuals got rich from arbitrage during the run-up. Many developers and speculators who flipped many properties made a mint between 2000-2008. Some of those got left holding the bag, but some made a lot more than they ended up losing.

It's likely that retail expanded well beyond what the economy demanded during the housing bubble. Since it also employed many of the lowest skilled workers, it's failure to bounce back left them with few real opportunities.

I agree with Slocum. One additional point--in my experience, not all deadwood, not even most deadwood is in the low-wage segments of the workforce. I watched our historically penurious company increase the number of executive level home office staff positions by a factor of 10. At the same time, there was a hiring freeze on production and technical personnel. When the total carrying cost of one of these high-wage positions equals the total carrying cost of 8 or more production positions, a business can be driven into the ground very quickly. Worse, the cost to onboard or eliminate one of these people is extremely high. My guess is that it is these people who can't bear the idea that their services don't have much value in the current marketplace. Although unemployment replaces only a fraction of their former earning power, they don't seriously consider a mundane job with mundane pay. I was a peer to these folks, and my honest opinion is that many of them may never have been anything but deadwood in any of their previous positions. In a few cases, it was apparent that their particular areas of expertise were no longer in demand, but in most cases, it was hard to find any areas of expertise;.

To the extent that I can make sense of what you have written, I find it astonishing that you would consider this an actual refutation of the carefully arguments of Romer. For example, she speaks explicitly to this point but you don't cite it and respond to her arguments carefully:

"I also see that wages, and the job market, are more flexible today than in a long time, with so much service sector employment, so much flex-time and part-time, and such a low rate of unionization. In most AD theories that implies the job market bounces back relatively quickly yet that is not what we observe."

One often hears "workers are paid according to their productivity" and "the least productive workers are laid off first". These are mutually incompatible statements as commonly used. Either workers are paid according to their productivity, meaning no productivity basis exists for determining which are laid off, or they are paid on bases other than their productivity and laid off on that basis. Productivity is just output over input. If workers are paid for their productivity, the input, their wages, has been adjusted to equalize productivity among workers, so how can some be less productive than others? Individual productivity may be difficult or even impossible to measure, but that would just mean it is irrelevant to pay and both statements are false. It may be difficult to anticipate when hiring, but new hires that don't work out are often terminated, and if not, wages can be adjusted by raises or their absence over time. There is only one sense in which these statements can be understood together.

In a downturn, what changes is the relative desirability or values of outputs, not inputs. The price usually doesn't even change much, but the quantity demanded. It is the work that becomes less productive, not the worker. Prices are sticky and wages are even more sticky. The worker that is laid off is no less productive than the co-worker that stays behind, rather, the workers that suffer layoffs are less productive in the sense of being less desired than workers that don't suffer layoffs. Productivity is an industry, company, and product concept, only wages are an individual one. It is not productivity the manager uses in selecting which workers to lay off, rather, it is desirability the market uses in selecting which industries to reduce. Managers could reduce prices and wages to maintain quantity and employment, but some costs are fixed, some work has to be done, and some are other inputs over which they have no control, so it is easiest to treat both prices and wages as fixed and allow quantity and employment to fall. This avoids them having to cut their own. So what criteria do managers use in layoffs when all their workers have become less productive in the sense of desired? They may choose to layoff those with the highest wages to minimize number of layoffs and keep those more able to improve or less likely to demand their productivity or cause trouble, or they may select on connections or influence, pliability or sociability, seniority, or even age, race, and sex, but it is not productivity, per se, in the common sense of the meaning. Layoffs are fundamentally about discrimination. This is probably why most managers dislike doing it, or at least the good ones.

"By the way, figuring out that the same amount of output can be produced with less labor is a positive capacity shock. Long run aggregate supply should grow more quickly."

The issue is the nature of what is creating the productivity increase. If a productivity increase is industry specific, then it frees up labor for the same role in other industries. If a productivity increase is due to something that effects a role across all industries then the people displaced have no where to go. There is no guarantee that those displaced will ever be able to fill other roles.

If there's a skills mismatch between the old and the new jobs, unemployment is not much of a long term issue; if it's an abilities mismatch, high unemployment is here to stay.

To Woolsey

I doubt you agree but I saw an oil price shock (that damaged the transportation and travel sectors, not to mention the last push for the auto industry) combined with a Fed that then rose interests rates at the same time a record number of adjustable rate mortgages were being reset.

(California was just a nuthouse with government employees.)

Cracks started to show in the secondary mortgage market. (Some places like Miami, Arizona, and Vegas were insane housing markets that had some national implications because of number of second home buyers speculating.) This was followed by an old fashioned run on the shadow banks. All the time the government was taking a leftward tilt with increased political uncertainty.

Unless you consider ObamaCare a Trojan Horse designed to create a structure that will quickly morph. To quote Gary Becker, it strengthened the weaknesses and weaken the strengths of the current system

Who pay the VAT tax will depend on the elasticity of demand. Some firms may pass on all the cost to customers, most will split the cost in the form of higher costs, lower salaries and lower profits.

Assuming that recent market gains reflect strong growth going forward is, I think, Pollyannaish. Perhaps the markets are pricing in political change in November that will blunt the worst of the leftist plans. I am less certain of Republican gains.

Health care costs are a significant cost for many firms. Once again the structure has been put in place, now the real haggling starts.

Your lack of understanding of labor economics would take to long to correct

I see the academic question here: why don't workers just suck it up and accept lower wages in exchange for immediate employment?

Why don't economists who argue wages should fall in times like these take the first step and tell their employer their wage should be cut, then having established their credibility, go on to convince all other workers to plead for lower wages?

From what I can tell, the economists who extol the virtues of lower wages do so on the principle that everyone else should have lower wages, but they should be given higher wages for increasing profits.

Of course, I'm not sure how reduced wages forcing cutbacks in spending are going to increase aggregate demand to enable increased employment....

Re: Unless you consider ObamaCare a Trojan Horse designed to create a structure that will quickly morph.

Unlikely, and see Switzerland, which has had a similar system for many years, as proof that a system of subsidized mandatory insurance can be stable. The Netherlands too has recently move to such a system.


ObamaCare is a work in process passed only after cooking the books on the true costs of the program. Assuming that it will not morph into a beast is to be oblivious to our political system.

Read an introductory textbook on economics - look at the section on who pays when a tax is imposed.

We are in the longest, deepest economic downturn since the Great Depression. Why? Are the anti-growth policies of the current Federal government blameless?

Milton Friedman often argued that markets can be wrong at any moment in time. swinging to high or too low before correcting.

Still, the health care sector seems to assume that ObamaCare will do nothing to bend the cost curve. It will distort, transfer costs, introduce senseless rules, and make the entire system about political battles.

US unemployment is about the fact that US workers are, in a global economy with free trade, overpaid.

Most production jobs for export, and many phone based service jobs, are being re-distributed to workers who can produce 80%-110% of the same output per week, but at 20-50% of the cost.

Comments for this post are closed