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Kling vs. DeLong

June 12, 2011

If you are new to Arnold Kling’s recalculation story (PSST), check it out here. Brad DeLong responded with some criticism, basically claiming that it’s demand problems, not supply that is the main story in 2008, along with some historical inaccuracies.

PSST is a “micro” or supply side explanation. It tries to describe why production is more difficult now than it was in 2007. One small problem. If production becomes more difficult, prices go up. Firms try to pass on the higher costs to their consumers and as they move along the demand curve, output falls. In 2008, prices actually fell and the TIPS spread has been very low since the crisis of October 2008, signaling that the market does not expect inflation any time soon. So while a supply shock doesn’t fit the data, a demand shock does. Since demand shocks hit housing and investment much harder than personal consumption, you can get a sectoral shift without any change in the costs of production. Now, once a demand shock is well underway, the unemployed workers do have trouble finding work and reestablishing patterns of specialization and trade. The second major piece of evidence in DeLong’s favor is that unemployment is higher among the unskilled. It might be hard to find a productive pattern of specialization for highly specialized, highly skilled workers, but not for the unskilled. To me, it looks like their wages just need to fall, and the recent increase in the minimum wage along with the demand shock is keeping the wage from adjusting. The third argument against Kling is that barter has increased recently. If patterns of trade became more difficult, people would try to use money as bartering is harder than monetary exchange. There needs to be a double coincidence of wants and the transaction costs are higher. Increasing barter only makes sense in a contractionary monetary policy environment.

I find it odd that free market economists have theories that imply that the market really sucks at finding productive uses for unemployed resources, even given a stable and predictable monetary policy and that more statist economists are saying that the market would work fine if the monetary policy central planning bureau would get its act together. Look guys, centrally planning prices screws things up. The case for the free market would be a lot easier if we got monetary policy right and the business cycle were reduced to only supply shocks.

Update: Bill Woolsey comments.

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