Recalculation--Two Versions

Arnold Kling has claimed that the current recession is due to a need to "recalculate." There are really two versions of the argument. As Frank Knight said of Keynes, I will argue that what is correct isn't new. And that what is new isn't correct.

Looking back at the housing boom in the past decade, there is good reason to believe that there has been substantial malinvestment. Too many homes have been built. Various capital goods have been produced that are specific to the production of housing. There is a similar problem with human capital--too many skilled carpenters.

With hindsight, fewer houses should have been produced. Fewer capital goods specific to housing construction should have been produced. Less carpenter skills should have been developed. Instead, other goods and services should have been produced, including both physical and human capital specific to other industries.

While those are all sunk costs at this point, it remains necessary to expand the production of other, more valuable goods. This involves shifting labor and other resources away from housing construction to the production of other goods and services.

During this process, the unemployment rate for labor will be relatively high. There is a longstanding term for this type of unemployment--structural unemployment. If the unemployment rate is relatively high, the employment rate is relatively low. The productive capacity of the economy is depressed.

Added to this problem is the fact that human and physical capital specific to housing construction are lost. New capital goods must be constructed and new skills developed. Labor productivity should be depressed even after labor is absorbed. The productive capacity of the economy will only gradually recover.

Personally, I think the term "recalculation" is inappropriate to describe this adjustment process. Perhaps "redeployment" is the better term. A shift from goods that were being overproduced to the goods that are currently being underproduced is a redeployment of resources.

That such a redeployment is likely occurring is important to keep in mind. For many years, monetary and fiscal policy was aimed at stabilizing unemployment or real output. If structural unemployment is currently high and productive capacity low, seeking to use expansionary monetary and fiscal policies to return unemployment to where it was before this redeployment began would be a mistake. Similarly, seeking to return employment and output to their pre-redeployment growth paths would be a mistake.

However, when Kling began using the term "recalculation," he sometimes described a quite different scenario which is not a redeployment of resources from what was overproduced to what is underproduced. Rather, he suggests that we must pause, and leave resources unemployed while we determine what to do with them. Of course, there is no "we" making conscious decisions, but Kling argued that "the market" must similarly pause to decide what to do, and so there is a "recalculation."

I believe that this conception of recalculation is inconsistent with the most important principle of economics--scarcity. There are not enough resources--land, labor, and capital--to produce all the goods and services that people can use to achieve their goals. It is certainly possible for a particular good to be produced in such large quantities that isn't scarce. Or even that it be produced to the point that some of it becomes garbage and someone must be paid to dispose of the excess.

It is conceivable that all tangible goods and services could be produced in quantities where none of them are scarce, but that isn't the situation that faces the world today. Billions of people in the world could use more of any number of existing goods.

Under conditions of scarcity, overproduction of any one good means that some of the good is worth less than its opportunity cost, which is the other goods or services that the resources could have been used to produce instead. To say that homes were overproduced is not to say that they are not scarce much less that some are garbage. It is rather to say that the other goods and services that could have been produced are more valuable. And to say that fewer homes should be produced today is not to say that no one could use the additional houses, much less that they will need to be demolished. It is to say that the resources that would be needed to continue to produce new homes at the rates typical during the boom have more valuable alternative uses. The other goods or services they could be used to produced are more valuable than those additional houses. And so, there is a need to redeploy resources.

Suppose, on the other hand, that the economy doesn't face scarcity. I don't want to tease out all the implications of this assumption--zero prices and wages--for example. No, assume that people decide that they don't want to purchase new homes, and there is nothing else that they want to buy. And so, until it is possible to figure out some new good that they want to buy instead of houses, there is nothing for people to do. They must wait around.

In a world of scarcity, this really isn't an issue. There are many things that people want to buy instead of houses. They bought the houses because they valued them more than the other things they could have instead used their income to buy. If they decide houses are not so desirable to buy, they buy other things instead.

Of course, the analysis above ignores leisure. It is possible that scarcity exists because leisure is valuable. People work in order to earn income to purchase new homes. They decide they no longer want to do that, and so they work less and earn less and purchase fewer new homes. Fewer homes are produced, so total output is lower. Fewer people work because they prefer more leisure, and so, there is less employment.

When someone comes up with a new good people want to buy, then people will go to work to earn the income to buy it. And firms will hire workers to produce it. Then why is output and employment low now? Because no one has determined what good they want instead of new homes. We know we don't want a bunch of new homes. But we must decide what we do want. We must "recalculate." Meanwhile, we enjoy leisure.

Unfortunately, this appears to be a very poor explanation of involuntary unemployment. It is rather an explanation of long vacations taken by people now have everything they need. It doesn't fit in well with people cutting back their purchases because they have lost their jobs. I personally know people who are new entrants into the labor force. They are currently unemployed and would like to work. The reason they would like to work is to purchase any number of existing goods and services.

Of course, if Robinson Crusoe finished up his house, and didn't want a second home, and had nothing else he wanted, then he would simply take it easy. He would take a vacation and have all the goods and services he could use.

But perhaps the problem is one of distribution. Some people, call them "the rich," have all the goods and services they can use. They don't want new homes. And so they buy less. And they work less. Meanwhile, other people, call them "the poor," have many goods and services they they want to buy. And so they work, earn income, and buy them.

Total output and employment fall because the rich don't want new homes and there is nothing else they want. So they work less and earn less income. Meanwhile, the people who face scarcity continue to work, earn income, and purchase goods and services. Once "the rich" discover some new good they want to buy, they will go back to work, and earn income to buy it. And firms will hire "the rich," so that they can produce this new good desired by "the rich," as well as continuing to produce the goods the poor continue to buy.

Unfortunately, this still appears inconsistent with people who face scarcity being unable to find work and earn income to buy the things they want. Of course, those "poor" people who produced houses no longer have customers. But those rich people who were producing goods for the poor no longer want to work. So the firms producing those goods have less labor. There is a need to redeploy resources. "The poor," who used to provide labor to produce new homes for "the rich," must shift to producing goods for "the poor." "The rich" reduce how much they work and how much income they earn, because they don't have anything they want to buy.

But, of course, I am imagining that people who have nothing they want to buy have no interest in earning income, and so they work less. Suppose that instead they save. They continue to work and earn income, saving that money so that they will be able to purchase these new goods and services that they might want to buy if and when they appear.

Note that this version of recalculation is very similar to naive Keynesian economics. Add the notion that the reason people save more is because they can't think of anything to buy, then we have an increase in saving, less spending on consumer goods and services, and so less derived demand for labor. The supply of labor isn't reduced. And so, a surplus of labor.

The approach is also very similar to Marxism. There are unemployed people who need goods and services. But they have no income. The income is being earned by "the rich" who have nothing they want to buy. They simply save the money. While coming up with some kind of new luxury good for the rich to consume might help, an alternative is to redistribute income to those who need it. They will spend the money they receive, increase the demand for goods, and create more employment.

But increased saving should allow for additional investment--spending on new capital goods. These capital goods will allow for the production of additional consumer goods in the future. However, in the recalculation story, no one knows what consumer goods will be demanded in the future, and so what capital goods should be purchased. In fact, "the rich" were purchasing new homes as a speculative investment. Once they no longer want to buy homes for that purpose, and there is nothing else for them to buy, they will continue to save, without there being any investment.

If people want to save more than they want to invest, interest rates should fall. And, in fact, during the current crisis "the" interest rate has fallen nearly to zero. But apparently, this lower interest rate has not motivated "the rich" to consume more. They have nothing more to buy. And the lower interest rate hasn't motivated them to purchase capital goods. Because they don't know what capital goods are appropriate.

But how can people save without there being matching investment? They must accumulate money balances. And so, "the rich" want to earn income, and save it, in order to be able to purchase new consumer goods in the future that might be developed. They don't want to invest in capital goods until they know what consumer goods that people like them will want to buy and so what particular capital goods are appropriate.

And so, they work and earn income, and save by accumulating money. They aren't accumulating money because there is a certain amount of real balances they want, and once they have accumulated those, they can go back to purchasing one of the many goods and services they have been sacrificing in order to build up those money balances. They aren't sacrificing goods and services to add to money balances. They are accumulating them in case some new good arrives that they will want to buy.

I don't want to claim that no one could possibly behave in this fashion. I called them "the rich," for a reason. To me, it is only the very rich that might be in this situation where they have everything they want to buy but rather than enjoy leisure continue to earn in order to be able to buy something that they might want in the future. Because incomes are so skewed, even if there are a small number of people like this, this behavior could conceivably have a significant effect on the economy.

As explained above, the argument is Keynesian in that it suggests there is too much saving. It is Marxist in that their appears to be a problem of distribution. (I am dismissing the possibility that anyone would be so blind to the reality that the vast majority of people have an entire list of goods and services that they would buy if they had additional income.)

I think it is obvious that having people who face scarcity--want to work to earn income to purchase goods and services--remain unemployed because other people want to work to accumulate money because they might want to buy something in the future is unacceptable. Making those facing scarcity, "the poor," pause until someone comes up with something "the rich" want to buy is a coordination failure.

It seems to me that the solution is that "the rich" need to work less. There is no point to saving if it isn't funding investment. If people don't want to invest, then they shouldn't save. If people are only working in order to save, then if they save less, they have no reason to work. And, so, if the market system is going to provide proper coordination, there must be a signal for these sorts of people to work less in this situation.

In my view, the market signal is obvious. The real interest rate from holding money must turn sufficiently negative to clear markets. Those who want to work now and save because they might want to buy something in the future, and they don't want to invest in capital goods because no one knows what particular capital goods are appropriate, need to pay in order to save. And if they don't want to pay, then they should work less.

In conclusion, redeployment of resources, including labor, is something that happens all the time. The notion that it always happens at a constant rate is implausible. It seems likely that the aftermath of the housing bubble requires more redeployment of resources than usual. This might raise unemployment and depress output for some time. However, redeployment means redeployment to somewhere else. There are plenty of scarce goods and services to produce, and so, there should be sectors of the economy with rising prices and profits, and rising production and employment.

The notion that it is somehow necessary to "pause" and have some industries shrink, nothing expand, and just wait until someone figures out something to do, is inconsistent with scarcity. With certain Marxist assumptions (the rich don't face scarcity) and Keynesian assumptions (people want to save but no one wants to invest because of uncertainty,) it is possible to explain such a "pause." But in the end, it always comes down to monetary disequilibrium.