Structural Misalignment and a Counterfactual Economy

Paul Krugman weighs in on the structural unemployment debate here , here, here, and most recently and comprehensively here. Here are two excerpts from two recent blog posts:

Claims that there has been a huge jump in structural unemployment — that is, unemployment that can’t be cured by increasing aggregate demand — are playing a large role in the argument that we should basically do nothing in the face of a terrible economy. No need for the Fed to do more; no need for more fiscal stimulus — hey, it’s all about defective labor markets, and we should work on structural reform, one of these days. And don’t expect improvement for years to come. Structural unemployment is invoked by Fed presidents who want to raise rates, not cut them, by economists who want austerity now now now, and in general by almost everyone in the pain caucus.

Legend aside, this is not mainly about displaced construction workers — and there are no other dying industries to point to. Lousy labor markets span the country, except in a handful of states with almost no people. It’s a terrible job situation for college graduates as well as high-school graduates.The idea that this economy is primarily suffering from mismatch is simply bizarre.

First let me say that I agree with Krugman in the essentials, but I find myself wondering if we can be confident that there really is not a larger structural problem embedded within the obvious acute problems of high unemployment and depressed aggregate demand? For example, suppose that there have been massive and pervasive distortions of human capital and labor and other markets resulting from massive distortions in or induced by financial markets. Suppose those distortions lasted at least 10 years and maybe a long as 30 years. Then many sectors of the economy and the workers in them have been shaped by the distortions in ways that may be difficult to discern.

The fact that the financial sector's share of GDP has grown so dramatically over the last 30 years suggests that other sectors have lost out in terms of the growth and productivity they might otherwise have delivered to the benefit of us all. A massive drain such as this must have affected both physical and human capital in those sectors as well as affecting the larger economy we would otherwise expect to see. Unfortunately, we have no way of knowing what is the conterfactual economy we would have observed without the bubble(s). (Note that if George Soros is correct and the last 30 years have been superbubble, then I think the effect I'm trying to describe is even more entrenched and difficult to detect.)

If my conjecture is right, might an economy, shaped by persistent and pervasive distortions in combination with a massive downturn and tightened credit, be characterized by no new and thriving sectors requiring new workers with new skills (because much of the capital that would have fueled them has been siphoned into contingent markets and housing) even as the existing sectors and workers languish? Could there be a larger structural problem, but we can't see it because the economy has been so distorted? 

My point here is that Krugman is right (as usual) that there is no evidence consistent with structural unemployment, but are we missing something bigger? A perspective perhaps that would argue that we have something worse than short-term structural unemployment such as we might see in an economy characterized over the long-term by well-functioning markets and by rapid progress and growth, at least in some sectors other than finance. What if the misalignment is so long-standing and has been so destructive to real innovation and productivity that real growth and innovation have been effectively squelched in many sectors? Perhaps not everywhere and always, but enough that now when we look for signs of structural unemployment as Krugman has done, we find no indication of it because sectors where there might have been innovation and growth that would now be demanding workers with different skills, were not able to compete effectively for capital? As I write this, I think this can't really be possible. Even crippled markets would allocate some capital correctly, yes?

The beauty of capitalism and commercial exchange when they work is that they coordinate, communicate and equilibrate the demand for and supply of capital, human, financial, and physical, to those places where productivity is highest and output most valued.  The false signals of bubbles do the exact opposite. Instead of producing growth in new technology, in new and better products, and in new jobs, our recent bubble most likely produced underinvestment in human and other forms of capital not directly beneficial to Wall Street along with immense amounts of unsecured risk, granite countertops and en suite baths.

I find myself asking, what would our and the world economy look like if Wall Street had been doing it's job? If I'm right, they would be dramatically different. In that case, as Krugman points out there is no mismatch between the jobs of that distorted economy and the skills of the workers who have been working in the economy that we have. If I'm right, the mismatch is between the workers of the economy we have and the workers of the economy we want and need to have to set us back on the counterfactual trajectory of more diverse growth and productivity; the counterfactual economy we would have had if Wall Street had been doing it's job. If I'm right then we have a major structural problem and I don't think anyone will be able to argue credibly that government should be shrunk and drowned in a bathtub. If it took years of misplaced private sector "enthusiasm" to create the misalignments, it will almost certainly require government to take a larger role in righting them. Thank you, Wall Street.

Let me make my case.

Earlier this year I observed that the price of casino-like finance is higher than we think. Specifically, not only did it siphon off trillions of dollars that created a surplus of homes and commercial real estate, not only did it siphon equity out of existing homes and transform it into bigger, more expensive cars and pickup trucks, and RVs, along with extra baths and state of the art kitchens that may or may not recoup value for homeowners, it also siphoned talent into the financial sector (and into the construction sector).

Now I’m going to ask you to imagine the counterfactual of the world in which the housing bubble occurred. Imagine that over the last 20 or so years our future mathematicians, social and physical scientists, and social workers had left undergraduate or graduate school in a world in which the financial sector had not become so large, so distorted by short-term private incentives, and therefore so personally lucrative. Moreover, imagine a world in which capital had not been siphoned to housing and real estate, but instead had been allocated (as we in the economics profession like to believe it will be) to those areas of the economy where potential returns to capital are highest, where technology is advancing (and presumably yielding benefit to us all). In the counterfactual world, the efficient allocation of capital would have blazed the efficient, productive trail into the steadily improving future we have for the most part observed since Adam Smith and others first noticed that the division of labor and the willingness of the owners of capital to seek its highest return appeared to take us all to something that was better than feudalism.

Now ask yourself: In that counterfactual world, where the financial sector was doing what it is supposed to do, what would the economy have looked like? Where would have been the jobs? How would individuals have adjusted their investment in human capital in order to increase their competitiveness for the counterfactual jobs? How would investors have invested? What would manufacturers have produced?

I believe that the answers to these questions tell us something about the nature of unemployment we are facing now and the policy options that are likely to drive us out of the (shallow thanks to the stimulus) unregulated-finance-sector-induced crater we find ourselves in.

The financial sector has muddied the waters for many years, not just the last quarter or two, signaling reductions in risk and returns to financial, physical and human capital that were highly distorted in many cases and that have consequently created large discontinuities in the demand for and supply of all types of capital and, consequently, in supply and demand in goods and services markets. The net effect in labor markets is that we now have a good match between skills and the jobs in the economy we used to have, but we may not have a good match between skills and jobs in the economy we could have had or the economy we would like to have. This is a structural problem, but not one that is likely to fix itself without some major restructuring in which the government and government policy must take active roles. Thank you, Wall Street.

If I'm right that we have a long-term structural problem, it will require remedies and restructuring that benefit more than the top 1% of wage earners. For this reason, shrinking government, while simultaneously refusing to stimulate aggregate demand, will almost certainly make the recession longer and deeper. On the other hand, stimulating aggregate demand in ways that preserve the old economy rather than reshaping it to produce the human and physical capital and public infrastructure that the counterfactual economy would have given us will only leave us mired in a dysfunctional economy.

Either way, when the private sector has been the problem, it's hard to imagine an effective solution that doesn't involve a safety net that includes health insurance combined with government action aimed at strategically boosting aggregate demand by targeting those most at risk and most likely to spend while also adopting public policies aimed at remedying the gross distortions in capital markets, human, physical, and financial, over the last 30 years.

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Krugman's response, a clarification with which I am in full agreement, here.

Comments

[rjs]

is it possible that a counterfactual may exist in other countries not suffering from the same cancerous growth of the financial sector that we have experienced, such as brazil or china, where the recession has barely had an impact? or am i stretching it?

[Louis]

Brilliant.

You may wish to consider using a serif font. It would be much easier to read.

[jcb]

Brilliant. Just brilliant.

Completely transcends and reconfigures the parochial economic debate over demand vs. structural features of recession.

Thanks.

[Ubihlee]

Fantastic article, but here my comments:

I believe our economic situation is analogous to a serious diabetic disease. If each complication of a diabetic disease is treated separately, the real treatment will escape us. Moreover, it may also cause other potential, perhaps fatal, complications. Again, I ask, doesn't it seem that we have made the same mistakes in the economy over the last several years?

I believe the operative paradigm of the market has been steadily outmoded over the last 20 years. (This is the real structure problem.) With this outdated market paradigm, we have not created enough jobs for middle- and lower-income people. It means that we have not achieved the level of consumer spending on the demand side that we could have had.

I am concerned about the economy. Unlike others who share our concern, I have a solution.

Please take a look at some of my writings in my blog: Saving the world economy: Overcoming an Economic Sisyphean Task – Or, the True Path Back to Economic Prosperity http://savingtheworldeconomy.blogspot.com/2010/09/overcoming-economic-si...
The Current Economic Recession, Analogous to a Serious Diabetic Disease http://savingtheworldeconomy.blogspot.com/2010/09/current-economic-reces...

[kayjay]

The "greens", the "sustainability people" have been talking about this for the longest time. You go to shop and see people buying coke/pepsi, cigarettes, potato chips and all the sweet junk food, etc. Is that sustainable aggregate demand? Unfortunately, Krugman does not confront this issue, because that would muddle his case for immediacy; "creating jobs" the fastest, till the next cycle, just a few years down the road. Democratic politicians have done the same thing for a very long time, be patient they say, or, the best is often the enemy of the good, etc.;; the Republicans are despicable of course, playing on the superstitious nature of the general populace, as now. No wonder, many of the products I try to buy are made in Germany!

[Myles]

My gut reaction is to agree that distorted incentives have been sucking talent into the financial sector. Can you help me understand how that would happen, though? Econ 101 tells me that there should be no difference between the lucritiveness of an industry and the amount of wealth it creates. How has Wall Street cheated the rules of the market? And whose money have they been taking? And how would a government act to prevent this?

I apologize if these are obvious questions; it's been awhile since I've studied economics...

[joeedh]

Why did the financial sector get so huge? Why did we carry such a huge balance of trade deficit to finance it?

Who was borrowing a significant percentage of gross national income, forcing the private sector to suck savings from abroad? Who was crowding out domestic savings?

Paul Volcker said it best:

http://www.c-spanarchives.org/program/ID/714&start=1160&end=1210

The private sector wasn't the root problem. The government was. By all means, let's have the government fix it--but be prepared to raise taxes on far more then the top earners; more borrowing will simply recreate the distortions all over again.

The author is correct, however, that any fiscal consolidation must be matched with a new, strong source of demand. Whether that be monetary policy and manufacturing or creative, targeted fiscal stimulus I don't know; this is a very, very difficult problem to solve.

[joeedh]

@Myles: Wall Street got the money from our trade deficit, if you didn't guess from my last post :)

The government had a vested interest in keeping the cheap foreign money flowing, which translated to encouraging overconsumption and giving special privileges to Wall Street, so it could absorb all the capital foreigners were loaning us.

I don't think it was domestic spending that drove this, either. Our government got an immense amount of international power from running a trade deficit; it propped up the reserve-status of the dollar after the Bretton Woods system collapsed. Look up the Triffin Dilemma someday.

Ironically, aside from government benefits there are few advantages to such a huge, consolidated financial sector (which is why federal regulators expect it to shrink significantly in the next few years, after the reform bill).

[Peter T]

Maxine

Nice post. I think you are probably right - and not just about the US. Same trends are evident here in Australia, and I believe in Europe too.

My take on this would be that markets favour wealthier participants over less wealthy (because they enable economies of scale, and because the wealthy are less vulnerable to small setbacks). This goes back at least to Solon. So widespread markets generate crises of distribution, unless checked by other forces. So Paul is right that demand is depressed, but you are right in that the structure of investment is badly skewed, in consequence of skewed distribution of wealth.

[jeff portser]

We don’t have capitalism in the free market sense here any longer……it’s centrally planned…..regulated to the hilt…………in fact look at the attachment showing gov’t spending as a % of total GDP

http://www.finance-insurance-loans.com/tag/tim-wallace/

[The Raven]

BTW, Krugman responded to you (with a link!) at http://krugman.blogs.nytimes.com/2010/09/28/structural-problems-not-structural-unemployment/

I don't know that capitalism in the developed world is the same animal it was, though. Capitalism, it seems to me, is an economic form that is adapted to developing and operating an industrial economy. In the developed world, it seems to be turning into something else, and I'm wondering if the old forms of capital allocation are at all appropriate. Our economic forms may, in other words, be "optimizing" (if that is what in fact capitalism does) things that are no longer of value to us.

[Bruce Wilder]

Krugman's response seems to me to be a demonstration of his style of thought, and its limits: finding an essential core, but losing the essential connections in the process.

He seems to be afraid of confusing people, afraid that people might accept the structural argument, and in doing so, lose focus on the immediate jobs crisis.

I would take the opposite view. I think Krugman is not persuading enough people, precisely because he doesn't extend his argument, extend his interpretation to take in many more facts and circumstances. What you've done here really does deserve much more attention, precisely because, I think, properly pitched, it would help to persuade more people that we could act responsibly on employment in the "short-term" with fiscal stimulus spending, designed to directly address groaning short-comings in "economic structure".

Economics really does need synthesis to balance the analysis. Good job.

[sbis]

Brilliant post & I agree about the distortions. But I am not sure more government is the solution. How would government be able to respond to price signals & allocate resources efficiently if free markets can't (Otherwise Soviet Union will be a success). It seems both free market & govt control economy suffer from principal agent problem. Those in power (doesn't matter gov't or private sector) will abuse the system for personal gain. In gov't control economy it is the bureaucrats. In free market it is the wall st. I think that govt will be even more inefficient in allocating capital as it will be held hostage by vested interest groups. Resulting market distortions could be even higher(e.g. Soviet Union).

[Retro Air Jordans]

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[taobao taiwan]

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