Sunday, April 3, 2011

Bubbles and Unemployment

There’s a lot of commentary going around on why unemployment has proved to be persistently high during the recovery. As Yglesias notes, this boils down to the question “Are recessions caused by asset price busts fundamentally different from recessions caused by central bank efforts to curb inflation?” Paul Krugman has a strong take on this:
Brad DeLong has recently written up a clearer version of a story I’ve been telling for a while (actually since before the 2008 crisis) — namely, that there’s a big difference between inflation-fighting recessions, in which the Fed squeezes to bring inflation down, then relaxes — and recessions brought on by overstretch in debt and investment. The former tend to be V-shaped, with a rapid recovery once the Fed relents; the latter tend to be slow, because it’s much harder to push private spending higher than to stop holding it down.
The idea that the precise conditions of this recession are different has implications for the favored policies of both the right and left. On the left, some folks believe that the notion of balance sheet recessions calls for more measures to tackle household negative equity, optimism for fiscal policy, and skepticism regarding monetary policy (say, Krugman). On the right, other people emphasize mismatch problems in the labor market and the role of structural forces behind unemployment. They are frequently skeptical of how fiscal policy can fix these problems (sometimes, also monetary policy). In general, there are widespread beliefs that some particular features of the crash have limited the scope for traditional macroeconomic stabilization policies.

Via Stephen Williamson, Minneapolis Fed President Narayana Kocherlakota has a new paper that goes into this issue. He draws on the Keynesian work of Roger Farmer, who shows this graph:

Farmer’s idea is that the rate of unemployment at any time is indeterminate due to problems in the labor search market. In the absence of markets for the search time of workers, price signals are not necessarily sent to match workers with the right jobs. Instead, the level of unemployment is determined by expectations of the strength of economic activity, which is proxied by stock market performance. One problem for this idea lies in explaining why unemployment has been slow to recover even as the stock market has recovered. Farmer writes,
This paradigm provides us with a new way to think about large recessions like the Great Depression and the Great Recession of 2007—2009. Using the model from this paper I would argue that the world economy in 2008 was headed rapidly towards a high unemployment, low wealth, equilibrium. The move to this bad equilibrium was triggered by a loss of confidence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets led to an amplification of the crisis as panic hit the global financial markets.

In the winter of 2011, the US labor market had still not recovered. I believe that much of the problem is connected with a lack of confidence bylobal investors who are concerned with the possibility of a further collapse. Even though the US stock market may be appropriately valued based on historical price earnings ratios — market participants are concerned that the value of stocks could fall further. Variations in the level of confidence are manifested in changing risk premia that are fully rational given the unpredictable behavior of future traders in the asset markets.
I find this argument more persuasive in explaining the employment dowturn than the failure of employment to recover; but it is easy to imagine alternate models in which employment growth is asymmetric with respect to the business cycle.

Kocherlakota's innovation is to bring this unemployment picture into a broader model involving bubbles and monetary policy. While his model is fairly complex, the end result is simple — as with Farmer’s model, the level of unemployment is ultimately determined not by prevailing wages, but rather by the amount of aggregate demand. The collapse of an asset bubble results in a substantial drop in demand, and will result in a hike in unemployment unless the central bank proves sufficiently accommodative in lowering nominal interest rates.

One way to think about this is to compare the stock market bust in 2000 with the housing bust in 2008. In both cases, you have an asset that drops dramatically in value (tech companies, housing) that results in large drops in comparable financial securities (tech stocks, mortgage-backed securities). The total wealth loss in the economy was roughly comparable between the two cases. Yet for the 2000 crash, the Fed was able to lean against the drop by moving conventional monetary policy enough. In the second case, the Fed quickly hit the short-term nominal interest rate barrier of 0, and was unable to ease further though conventional channels. It did pursue unconventional policies like QE2, but was hesitant to do so and faced unprecedented levels of backlash for the easing that they did happen.

So, one way to read Kocherlakota is the following: given that monetary policy-induced demand fixes the rate of unemployment, recovery difficulties now reduce to the fact that the Fed has been insufficiently accommodating as the some interest rates hit the zero-rate bound. If the Fed instead proved more willing to consider unorthodox policies like quantitative easing or currency depreciation, we could have whatever degree of unemployment we liked.

The ultimate origin of a recession, in this model, is completely irrelevant to the possibility for the recovery. Issues with debt overhangs, structural unemployment, etc. are all second order effects relative to the fact that Fed-induced nominal spending has lagged; and the optimal recipe is not fiscal stimulus, but further Fed-based easing. Recessions caused by asset-bubble bursts do not differ from the garden variety recession, as long as the Fed is in fact appropriately accommodating.

So, the real issue is not that bubble-induced recessions are diffrerent in some way, but rather that policymakers respond to them differently. Rather than saying “the recovery in the 80s was quick because it was a Fed induced recession”; the issue instead is that the Fed had more scope to tackle that recession than this one.

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