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Sunday, August 29, 2010

The very nature of an economy

Arnold Kling gives us his ideas about economic circumstances here: (heavily excerpted)

In the United States, the economic mystery of 2010 is the persistence of high unemployment, in spite of the application of the stimulus treatment that follows the prescription of the prevailing Keynesian orthodoxy. I wish to offer an alternative to that orthodoxy.

For the followers of John Maynard Keynes, economic activity consists of spending. When economic activity slows down, their prescription is to increase spending by government, businesses, consumers, or all three. Instead, what I like to say is that “economic activity consists of sustainable patterns of specialization and trade.” This is my mantra of macroeconomics.

Here is a simple pattern of specialization and trade: Suppose that all of us eat grain and fruit, which we could grow for ourselves. If some of us have land better for fruit trees, while others have land better for growing grain, then specialization and trading can pay off. It is inefficient to waste good tree land by growing grain on it and to waste good grain land by planting trees on it. Instead, economic activity gives all of us more to eat.

What I mean by a sustainable pattern of specialization and trade is that everyone involved would voluntarily continue to follow the pattern. In accounting terms, profits are a sign of sustainability. If the accounts show a profit, then the value of output exceeds the cost of input. If not, then the pattern is not sustainable.

As conditions change, the patterns of specialization and trade evolve. For example, improvements in transportation make new trade patterns sustainable. Recall the changes brought about by ocean-crossing sailing ships, then steamboats, then railroads, then the automobile and the airplane. As new patterns become sustainable, older patterns become unprofitable and therefore unsustainable. The truck replaced the horse-drawn cart.

Patterns of specialization and trade have become more complex over time. The example of fruit pickers and grain harvesters could have been used hundreds of years ago. But many of the jobs that form today's pattern of specialization and trade are less than 50 years old—or younger.

The contemporary pattern of specialization and trade can be described as roundabout production. I first heard the term in a course on capital theory that Alan and I took from Paul Samuelson. Samuelson was explaining the Austrian theory of capital, as articulated by Eugen von Böhm-Bawerk, who developed his analysis more than a century ago.

The idea of roundabout production is to use intermediate activities to increase final output.

The trend is for the proportion of people employed in final-stage production to get smaller and smaller. Two or three generations ago in the United States, agricultural workers and manufacturing production workers made up half of the labor force. Today, that figure is less than 10 percent. However, thanks to roundabout production, we can produce more manufactured goods and more food than ever.

Much of today's American workforce is engaged in roundabout production, which Böhm-Bawerk equated with capital. There is no longer a meaningful distinction between labor and capital. Labor is capital.

If labor is capital, then we have lost the automatic tight connection between spending and employment. Firms can vary their output with little or no variation in employment. This explains how we can have a “jobless recovery,” meaning a large percentage increase in output without a comparable percentage increase in employment. For firms in today's economy, labor represents an investment. Firms hire workers in order to develop capabilities that will eventually produce output more efficiently. The return on an investment in workers may take as long or longer to realize as the return on investment in a machine. The return on investing in workers may be at least as uncertain as the return on investing in equipment.

The phenomenon of roundabout production suggests a story for the current recession. The economy was suddenly caught in an unsustainable pattern of production, which involved too much housing construction in the “sand states” of Florida, Nevada, and California as well as too much financial activity related to mortgages and mortgage securities.

The suddenly unsustainable housing and mortgage boom comes atop the ongoing obsolescence of various patterns of specialization, as the Internet and globalization continue to foster new forms of organization and competition. The result of the boom-bust cycle superimposed on the ongoing obsolescence is to overload the market's ability to reconfigure production patterns so that workers are fully employed.

The market needs to undertake a recalculation in order to deploy workers in a new, sustainable pattern of specialization and trade. The process involves gradual, decentralized trial and error. Firms need to be launched by entrepreneurs, who will make risky investments in employees. The failure rate will be high, but eventually the successes will have a cumulative effect that brings about more economic activity.

The challenge is made difficult by the increasing specialization of labor-capital. The problem of matching skills with needs in roundabout production is much more complex than the problem of adding or subtracting workers in final-stage production.

The Keynesian prescription for a recession is to increase government spending. Even if the resulting output is not valuable (the proverbial digging ditches and filling them in again), the thinking is that this will stimulate productive output. Again, this is based on the theory that economic activity is spending. Supposedly, spending will encourage more spending, through the “multiplier” effect.

From our more Austrian perspective, the Keynesian prescription will fail. Government spending tends to create or reinforce unsustainable patterns of production—temporary housing booms, transitory increases in auto sales, and the like. However, there is no reason to expect unsustainable patterns of production to stimulate the creation of sustainable patterns of specialization and trade. If anything, it would seem likely that government support for unsustainable patterns of production could make the market's recalculation problem more confusing. It will delay long-term recovery, rather than hasten it.

What needs to emerge are new, sustainable patterns of specialization and trade. Government does not have much incentive to create sustainable patterns of specialization and trade. In fact, the political system tends to favor subsidies to outmoded and unsustainable businesses.

Government could reduce the cost of investing in labor-capital. If it can be done in a fiscally responsible way, it would help to reduce the marginal tax rates on investment (the corporate profits tax) and employment (the payroll tax). This may require offsetting tax changes, such as eliminating the mortgage interest deduction or the deductibility of employer-provided health insurance.

On the whole, the best way to help the process of market recalculation and the creation of sustainable patterns of specialization and trade may be for government to get out of the way.

Well there are some things that might help but policy makers have chosen not to do them. Many of the things that have been done are counterproductive.

14 comments:

AVeryRoughRoadAhead said...

"There is no longer a meaningful distinction between labor and capital. Labor is capital."

Rubbish.

That Eugen von Böhm-Bawerk equated "roundabout production" with capital DOES NOT MEAN that they're now the same thing - it merely means that labor can, in some circumstances, be substituted for capital. Arnold Kling is overreaching here.

I, many of the readers of this blog, and at least one of the bloggers here are or have been entrepreneurs; I'll eat my hat if any among us have found that all labor, no capital is a viable business model.


"The challenge is made difficult by the increasing specialization of labor-capital. The problem of matching skills with needs in roundabout production is much more complex than the problem of adding or subtracting workers in final-stage production."

Agreed. The increasing complexity of workers' necessary skill-sets, and the correspondingly increasing lengths of time needed to acquire such, mean that it's likely that future workforces will be less flexible than has been the historic norm, and further that larger amounts of resources will have to be used for various social-relief programs, as the unemployed take longer to find work for which they are suited, and a higher percentage of them remain more or less permanently unemployed.


"Supposedly, spending will encourage more spending, through the 'multiplier' effect."

Not just "supposedly"; the velocity of money is inherently ZERO if there are no transactions. Therefore, spending makes further spending possible.


"...such as eliminating the mortgage interest deduction or the deductibility of employer-provided health insurance."

A big thumbs-up to both of those ideas.

Bret said...

Rough wrote: "Rubbish."

Kling oversimplified, but the gist is valid (i.e. not rubbish). Whereas labor can't always be substituted for capital, after a minimum amount of capital, labor and capital are fairly interchangeable and becoming more so as time goes on.

Rough wrote: "The increasing complexity of workers' necessary skill-sets, and the correspondingly increasing lengths of time needed to acquire such..."

Everybody tells me this, but I just don't see it. Everything I've been involved with has become easier to do, easier and faster to learn, and easier and faster to train others. I'm sure there are areas where workers skill-sets are both more complex and harder and slower to learn, but I'm skeptical that's true for most things.

Rough wrote: "Therefore, spending makes further spending possible."

Sort of, but sort of misleading as can be seen from counter-examples. If the Fed makes money available, banks can lend and people can spend, even without other spending. On the other hand, if nobody is spending anything, if the government employs and pays people to dig ditches and fill them in, that doesn't necessarily change people's inclination to spend, so the real economy will be untouched. Also, the questions is "when"? Spending now may increase or decrease future spending and economic activity.

I'm not completely anti-Keynesian in that I can see circumstances where government spending can help. Unfortunately, governments tend to overdo it, and I think they definitely made an enormous mistake with the poorly thought out and implemented stimuli of the last couple of years.

Susan's Husband said...

"Not just "supposedly"; the velocity of money is inherently ZERO if there are no transactions. Therefore, spending makes further spending possible."

But that doesn't address Bret's point by showing that the "multiplier effect" has a value > 1. Your statement would be true even if the value were, say, 0.1. And if the value is less than one then it's wasteful.

Harry Eagar said...

If labor and capital are equivalent, I want to see some examples where entrepreneurs junked machines and replaced them with navvies. (In fact, it does happen, but insignificantly often.)

As I long ago said, Keynesian stimulation is not likely to be very effective, compared to the '30s, because labor is less fungible. In 1935, you could take an unemployed machine minder and make him into a road paver. It is less easy to find a government-stimulus job that will suit a former buyer for Toys R Us.

The idea that cutting taxes would work better has nothing to recommend it, though.

That's why you want to avoid deflation, even at some cost, because nobody knows how to reverse it in a late modern economy.

Susan's Husband said...

" I want to see some examples where entrepreneurs junked machines and replaced them with navvies"

Me. When I started my business, I used my own labor instead of getting loans or venture capital. If you mean literally junking machines, the problem is that machines get better, faster, and cheaper, and people don't.

"The idea that cutting taxes would work better has nothing to recommend it, though."

Except actual economic history.

Harry Eagar said...

I have been interviewing employers, several of whom say they would hire except that they cannot get loans.

So far, not one has said taxes are holding him back.

Bret said...

Harry Eagar wrote: "So far, not one has said taxes are holding him back."

What exactly are you asking them (i.e., the exact wording of the question you ask)?

Susan's Husband said...

Bret;

Maybe he could interview the business owners who write here. Why should his anecdotes trump ours?

erp said...

Why not interview each other?

Bret said...

Okay. I'll sorta self interview.

Me (Interviewer): Are taxes currently causing you not to hire more people?

Me (Interviewee): No. In fact, I paid less taxes last year (and will pay less this year) since I'm making so little money compared to the past.[At this point I suspect Harry would move on to the next line of questions]

Me (Interviewer): Then why aren't you hiring?

Me (Inteviewee): Because there's less demand for my company's services.

Me (Interviewer): Why do you suppose that is?

Me (Interviewee): I've asked my past and potential customers exactly that. Their answers vary, but generally fall under a few categories: higher operating costs due to increased regulation; lower expected ROI due to expected increased regulation and taxes; and much higher uncertainty about the future due to massive new legislation that will take years or decades to sort out in the courts. As a result, they are sitting tight because they either can't afford to continue existing programs, the changed ROI and risk makes it prudent to put various lines of business into a holding pattern, or both.

erp said...

(Interviewer)

We'll just put you into the "Taxes aren't holding you back" column.

Thank you sir and we hope you've enjoyed our "Summer of Recovery."

Click ... dial tone.

Bret said...

Exactly.

AVeryRoughRoadAhead said...

"The increasing complexity of workers' necessary skill-sets, and the correspondingly increasing lengths of time needed to acquire such..."

"Everybody tells me this, but I just don't see it. Everything I've been involved with has become easier to do, easier and faster to learn, and easier and faster to train others."

Blue-collar, unemployed and seeing red | by James B. Kelleher - Reuters:

"No section of the country has been more buffeted by the changes sweeping U.S. manufacturing than the Midwest, home to the largest concentration of factories making everything from passenger cars and commercial trucks to construction equipment and food products. The irony is that as the sector's profit rebounds, employers here complain they can't find enough qualified workers -- despite the millions of former manufacturing workers desperate for a job. The problem, Crocker said, is the gap between the legacy skills most unemployed manufacturing workers have and the skills employers are looking for."

Bret said...

That doesn't necessarily imply that the required skills are increasing in complexity. Just that the workers aren't getting the new skills, even if easier, for some reason. But maybe manufacturing jobs are becoming more complicated. I have no idea why though, because the pieces of manufacturing I'm familiar with like welding and machining are much easier now.