One upshot of the recession is that it will shine a light on two more or less competing explanations of what causes recessions.
While economists share broad agreement on a surprisingly large number of issues, the most visible discord lies in how two groups view the causes of recession, and hence how to remedy their effects. Both groups rely on sophisticated mathematical models. So, at the risk of enormous oversimplification, let me explain.
One camp views recessions as largely a market response to an unfortunate set of circumstances, such as an energy-price spike or financial crisis. While they’d agree that governmental action could prevent many of these events, once they do happen, there is little government can do. Markets may not give us the result we want, but they give us the best possible outcome.
The other group believes recessions occur as a consequence of small imperfections in markets for goods and services. For example, restaurants cannot inexpensively change their menu prices, so they will absorb a small loss instead of cutting prices. Businesses will honor long-term contracts, even when they might legally make small changes as commodity prices or demand for their goods changes. When these small effects are added together, the effect leads to a recession. As a result, government action, such as a stimulus, might help edge an economy out of recession.
For the record, I belong to the second group. A modest amount of my empirical work has documented these market imperfections. The columnist and Nobel laureate Paul Krugman, and Clinton and Obama administration luminaries Lawrence Summers and Christina Romer are leading advocates of this theory. So, too, is Harvard University professor and George W. Bush’s top economist, Greg Mankiw. This difference of opinion is not ideologically driven.
This recession might well make the truth more clear. That would be helpful because there is much doubt about the effect of government action to date. For example, the Obama administration estimates the federal stimulus plan has resulted in 2.1 million more jobs now than would be the case without it. Harvard’s Robert Barro, a leading researcher of the first group, estimates the stimulus has actually suppressed private investment, resulting in a net loss of jobs.
These are not easy things to reconcile; a simple accounting of jobs or glance at the unemployment rate will not do. It takes a model that accounts for at least dozens of complex interactions, calibrated on history and looking forward across an uncertain policy environment.
The unsettling truth is that those of us who believed the stimulus would significantly improve the economy face a daunting trial. You see, even if the administration’s most optimistic estimate is right, those stimulus jobs cost us a tad more than $400,000 apiece. Without an explosion of stimulus-related employment, the economic models supporting it are in trouble. One problem with those models: None accounted for the huge uncertainty over public policies like health care and cap and trade that are scaring many employers.•
Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at firstname.lastname@example.org.