Which production factor gets destroyed in major recessions, part I?

(cross-posted with Core Economics)

There has been much talk in the last 12 months about the relationship between macro-economic theory and explanations of the current recession. Krugman essentially dismissed most current macro theory as being delusional about the workings of major recessions. His major argument (which goes back at least to Stiglitz in the mid 1990s) is that, within Real Business Cycle theories, major recessions are at their core viewed as mass holidays.

The holiday view of recessions essentially arises from the fact that most macro-models take a perfect-market view of the aggregate economy and boil down the complicated machinery of GDP creation into a smooth production function which usually only includes Labour, Human capital, Physical capital, and Technology. As soon as you realise that the factories have not been bombed, that no-one has shot the workers or de-educated them and that people havent forgotten how to use the internet, then you are by necessity forced to say that any large reduction in production must have been because workers decided to go on holiday. Of course, you can redefine any of these basic production factors to mean the rest in which case you can tautologically say changes in it explain everything, but that kind of window dressing is ultimately useless.

In this blog I simply want to pose the question of which additional production factor we would have to think of to augment our models with, such that we get a more palatable story of what happens in major recessions, whilst still remaining within the confines of a production function view of the economy. Lets look at what must roughly be true of this mystery production factor X:

  • It must be easy to destroy X and hard to build up. If it wasnt true that X was easy to destroy, then one couldnt have a major reduction in GDP because the other production factors dont really take a hit during recessions. If it was easy to build up again, then recessions should be over very quickly and one should be able to return the aggregate economy back to the path it was on previously. We know this is not true and that it has, for instance, been argued that the Great Recession of the 1930s really only ended in the Second World War (see here for support and here for a paper with a contrary view).
  • X must have something to do with the utilisation of labour. This is because we know that the utilisation of labour quite closely follows the downturn and subsequent upturn, just as in this recession the GDP downturn was very quickly translated into losses of jobs and losses in labour participation. In the latest recession for instance, the US Department of Labor estimated the gross job losses totalled 7.4 million in the first quarter of 2008, whilst the US Department of Labor figures showed a loss of 533 000 jobs in the month following October 2008, the biggest drop since December 1974. For more, see here.
  • X must have an element of a negative externality about it. If this werent true, then one would be forced to arrive at the absurd conclusion that people knowingly destroyed their own X and accepted the huge loss of income stream associated with it. There is no believable story that would make individuals inflict the kind of income loss that we see in recessions on themselves. Hence, to some degree, the reduction in X must be due to the actions of others and the destruction of the X of others might well be due to our actions. X must therefore be two-sided in that it is not something that would arise in a Robinson Crusoe economy.
  • If we take the stylised story of this financial crisis at face value and accept that things like banks can be too big and integrated to be allowed to fail, then X has to have something to do with the other production factors being integrated. It must also be relatively easy to make up stories that tie the making or destructing of X to what happens in the financial sector.
  • X must make internal sense as a production factor. This means it must cost resources to build up, that investments into it are in some sense visible (even if they are not yet measured by statistical agencies), and it must actually be associated with production. Hence things like trust or confidence do not qualify because they dont actually directly involve the production and sale of goods. A lack of trust makes it hard to organise production and sales, but is not itself a production factor. Trust might be involved in the cost of building X, but it doesnt make sense to call it a direct production factor in itself. In a pure command-and-control economy for instance one, in principle, needs no trust between people at all to have a reasonably high GDP. This of course does not preclude the possibility that the start of a recession is a dramatic change in things like trust which might affect the costs of making or breaking X.

Is it worth saving the production function approach at all, you might ask? Shouldnt we simply give it up as a bad job? I think it is worth saving, because the production function approach is the most obvious way to interpret GDP and growth regressions, and forms a logical basis for expanding the set of economic macro-variables the statistical agencies look for. It is also the easiest way to teach students about the macro-economy because it is nice and compact. What is hence wanted are reasonable candidates for X and a model that convinces the profession it forms a palatable answer. We need an X to save the production function approach to macro. Any ideas?

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David Coles
David Coles(@david-coles)
12 years ago

Could X be cashflow/credit? Let’s run it through the criteria:

It must be easy to destroy X and hard to build up: Increasing cashflow is critical for a business to grow. In good times you can augment cashflow with easy credit, but that’s not available in recessions.

X must have something to do with the utilisation of labour: If you’ve got no cash you can’t pay people? I’m a bit dubious on this one.

X must have an element of a negative externality about it: Increasing your cashflow by issuing short invoice terms, but only paying your bills at the latest possible moment screws others of their cashflow. See Nicholas Gruen’s post asking why the government doesn’t pay invoices sooner.

Integration of other production factors: Labour, Human capital, Physical capital, and Technology. Physical capital often has running costs you need ready cash to pay, technology also but generally not as much. Labour doesn’t much like IOUs, and creating human capital is done by training, which costs either money or lost production for the duration. Banks having no cash means they’re insolvent, even if their non-current assests could cover their liabilities.

X must make internal sense as a production factor: Cash laying about is money that could be put to other uses. Credit can substitute for cash, but is obviously dependent on the bank or bond market’s trust in your business.

I’m just a layman, so I might be completely missing the point here, but this seems to fit to me. Also your titling “part I” suggests you’ve already got an answer.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
12 years ago

Thanks Paul,

Great puzzle you’ve posed us. I’m not sure why this thing needs to be a factor of production.

I don’t follow why it can’t be ‘trust’ or to be more forensic about it ‘risk tolerance’. This goes up and down and has strong externalities about it. And is difficult to rebuild.

(If we’re serious about the challenge from an empirical perspective, there are quite a few candidates for X and I expect most of them have a role. So one can think of work skills atrophying, and needing to be refurbished in any new job, search costs as well as my first choice above – changing risk tolerance – and its concatenating effects)

Richard Tsukamasa Green
Richard Tsukamasa Green(@richard-green)
12 years ago

There’s a strong current of physics envy in economics, so we should be true to our roots and tap that current. After all, it is our emulation of that most chauvinistic of disciplines that allows us to keep up our own chauvinism towards the other social sciences.

Since the models say the factor X is there, it must be there, even if it cannot be observed in anyway. Let us therefore call it “Dark Factor”. Just as Dark Matter powers starships, Dark Factor can inspire enough hand waving explanations of improbable societies to keep Science Fiction writers in clover for years.

Facetiousness besides, I’m quite pessimistic about about the chances of finding factor X, despite sincere wishes that it did exist. The plausible factors all seem to be behavioural features which would be a pain to measure, unless we decline to empirically test the proposition and merely assign the residual to it, and we’re already trying a similar slight of hand with Capital.

I guess surveys could be used, but they might be undesirable for the same reasons revealed preference is preferred. We could try to isolate it from market transcations, particularly financial markets, but this task is fraught with influence from other factors, particularly if liquidity or the like is also a factor.

If we remain intellectually honest and avoid hand waving answers, this might become a party game for generations, a windmill to tilt at between less quixotic activities. But I can’t shake the feeling that the simplicity and apparent strengths of the production function in macro have led us into an intellectual dead end, through only genuine attempts to explain. Maybe economics physics envy merely resulted in economic theories of ether.

John Quiggin
John Quiggin
12 years ago

It’s a nice way of thinking about the problem, but like Nicholas I’m not convinced by the argument you’ve given to rule out trust (or its derivative, credit, as noted at #1). The fact that trust isn’t needed in a pure command-and-control economy is a point in its favor, since such economies are typically not subject to recessions, but are subject to other costs associated with lack of trust.

Tony Harris
Tony Harris(@tony-harris)
12 years ago

John, are you suggesting that a pure command and control economy is an option in the real world?

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
12 years ago

You say that trust doesn’t produce anything by itself. Neither does anything else. These things become factors in production in combination. So I’m finding it hard to understand your point.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
12 years ago

And Paul, re your answer to James, why are you still after a *single* X. There will be quite a few of them rattling around won’t there?

Dr Troppo
Dr Troppo(@dr-troppo)
12 years ago

Admittedly I have no expertise in economics, but I understand that it allows theorists to introduce “wildly inaccurate descriptive representations of reality” as assumptions.

I’d like to do that now.

Assume that there exists a wiki that provides users with information about the economy. It tells people whether they are likely to lose their job and not be able to find another one, whether their house will go up in value, what interest rates are likely to be next year, and whether their customers will want to buy more or less of whatever it is they produce.

Assume that most people use this wiki to make decisions about how much of their income to spend and how much to save, about borrowing, hiring additional staff, investing in plant and equipment etc.

Being a wiki, it is constantly updated by multiple author/users. As circumstances change, the wiki gets updated.

Normally the updating process is smooth. At the margins there are disputes (which you can read about in the wiki’s separate discussion pages) but there is a solid core of stable information which represents a consensus within the author/user community.

But every so often something happens to disturb the stability of the wiki (an external shock of some kind). Updates become more frequent and more contested. Disputes erupt and the consensual core disintegrates. THE WIKI BREAKS.

When the wiki breaks its users are like tourists in a strange city without a map (or sat nav). They no longer feel confident that they no the consequences of any decisions they make. As a result they do things like save rather than spend, stop replacing staff, and running down their inventory rather than increasing production.

Of course there is no actual wiki that everybody uses. But often there is a rough consensus among journalists, politicians, lobbyists, consumers etc.

I say that the wiki is X.

Tel_
Tel_
12 years ago

X must have something to do with the utilisation of labour. This is because we know that the utilisation of labour quite closely follows the downturn and subsequent upturn, just as in this recession the GDP downturn was very quickly translated into losses of jobs and losses in labour participation. In the latest recession for instance, the US Department of Labor estimated the gross job losses totalled 7.4 million in the first quarter of 2008, whilst the US Department of Labor figures showed a loss of 533 000 jobs in the month following October 2008, the biggest drop since December 1974.

There’s a bit of handwaving here: X could equally well be related to utilisation of commodity resources which don’t get tracked nearly as closely as labour. Commodity prices do drop during a recession, suggesting fall in demand.

Also, there’s a large informal and untracked economy that actually grows during a recession. Most unemployed (or underemployed) people don’t just stare blankly, they go and do the things they want to do but didn’t have time for when they were working. Such as catching up some reading, teaching themselves skills, meeting old friends, fixing that clunking noise in the back of the car that has been annoying for years, doing that job for mum you promised and never got round to. Some of this is “holiday”, quite a lot of it is useful.

The other unfounded presumption is that X is any single factor. For example, suppose you have a business selling large, inefficient gas-consuming cars. People are willing to buy big cars when petrol is cheap and loans are easy to get, but they are very willing to “flip over” to buying smaller cars when petrol is expensive and credit is tight. For the transport system as a whole this is merely a minor reorientation of direction, for the manufacturer who is all geared up to sell big cars it is a disaster.

But this is merely one example where production capacity can become misaligned with buyer preferences. The factory has not been bombed, but by the time it gets rebuilt to cater for the current state of the market it might as well have been (arguments after WWII were that the countries whose factories were bombed actually ended up better off because plant was upgraded).

Many individual misalignments exist, also in worker skill sets. In a generous boom environment they generally continue to exist because human nature is such that people only do what should be done when they discover it really HAS to be done (and in a boom, no one wants downtime, so leave the plant running, worry about upgrades later).

Come a recession, the lots of little problems that we were overlooking earlier become big problems (usually quite quickly).

You could lump the average of a lot of small issues into some overall efficiency factor — but such a fudge factor is completely artificial. If serves to plug some equations, but good luck trying to quantify it in any practical manner.

Tel_
Tel_
12 years ago

Higher trust reduces transaction costs, makes specialisation easier, etc.

It also makes it easier for fraudsters to rip people off.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
12 years ago

Very nice Dr Troppskevich.

doctorpat
doctorpat
12 years ago

X is Business Structures. Not physical structures like buildings, but relationship structures, such as are depicted in all those HR org charts.

But there are three types of business structures.

1. Intrabusiness: These are the ones that are actually in the org charts. These are most understood, and the most robust. It isn’t until a lot of the employees have been fired that the internal structure of a business is damaged. But once it is it takes years to rebuild. Sure you can take out the org chart from 2008 and hire another 4 engineers and 23 production workers to fill those blank spots. But it will still take ages for everyone to learn their new jobs. (Not just the formal parts, but the informal stuff, like if you need a new widget then it’s much better to go directly to the storeroom instead of filling in a request form, but ask Mary, not Bob, he doesn’t help at all…)

2. Interbusiness: Who is your supplier for widgets? Who is their supplier for widget bearings? Who supplies them with grease for the widget bearing machine? All this needs to be established before business can work. And it takes years of tweaking and fine tuning for it to work well. Sure company A supplies widget nuts. At a similar price to company B. It isn’t until you’ve been buying them for a year that you find Company B always delivers on time, while company A has issues with it’s transport and storage. This will break down faster than Intrabusiness structure, but can be rebuilt faster proving all the related companies are still in business, and modern communication tech may help here.

3. Customer to business: The customers can’t buy widgets unless they have money, they don’t have money because they’ve been fired from the widget bearing grease mine. This is the well known economic structure and is what stimulus is meant to address. If it isn’t addressed fast enough then the first two types of structure break down too. At this point stimulus won’t help (or at least won’t help nearly as much).

David Coles
David Coles(@david-coles)
12 years ago

doctorpat: Aren’t 1 and 2 just human capital?

doctorpat
doctorpat
12 years ago

James A,

It depends how you define human capital. The way I understand it (I have no economics training outside of some masters level coursework in commerce) the human capital is the knowledge and skill that individuals have acquired. This is not destroyed or damaged quickly.

But these individuals have to be arranged in a functioning structure to apply their human capital.

If you have a skilled production line, but they are laid off for 6 months because of poor sales, and they all go off and one guy becomes a truckie and three of the women set up a house painting business and two go back to their own country etc etc… then when demand picks up:

1. You can’t just hire the old people back. Half of them aren’t available any more.
2. You have to hire new staff (cost and time) then they need training (more cost and time).

No human capital has been lost. Adam, Barry, Charlotte and Denise still have all the same skills. But because they are no longer in the same structure their old skills have lost some value, and new people must learn the skills for the rebuilt team.

Hence, value has been lost. Value must be rebuilt before the economy can recover.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
12 years ago

Paul,

Yes, it’s true that isolating factors is the approach that’s consistent with standard economic methodology. And I guess it’s consistent with any methodology, other than a kind of commonsensical discursive one (as is used in narrative and as we use to get through our lives every day). So it’s well worth considering going down the path you consider. What is so often NOT considered however is that the method proposed might not actually get much further than what we already know.

That is the various issues will be isolated and tested, and people will come up with clever tests to isolate them in the data. They’ll be clever but not necessarily wholly convincing. Then there will be innumerable articles on which factors are REALLY more important than others.

I’ll give you an example. In the 1980s a new sub-discipline was born which looked at Intra-industry trade. Any number of articles were penned asking whether factor proportions drove IIT, or was it ‘Technology’ and if the latter was it ‘trade cycle’ or more traditional economies of scale, was it clusters etc etc.

Well, the answer came back pretty much as it had been before the great endeavour was embarked upon – a good solid mix and we can’t say much more than that. It depends on the circumstances.

Harry Johnson put this well in 1970.

[T]he ‘adversary procedure’ of testing one hypothesis against another is a useful scientific procedure up to a point; but, when both hypotheses perform well and seem to be fairly evenly matched, it is not necessarily the best scientific procedure to send the challenger back to training camp with good advice on how to prepare for the next month. In the realm of ideas, a conflict of equally well (or equally imperfectly) supported hypotheses may be more fruitfully resolved by merger into a composite hypothesis.

So what you’re proposing is a good thing to propose, no question, but keep in mind that your scientific apparatus may be a bit like the moon buggy on a golf course. It mightn’t do much better than a golf buggy. And golf buggies are cheaper. There are any number of dead ends like this. To some extent that’s in the nature of science, we can’t be sure that something is a dead end until we go down and check it. But we can at least keep it in mind. Find me a single article pursuing the IIT analysis that even considered the possibility until it was too late and it became fairly clear that very little had been learned. Ditto for strategic trade theory.

What if you were asking another question about the empirical world “what is it that is decisive in a military conflict” and you wanted to know because you were fighting one. You could come up with all sorts of formal models, you could do lots of econometrics on things that were more or less measurable. But you’d have to improvise and use commonsense a lot more than anything else (I would assert that anyway). If Hannibal and Napoleon won battles with encirclement, if the regressions came up best for encirclement, you would need a fair bit more than econometrics to be confident that that should be your strategy. We live in a big messy world and sometimes those moon buggies aren’t much use. More to the point, if you had resources to spend on trying to work out how to win the next battle it’s far from clear you’d want to spend many on econometric investigations of past battles (though you might want to spend some resources doing that).

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
12 years ago

I just wrote a long reply and it got gobbled up. :( I may return but have had enough frustration for one 20 minute period!

David Coles
David Coles(@david-coles)
12 years ago

Coming at it the other way, Anthony Towns has a few posts trying to work out the best way to implement stimulus taking into account MV=PQ and notes (amongst other things) that increased Velocity of money means more production.

Tel_
Tel_
12 years ago

Paul,

In order to model the misalignment of manufacturing and marketing, you need to model both the factory (traditional production) and the sales side (which can reasonably be seen as production of profits, but maybe I offend some by treating it this way, I’m an information engineer so inputs and outputs are all the same to me).

commodity + labour –> [FACTORY] –> widgets

widgets + labour –> [SALES] –> profits

Let’s keep it as simple as possible, presume that [FACTORY] is managed in such a way that it has easy access to commodities and labour and auto-optimises to make the bottleneck the factory itself. Once tooling is done for a run, the equipment runs at a certain maximum rate and no faster.

The [SALES] side can run very cheaply and efficiently if the widgets are desirable to the market. If the widgets are less desirable then they will still sell (given enough labour effort by the sales team) but the profits are a diminishing function over time as increasingly the market becomes jaded with the product and wants something different.

Eventually, [SALES] can’t keep up with [FACTORY] and widgets start to stockpile. At some point it just doesn’t make sense to run the factory any more. At this point the widget stockpile is big and it’s a better idea to stop making any more, and spend time doing a complete retooling. During retooling the production is zero… you are doing it in the hope of a future product.

This all presumes that the time dimension is still active in the model, which it must do if you want to model “boom and bust” or any sort of market dynamics. In effect, time is an input into the production function. The function for [SALES] changes with market fashion (generally getting worse with time), the function for [FACTORY] stays fixed until the moment of retooling is chosen, then it drops to zero, then jumps up again. You could build a combined function that includes the stockpile if you like, there will be an optimal point where it is ideal to retool, but external factors (e.g. sudden drop in sales) can force that (out of control of the factory owner).

As for people never being unemployed and engaging in more or less productive activities — that leads to multi dimensional utility. Some things that money can’t buy, etc. Productivity is a subjective measure.

Tel_
Tel_
12 years ago

In your simple model, you envisage sales to be the direct effect of the labour input in that period, i.e. no effect of previous labour inputs or any form of specialisation into the business of sales.

I didn’t rule out specialisation, I merely presume that the business in question is small enough in comparison to the available labour pool that whoever they need is available (including skills as required). That presumption is only a simplification, you could add complexity to the model if required. I was trying to demonstrate the concept in a minimalist way.

As for repeat business and ongoing sales, that creates something akin to “momentum” in the model, yes that would probably be a realistic addition. Not quite the aspect that I was trying to get across. I have noticed in real-world technical industries that any supplier has a cost penalty in maintaining a broad catalog, but in the market some buyers have been buying the same widget for years and have huge investment in that design (e.g. maintenance manuals, parts inventory, compatible interfaces, etc). Those old designs don’t attract new customers. Sooner or later, every supplier breaks with the old design, because their long-term customers are insufficient to support the business. The only real-world exception I can think of is Kenwood mixers :-)

Hence within your type of world, we could simply redifine the production function as the sold output function and have it depend on labour and capital (presuming that the input good commodity in your model itself again comes from capital and labour).

Yes you could roll the two sides into a single production function but the time variable does not go away, and the rolled-together function is more complex to calculate (and more complex to describe) because it contains a state variable (the widget stockpile).

You could remove the time component by sufficient averaging but that’s probably even more difficult to calculate because you only get an average over many time steps and the most interesting variable in the system is the optimal time to switch from production to retooling (gets hidden by time averaging). This is a bit like assuming an answer and ignoring the question — great when you get the answer right!

It is interesting to note though that you adopt a model that violates the notion of perfect markets in that it takes production inputs to sell something. That is incompatible with the market cross and with the assumption of perfect costless information.

Well, if I’m violating perfect market theory, I guess every salesman who gets paid for their work must also violate the same theory. As an empiricist I’m sadly forced to keep company with sales guys.

Seriously though, does anyone believe in perfect costless information? I dare you to ring up your ISP support desk and explain why the theory of perfect costless information requires them to offer you free Internet. Chances are they will explain to you their theory about how you really don’t need any Internet at all :-)