Recalculation in Iceland

As you know, I’ve been critical of “recalculation” models of the US recession.  I think it’s mostly demand-side, and some unknown part of the supply-side is government labor market interference.  Only a modest portion is recalculation.  But Arnold Kling’s model almost perfectly explains the current Icelandic recession:

Economy Minister Arnason wants more for Iceland than fishing and geothermal energy. He acknowledges that the nation got into banking without the right infrastructure or the know- how to do it well. Still, he doesn’t think Icelanders have to go back to fishing now that they’ve proven themselves inept at finance.

His government needs to find work for the 2,000 highly educated finance-sector employees who lost their jobs, he says. Otherwise, they’ll migrate, and a shrinking population is the biggest scourge for this small, isolated island nation.

“The choice isn’t between fishing and banking,” Arnason says. “The choice is building a healthy, diversified economy.”

Some Keynesians might object that it’s also a demand problem; after all, Iceland went through a severe financial collapse, one of the worse in world history.  All the major banks failed, with liabilities totaling 1200% of GDP.  The housing industry collapsed.  Surely that points to a decline in AD?

Actually no.  Those Vikings wouldn’t have been able to survive in that harsh climate without having some smarts.  Unlike the foolish Irish, the Icelanders decided to let the big banks fail and have the creditors pick up the tab, not the taxpayers.  To prevent a fall in AD, they sharply depreciated the kroner.  I had trouble finding NGDP data, but if you look at the graph halfway down this link, you’ll see Icelandic NGDP rose continually through the worst of the 2008 crisis, and has continued to move gradually higher.  In contrast, Irish NGDP has plunged.  Ireland lacks the nominal income to repay its euro debts, and even to pay euro wages without steep wage cuts.  Ireland faces both recalculation and a severe demand shock.

The rise in NGDP did not prevent a fall in Icelandic RGDP; their financial collapse was a very severe real shock.  Those bankers can’t be immediately retrained as fisherman.  The reason Iceland fits Kling’s model so perfectly is:

1.  There was no demand shock

2.  It’s not even clear what the new patterns of specialization and trade should look like. Iceland is groping in the dark (literally, during these winter months) for new industries.

Paul Krugman also has a couple posts on Iceland.  In this one he points out that Icelandic RGDP fell about the same amount as in countries with much smaller financial crises, and that employment did considerably better.  I see those two arguments as being related.  Suppose Iceland had a real shock big enough to reduce RGDP by 15%, whereas Ireland and the Baltics merely had real shocks big enough to reduce RGDP by 8%.  But now assume that Ireland and the Baltics also had negative demand shocks, caused by their attachment to a euro that was way too strong for their economies (and indeed a bit too strong even for Germany.)

In that case Ireland and the Baltics might see RGDP declines as big or bigger than Iceland, even though their real shocks were smaller.   And this is what happened.   This also explains why employment did better in Iceland.  Recall that their real shock was much bigger, so for equal drops in employment you’d expect a bigger drop in Iceland RGDP than in the other crisis countries.  But we know that the decline in RGDP in Iceland was actually a bit less than most of the others.  This is because the good AD policies allowed some fraction of unemployment bankers and real estate people to find jobs in other industries.  Those new jobs were at lower levels of (measured) productivity per worker, which explains why RGDP fell more than employment.)

In other words, monetary policy did not slow the process of recalculation in Iceland.  In the other crisis countries monetary policy took a bad situation and made it even worse.   Unemployed workers in overbuilt sectors were not able to find jobs in other sectors, as total demand was falling.

PS:  How about some suggestions for Iceland:

1.  More tourism; most people don’t realize how awe-inspiring their volcanos are.

2.  Create more quirky pop groups.

3.  Give banking another shot.  Don’t assume Icelanders are “inept” at banking; assume they’ve become “experienced.”

4.  Grow pineapples in greenhouses heated by geothermal power.

5.  Resume raping and pillaging northern Europe, as in the Viking days.  (Oops, that’s already been done to northern European creditors.)

6.  Become the 51st state, or rejoin Denmark.

What else do you guys suggest?  Where’s their comparative advantage?

Recalculation vs. the data

There’s no question that Arnold Kling’s recalculation view is more intellectually appealing than the messy arguments about wage stickiness used by us “GDP factory” proponents:

Regular readers know that I am trying to nudge them toward a different paradigm in macroeconomics. I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade. Even if there is only a small chance that this alternative paradigm is useful, I think it is a worthwhile exercise.

One reason for wanting to change the paradigm is that I believe that trying to describe economic activity using an aggregate production function is a mistake. When I use the derisive expression GDP factory, I am referring to the aggregate production function.

Yes, macroeconomics should be all about specialization and trade.  Except business cycle theory, which needs a special ad hoc sticky wage/price model.  Why?  Because the evidence simply doesn’t fit any other approach.  Here’s Kling on the construction bust:

I want to suggest that the output that is “lost” is output that people do not want. In 2008 and 2009, Americans do not want 2 million houses to be built. So I do not think that it is right to speak of a shortfall in output. Instead, we should say that the people who were building houses have not found a pattern of trade in which they can produce something that people want.

Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:

January 2006 — housing starts = 2.303 million, unemployment = 4.7%

April 2008 — housing starts = 1.008 million, unemployment = 4.9%

October 2009 — housing starts = 527,000, unemployment = 10.1%

So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs, which is what is supposed to happen if the Fed keeps NGDP growing at a slow but steady rate.  Then NGDP plummeted, and housing fell another 480,000.  Is this because people didn’t “want” those houses?  No.  They didn’t want 2.2 million new houses a year; that really was a societal screw-up (with many possible villains.)  Kling’s completely right about that.  But they probably do want about a million new houses a year as our population grows by 3 million per year and families average about 3.  The reason housing fell far below normal is because the severe fall in NGDP created a deep recession.  Unemployed factory and service workers aren’t going to buy new houses.

Most importantly, the huge run-up in unemployment did not occur when the big fall in housing construction occurred, but much later, when output in manufacturing and services also plummeted.

Here is Kling on the Great Depression:

I think that technological change can drive the marginal product of many workers close to zero (When I mention ZMP, I always feel I owe Tyler Cowen a footnote.) I suspect that this happened in agriculture in the U.S. in the late 1920’s and early 1930’s, dumping a lot of manual laborers into unemployment.

I don’t agree with this.  There had been a very long term secular decline in farm jobs going back for decades before the Depression.  Those workers gradually moved to the cities and were absorbed by growing manufacturing and service industries.  So what changed between the booming late 1920s when unemployment was about 3%, and the early 1930s when it rose to 25%?  The answer is manufacturing collapsed, as industrial production fell by roughly 50%.  It was factory workers losing jobs that explains the Great Contraction, not farm workers.  Yes, farm workers continued losing jobs, but there was no longer any place in the cities for them to find jobs.  Why not?  Because NGDP fell in half between mid 1929 and early 1933.

Here’s Kling on oil prices:

Could “pumping up demand” help in such a situation? Perhaps. But if the recalculation story is right, the higher demand could end up not doing much for employment. Instead, it might only do a lot to raise oil prices.

Of course more demand could raise nominal oil prices by boosting inflation.  But with CPI inflation running around 1% it’s more likely that Kling is referring to an increase in real, or relative, oil prices.  Could monetary stimulus boost real oil prices?  Absolutely.  But if and only if it raised expected levels of output and employment.  In other words, if and only if it was expected to work.

In my next post I’ll address Tyler Cowen’s ZMP workers argument.