Tuesday, December 23, 2008

Supply-Demand Accounting for the 2008 Recession

Let's look at labor quantities and productivity now and at the end of 2007 (when employment peaked and NBER says that the recession started):
  • From Dec 2007 to Nov 2008, aggregate hours are down 4.7 percent relative to the trend for the prior 36 months

  • From 2007 Q4 to 2008 Q3, productivity per hour is UP 1.9 percent, or 0.7 percent above the trend for the prior 12 quarters.

  • Productivity numbers are not in yet for 2008 Q4, but let's suppose that (as compared to 2007 Q4) they are 0.9 percent above trend (that is, continuing the pattern of the prior three quarters).

The graph below is a supply and demand representation of the situation, based on the assumption that labor demand has an elasticity of -0.3 --> with stable labor demand, a 4.7 percent labor reduction would be associated with a 1.4 percent labor productivity increase.


We see that Dec 2008 is explained mainly by a supply shift. The magnitude of the supply shift is not unusual as recessions go. The lack of a significant demand shift is.

I expect that economists and others will find this conclusion very controversial, even though this is exactly the kind of accounting that Murphy and Katz did on their well accepted paper on the skill premium. Indeed, their method is better applied here because we know more about the aggregate labor demand elasticity than we do about the cross-skill elasticity of substitution in production.

[Technical Note: I stretched the price axis for the purposes of illustration. If drawn to scale, the demand shift is even smaller relative to the supply shift than shown above. Assuming that labor demand follows Cobb-Douglas with 0.7 labor's share and the elasticity of labor supply is less than 2, then more than 90 PERCENT of the reduced quantity of labor is due to a labor supply shift.]

29 comments:

Karl Smith said...

I find this conclusion controversial because at the heart of it are the assumptions that all markets are clearing and that the data purely identifies underlying properties of the production function.

The first is problematic because a key feature of a recession is a rise in unemployment. At the very least people seem to be telling us that they are trying to sell labor and cannot.

Indeed, over the same period we have seen a 2 percentage point increase in U-3 unemployment. This is hard to square with only ,47 percent reduction in labor demand. Moreover, the rise in U-6 has been greater than U-3, suggesting some increase in involuntary reduction of hours worked.

Second, linking measured productivity and labor demand on such a short timescale seems problematic. Suppose for example, labor demand falls, and with it hiring falls and some new workers are laid off. We could very well expect measured productivity to increase, for several reasons including, an increase in the average worker experience level, a tendency to keep the most productive workers because non-differentiated pay, a reduction in labor spent training new workers.

Now economic productivity may not have increased because there is human capital which is not being produced and the remaining work force is experiencing a higher human capital depreciation rate, but none of that is captured in the data.

However, coming back to the original point, the challenge I see with recessions is explaining why there are periods with rapidly increasing unemployment levels. Its hard to do that if you are assuming market clearing.

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