Recession Supply Debate

I have shown that there is a close theoretical relationship between crowding out (of government spending) and the quantity effects of supply. To recap,

• the crowding out view of government spending says that supply is scarce in the aggregate: if you want more employment and output, factor rents have to adjust to induce suppliers to be willing to do the work that it takes to have a job and be productive. The higher factor rents created by public sector demand will reduce private sector factor demand.
• by the same logic, a significant increase in labor supply should significantly increase employment and output, precisely because supply is scarce
• Thus, if you think crowding out is unimportant, you must conclude that supply is not an important determinant of the aggregate quantities of employment and output.

My recent paper reviews this theory, and offers evidence from the 2008-9 recession that aggregate employment was impacted by supply. Yesterday, I updated part of that work: my work on the aggregate effects of seasonal supply shifts (thanks to NGM for the link and cliff notes!).

In doing this work, I have benefitted from discussions with Dr. Gauti Eggertsson at the FRB of NY, who believes that fiscal policy has no crowding out effect at times like this, when the economy is supposedly in a liquidity trap.

So you may be interested in our exchange to date (NOTE: our exchange is ongoing, and I expect that Dr. Eggertsson has some new points yet to make, or will help me better understand points he has already made).

• Summer 2009: Dr. Eggertsson was working on his theory paper claiming that, in a liquidity trap, the economy would paradoxically react to MORE labor supply by having LESS employment. He told me about this in September when I visited FRBNY.
• Summer 2009: Although not yet aware of Eggertsson's paradox, I was skeptical of even the more moderate view that "supply matters less during a recession." As soon as the July 2009 employment data was released, I ran my first test on the seasonally unadjusted employment series. It showed that labor supply does affect aggregate employment, and to about the same degree that it did before the recession.
• Fall 2009: I learned about Dr. Eggertsson's Paradox of Toil paper, as well as Professor Woodford's paper claiming that crowding out effects might (in theory) disappear in a liquidity trap, so I began to collect the various Great Recession labor market events that might confirm or contradict their claims, and emailed some of my results to them (my paper was later distributed more widely by NBER).
• May 2010: Dr. Eggertsson kindly wrote back, and pointed me to his new reply paper. In his view, empirical work that properly tests the aggregate effects of supply shifts in a liquidity-trapped economy could not only confirm or reject his particular model, but "pretty much any model that features nominal rigidities" (p. 2, emphasis in the original). So a lot is at stake here!
• May 2010: With regard to my seasonal fluctuations test, Dr. Eggertsson said that a seasonal labor supply increase would not REDUCE employment (even while other sorts of labor supply shifts would), but would leave it UNCHANGED: compare Figures 1 and 2 in his reply paper, respectively.
• July 2010: I write back to Dr. Eggertsson that his Figures 1 and 2 are hardly different in the sense that they BOTH say that the aggregate effects of supply are fundamentally different in a liquidity trap than they "normally" are. Figure 1 says that more labor supply reduces aggregate employment, Figure 2 says aggregate employment is unchanged; both of those are fundamentally different than my view that more labor supply INCREASES aggregate employment regardless of the state of the liquidity trap. The seasonal data support my view, and contradict both his Figure 1 and his Figure 2.
• July 2010: I also wrote requesting guidance as to, in theory, which labor supply shifts, and which fiscal policy shifts, should be analyzed with his Figure 1, and which should be analyzed with his Figure 2. In any case, both versions of his theory are contradicted by the seasonal employment data
• ... more to come.