Preparing for Disaster

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Hurricane Irene traveled the East Coast last weekend and was expected to be one of the rare hurricanes to hit New York (by the time it reached there, it had been downgraded to a tropical storm). Although many thousands of people in the region may be without electricity for days to come, New Yorkers are glad that Irene did little damage as hurricanes go.

The storm began to receive media attention the weekend before it arrived, and people in the New York area used the time to prepare themselves. Forecasters have been criticized for overestimating the amount of wind that New York would experience, but the winds and tides were plenty strong. Preparation was an important reason that damage was limited.

For example, the eye of the storm passed right over Kennedy International and LaGuardia Airports, but planes did not crash because the airports were shut during the storm. Few lives and little cargo was lost from ships in the area because the ports were closed, and vessels moved out of the area.

Hundreds of thousands of people were left without power, and many homes were flooded. But, clearly, the damage would have been much worse if Hurricane Irene had hit with no warning.

I have no expertise in climate, weather, physics or aerodynamics, but one of the lessons of economics that environmental changes are less harmful when they can be anticipated. With only a few days of preparation, as with Hurricane Irene, people and mobile capital can be moved out of harm’s way. Protective barriers can be constructed for the immobile capital like homes.

New York was not given a definite warning of Irene a year ahead, let alone a decade ahead. But if it had been warned years ahead, the economy could have adjusted even more by making plans to locate activity in more protected places. Or perhaps even to invent goods and production processes that are more hurricane resistant.

The opportunities for preparation are one reason why economists expect the damage from global warming to be different, and perhaps less, than from natural disasters that hit by surprise.

Global warming is expected to raise temperatures and sea levels over a period of decades – perhaps centuries. Even if scientists are completely unable to retard or reverse the environmental consequences of global warming, thanks to decades of warning the economy can greatly adjust to minimize the economic costs of those environmental consequences.

That’s the thesis of a recent book, “Climatopolis: How Our Cities Will Thrive in the Hotter Future,” by Matthew Kahn of the University of California, Los Angeles (disclosure: Professor Kahn is a friend and was my classmate at the University of Chicago). Given advance warning, people will protect themselves and innovate in order to make sales in future market when the symptoms of global warming are more threatening.

A Fallacy of Composition

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In 2009 the New York Yankees opened their new stadium on the north side of East 161st Street, replacing the historic stadium on the south side of the street. Not surprisingly, 2009 spending by consumers, news organizations and entertainment businesses, among others, on the north side of East 161st Street was a lot more than it had been in years past. It all started from the Yankees’ spending at the new location.

So a spending advocate might assert that this episode is proof that spending by one organization can stimulate spending by others, because the spending by the others on the north side of the street surged at exactly the same time that the Yankees started having their people work there.

Of course, such an analysis is flawed, because it ignores what happened on the other side of the street. Much of what happened north of East 161st Street was just a displacement of activity from the south side, rather than a creation of new activity. Even the construction workers building the stadium may well have been drawn from other tasks.

This pattern is not special to the Yankees’ move. A number of studies have shown that consumer spending associated with a sports team to a large degree displaces spending in other areas and displaces spending on other leisure activities; a family is unlikely to conclude that because there’s a new team in town or a new stadium, it should sharply increase its spending on entertainment.

Yet ignoring the displacement effects is exactly what Paul Krugman and Dean Baker have done in their praise of recent studies that use “cross-state variation in stimulus spending per capita to estimate the employment effects of the stimulus,” studies comparing states that received more stimulus to states that received less.

Spending from the American Recovery and Reinvestment Act (a.k.a., the “stimulus”) could be very much like the stadium spending — a locality that received more stimulus spending merely enjoyed a displacement of activity into its area from localities that received less spending, and that nationally little or no additional spending occurred as a result of the legislation.

If you want to know about the national effects of the stimulus, at least part of the analysis has to look at the nation as a whole. The same is true of the national effects of changes in labor supply. If one group suddenly becomes more willing to work, it is possible that the group solely takes jobs from the rest of the population, with no new jobs being created for the nation as a whole.

That is why, in addition to looking at the experiences of specific groups and specific regions, I have examined the effects of supply and demand on national employment. (Professor Krugman and Dr. Baker assert in so many words that I ignore national employment, though my papers on the subject look very much at national aggregates. For example, see Figure 3 and Figure 6 of this paper and Table 2, Table 3, Figure 2, Figure 3, Figure 4 or Figure 5 of this paper).

I found, for example, that national employment increases during the summer precisely because young people are more willing to work. Not surprisingly, the summer surge of young job seekers does seem to reduce employment of the rest of the population, but the net national effect is still almost a million more jobs in the summer.

For now, it appears that government spending reduces private spending, even while it may benefit specific regions or groups.

Exceptions to Keynesian Theory

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While taxpayers have been wondering if all of the extra government spending of the past couple of years has actually served to impede the recovery, Keynesian economists have been asking them to keep faith in the promise that government demand is the secret to economic recovery. Now Paul Krugman, an outspoken Keynesian stimulus advocate, admits that Keynesian theory has many exceptions.

It’s pretty easy to see how various types of government spending might reduce employment, rather than increase it: a number of government programs have been reducing the incentives for people to work, and reducing the incentives for business to hire.

Unemployment insurance is an example (among many) of how the work incentives of so-called stimulus programs operate. Unemployment insurance payments to individuals cease as soon as the individual starts to work again. I agree that such payments are compassionate, and may well be the right thing to do, but economists have long recognized that such compassion is not free: unemployment insurance reduces employment, rather than increasing it, because it penalizes beneficiaries for starting a new job.

Without offering any proof that incentives suddenly ceased mattering, stimulus advocates, and even the Congressional Budget Office, have recently ignored this effect. Many of them aim to prove the potency of unemployment insurance and other components of the stimulus law by insisting that the recession was caused by a lack of demand, and that any public policy that raises aggregate demand must be a big help.

Even if they’re right that the recession was a result of low demand, it does not follow that the way to recovery is to destroy supply, too. Before we turn away from one of the basic lessons of economics, we ought to have some evidence of the fundamental Keynesian proposition that “incentives to seek work are, for now, irrelevant.”

(Another tendency of Keynesians is to “prove” their supply claim by pointing to the existence of unemployment. Of course, unemployment exists in large numbers, but that does not tell us whether, and how much, incentives affect employment rates.)

Part of my research has been to examine episodes, from the current downturn, of changes in the willingness and availability of people to work. If, as Keynesians have been insisting, the incentives to work are in fact irrelevant in a recession, then none of these episodes would be associated with employment changes. (In their view, an increase in the number of people willing to work would just increase, one for one, the number of people who are unemployed.)

I looked at seasonal changes in labor supply. I looked at the increase in supply of workers to the nonresidential construction industry (workers who were leaving home building after the crash). I looked at the increase in the supply of elderly workers. I looked at the increase in supply of workers in Texas. In all of these recession-era episodes, more supply meant more jobs, and less supply meant fewer jobs.

(I also looked at some recession-era demand changes to see if they were at all constrained by supply, and they were — very much as they were before the recession.)

There is still no evidence to confirm the fundamental Keynesian proposition that supply doesn’t matter.

Rather than completely discard that proposition, Professor Krugman has recently formulated a theory of exceptions to the Keynesian theory, which he believes can help explain some of my findings:

Here’s the question: why do patterns of employment over time that are, in fact, normally supply-driven continue to be visible even during a demand-side slump? And here’s the answer: businesses make long-term decisions that influence hiring patterns over time, and those decisions continue to shape their behavior even when there is a surplus of labor.

In other words, Keynesian theory has exceptions that have to do with business’s long-term hiring decisions. For example, businesses have lived through enough seasonal cycles to know that they can normally make more money when their hiring patterns are responsive to the seasonal availability of people to work, so businesses continue to be responsive to the seasonal pattern of labor supply even during a deep recession when there are plenty of workers available throughout the year.

I don’t understand how Professor Krugman explains that the nonresidential construction industry took advantage of the plentiful supply of home builders after housing crashed (he also has no explanation for my minimum wage findings, Christmas seasonal findings or elderly employment findings). He also fails to explains why some business hiring patterns survive the recession intact, while other practices are completely different (e.g., businesses used to think they needed 138 million payroll employees, but by 2009 they got by with fewer than 130 million).

But even if Professor Krugman were correct that the ghost of labor supplies past haunts the recession through business’s long-term decisions, how can he be so sure that the labor-supply effects of government spending programs would not also have the same effects they did in the past?

For example, employers found that people were more difficult to hire and retain when a generous safety net was available. In this way, unemployment insurance would continue to reduce employment even after the recession began because employers have learned that the more generous the safety net, the more they must get by with fewer workers.

Would Keynesian stimulus spending work only when it came as a surprise? Or only when the spending was outside the range of prior business experience? Keynesian economists have not even begun to answer these questions. For now, Keynesian theory has so many exceptions that we might as well discard it.

Supply of Admissions

Professor Krugman is slowly converging to my view that supply matters even during recessions. I'll explain more tomorrow in a more lengthy blog post, but the basic idea has been in my seasonal supply paper (see the final para).

The Debt Downgrade and Stock Prices

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The big financial story in the last few days has been the declaration by Standard & Poor’s that United States government bonds were no longer worthy of its AAA rating. The agency, in a nutshell, thinks there is some chance that the government will default or be delinquent on its debt payments.

The announcement was followed by a wild ride in the stock market in the last two days — a plunge of almost 7 percent in the Standard & Poor’s 500-stock index on Monday, followed by a surge of almost 5 percent on Tuesday.

But with the index down almost 18 percent from its April peak, it is clear that investors’ concerns long predated the downgrade.

The real news is how poorly the economy is doing, and how poor its prospects seem. The chart below shows the changes in several indicators of economic activity over the last nine months. The blue series is an inflation-adjusted stock price index, which (even with Tuesday’s big gain) is lower than it was nine months ago. Through May 2011, real housing prices (black series) were down 7 percent. Real consumer spending (red series) has failed to increase, and inflation-adjusted spending on consumer durables has fallen four months in a row.

All of these indicators are forward-looking in the sense that they depend on what people expect to happen to incomes and profits in the future. These indicators had been looking better during much of 2010 but now it seems that consumers and investors are not optimistic about what is ahead (are they worried about riots like in London? higher taxes? government program cuts?).

In my view, a rating agency does not move the market but rather reacts to some of the same prospects that are reflected in the decisions of consumers and investors. For example, to the degree that incomes continue to remain low, tax collections will also remain low, making it that much more difficult for governments to pay their obligations.

Recovery for the stock market, and the wider economy, needs a lot more than an agency to change its mind about government bond ratings.

Previous Trends Continue: More Evidence that Supply Matters

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The supply of various types of workers has increased during the recession, continuing an earlier trend. That such trends continue to be associated with trends for employment contradicts the Keynesian claim that supply suddenly stops mattering during recessions and “liquidity traps.”

A number of bloggers have pointed out that employment in Texas has been rising and has almost reached prerecession levels. Paul Krugman’s explanation is that the supply of people available and willing to work has been increasing in Texas, continuing a previous trend.

One example of that supply is the inflow of immigrants from nearby Mexico; another is the migration of Americans seeking cheaper housing. I might quibble about the details, but I agree that supply trends are crucial for understanding what has happened in Texas.

In previous posts I have pointed out that national employment per capita actually increased among the elderly during the recession. I, and other researchers, concluded that elderly employment deviated so much from the general population because of changes in elderly labor supply.

In reaction to my post, Dean Baker attributed the elderly increase during the recession to a previous trend. Because the previous trend was itself the result of supply, Dr. Baker’s explanation of the recession is essentially a supply increase, too.

So we all agree that in at least two cases labor supply increased during the recession, and in each case the result was more jobs for the affected groups, or at least fewer job losses than in the general population.

Recession-era supply episodes like these are important to identify, because they can prove or reject Keynesians’ fundamental assertion (so far unproven) that supply does not matter during a recession or a “liquidity trap” such as we’ve experienced since the recession began.

Consider, hypothetically, an immigration trend that continued even after the recession. In my view, the market would create jobs for many, but not all, of the immigrants and would continue to do so after the recession.

In the Keynesian view, immigration might create jobs before the recession, but could not create them once the recession began because “what’s limiting employment now is lack of demand for the things workers produce,” Professor Krugman wrote. “Their incentives to seek work are, for now, irrelevant.”

In the Keynesian view, all that extra supply does during the recession is add to unemployment rather than adding to employment. In other words, supply trends normally affect employment, but Keynesians assert that they cease to affect employment during a recession or liquidity trap.

The chart below shows monthly employment (left scale) and unemployment (right scale) in Texas since 2007. Despite the fact that our nation is in a liquidity trap (near-zero interest rates on Treasury bills, the results of the extra supply in Texas since 2009 have been to increase employment much more than increase unemployment.

Data From The Federal Reserve Bank of St. Louis

Or consider that more recent cohorts have found themselves in careers that involve less manual labor, producing a increasing number of people reaching age 65 and still willing and able to continue their work. In my view, elderly employment would rise and might even be rising enough to more than offset a demand reduction during a recession.

In the Keynesian view, all that extra supply does during the recession is add to unemployment rather than adding to employment.

When it comes to analyzing specific events during the recession, fiscal stimulus advocates often take the common sense approach that labor supply affects employment. But when it comes to making promises about the anticipated results of a large fiscal stimulus, they insist, without proof, that supply doesn’t matter.