Thursday, September 18, 2008

Unemployment is the problem

In his Sunday commentary in the Washington Post, "Quit Doling Out That Bad Economy Line," Donald Luskin used the last quarter's reported GDP growth, which came at an annualized rate of 3.3%, to claim that the economy is actually in great shape. Most people found this self-evidently absurd. But even putting aside the much lower GDP growth rates in previous quarters (conveniently ignored by Luskin) and the likelihood that the most recent result will be revised downward as more data comes in, his approach is fundamentally misplaced. The most serious consequence of recessions isn't a slight drop in GDP; it's the unemployment that should concern us.

Back in the 1980s, economist Robert Lucas attempted to mathematically estimate the cost of fluctuations in economic output. His idea was simple: what price should we pay in exchange for a permanent smoothing of the business cycle? He wanted to estimate what the cost of growth that isn't stable -- maybe it's -1% one year and 5% the next, instead of a consistent 2% -- really is.

His result was shocking. Using reasonable values for all the relevant economic parameters, including risk aversion, he claimed that we should only be willing to pay the equivalent of .1% of lifetime consumption, even for a complete smoothing of economic growth. It's hard to imagine any theoretical result less consistent with the immense weight that voters and politicians place on preventing recessions.

But there was a catch: Lucas's model used the concept of a "representative agent," where losses in production are felt by a single entity that "represents" consumers more generally. This isn't necessarily bad -- often economists need representative agents to make their models tractable -- but in this case, it's a critical decision. Temporary jitters in the growth rate hardly make any difference to the welfare of a single agent. If your wages fall 1% this year and increase 5% next year, you might be a little annoyed, but your life won't drastically differ from the parallel universe where you receive constant raises of 2%. 

The real economy, however, consists of many different consumers, some of whom feel the effects of a recession much more intensely than others.  A 100% drop in income for one person, obviously, is a lot worse than a 1% drop for 100 people. If we average out the effects of a recession using a "representative agent," we'll barely begin to capture the pain that it causes, making Lucas's 0.1% figure an extreme underestimate.

Lucas's calculation, however, does have some value: it shows us what the real problem with economic fluctuations is. In a world without unemployment, where gains and losses are shared among all consumers, we have little reason to care about the perfect stability of the economy. But in a world where some families experience sudden, severe changes in income, we have a very serious problem to address.

This is why Luskin's fixation on short-run GDP is so wrong. Our current downturn is painful because it's throwing millions more people out of work. That's much more important than transitory fluctuations in GDP.

1 comment:

Ellen Cheng said...

lucas research is amazing...but stable growth seems more meaningful, as people could have a certain expectation of economy growth. growing too fast or grow too slowly will cause some unrest. and a stable economy growing shape also interacts with other good relative policies and a mature government.

by the way, I have seen your resume...you make me redefine what a talent is, that's all. T.T