Against Top-Down Macro

PSST is bottom-up instead

I talked about this on Monday, November 7.

What everyone thinks of as macro is top-down. Nominal Gross Domestic Product is determined at the top, and it filters down to individuals.

In Scott Sumner’s market monetarism, for example, the Fed has a dial, like the temperature control on an oven, that it can turn in order to keep NGDP on a trend path. When NGDP differs from that trend path, the Fed has messed up.

I think that the Fed’s controls are ineffective. They are more like the steering wheel on a bumper car. If you’ve ever been on a bumper-car ride, you know that as much as you want to avoid getting hit from the side or from behind, you just do not have as much control over the car as you would need.

I think of NGDP as built from the bottom up, not from the top down. Households and businesses create patterns of specialization and trade. That is real output, or real GDP. They make pricing decisions. Once you have prices and real output, you have NGDP.

There is a relatively new macroeconomic statistic, called JOLTS, or Job Openings and Labor Turnover Survey. It shows that each month, about 4.5 million people take new jobs, and about 4.3 million people separate (voluntarily or otherwise) from their previous jobs. These flows are enormous. The payroll employment survey, in contrast, will show a net gain or loss of about 200,000 jobs in a month. That is only 0.2 million.

It is the small net number of job gains or losses that determines the change in real GDP. A huge amount of bottom-up churning (4.5 million new jobs) lies underneath the GDP gain, which comes from the net new jobs (0.2 million).

Each of the 4.5 million new jobs represents a new pattern of specialization and trade, but each of the 4.3 million separations represents an old pattern that is disrupted. Some of the 4.5 million new jobs are actually old jobs with new occupants. In other cases, new businesses are being formed. Or established firms are trying out new projects to try to innovate for the customer, reduce costs, or manage more effectively. Some of the new businesses and new projects will turn out to be sustainable, and some won’t.

Why does total employment fluctuate? I believe that when the economy is not suffering from shocks and when capital is sufficiently abundant, the process of creating new patterns of sustainable specialization and trade has forward momentum. Those conditions describe an economic upswing.

I think that as we approach a minimum level of unemployment, businesses start to hoard labor. They hold on to workers who are not very productive at the margin “just in case” they might be needed. They hoard workers because finding new ones is difficult. If capital remains abundant, new firms can get funding while “zombie” firms can persist.

There is a lot of current talk about labor hoarding. Malcolm Kyeyune writes,

Twitter couldn’t have gone much longer without massive layoffs. The same thing is happening across Silicon Valley. Last week, the online-payments company Stripe announced it would cut 14 percent of its workforce, as did the rideshare giant Lyft; Facebook parent company Meta looks poised to do the same. Like Wile E. Coyote, tech companies ran off the cliff long ago; only now is economic gravity starting to assert itself.

But as I recall, many years ago there was talk about the “end of expansion productivity effect,” in which labor productivity fell late in an expansion. It seemed as if in a really hot economy, firms would take on and keep workers who were not doing much for output.

But eventually, investors will see that firms are not delivering the desired profits, and capital will tighten. In order to reduce borrowing needs and/or please shareholders businesses go into cost-cutting mode and reduce workers. Zombie firms finally go out of business.

When firms decide to shed excess labor, they may do so all at once. When you see another firm getting rid of workers, you decide that it is safe to cut your own staff. If you need new workers in a few months, it will not be hard to find them. You stop hoarding labor. You get broad-based employment declines because of this sort of herd behavior on the part of firms.

Inflation also is driven somewhat by herding. If other businesses are keeping prices steady, you will upset your customers if you increase prices. But if prices are rising in general, it is safer for you to try to push through a price increase.

Inflation thus tends to have two regimes: low and steady; or high and variable. Transitioning from one regime to the other is difficult.

Government creates paper wealth by running deficits without producing anything. Paper wealth also rises when price/earnings ratios increase in the stock market. I think that when people have a lot of paper wealth, eventually that will trigger a move into the high and variable inflation regime. If government slows down its deficit spending, eventually inflation will drop back into the low and steady regime.

How would I use the bottom-up framework, which I call Patterns of Sustainable Specialization and Trade, to look at today’s economy? We can ask which patterns of trade might break up soon. One possibility I foresee is a decline in hiring in the non-profit sector, which employs about 10 percent of American workers. The loss of stock market wealth is likely to cause a drop in contributions to nonprofits as well as a decline in the value of endowments.

The construction industry will shrink some, because of higher interest rates. And we have seen some major tech firms announce layoffs in order to trim expenses. The job openings in retail businesses might absorb some of the workers from other industries, but I doubt that the college graduating class of ‘23 who are hoping for jobs in the non-profit sector will want to work for Chick-Fil-A. So I think we will see some modest declines in the net increases in employment.

To buy into the bottom-up view of how NGDP gets built up, you have to discard the assumption that the Fed is in control. Dropping that assumption takes many people out of their comfort zone.