«BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW Jeffrey C. Fuhrer and Scott Schuh* In the summer of 1997, when the Federal Reserve Bank of ...»
Caballero contends that the term “job reallocation” is a misnomer.
He does not dispute the fact that Schuh and Triest’s measure of job reallocation is countercyclical. However, he argues that the main feature of job reallocation over time is a signiﬁcant ﬂuctuation in total job destruction that is unconnected with the process of total job creation.
Thus, while individual jobs are destroyed and created at the plant level, thereby generating worker reallocation, it is what he calls a “dynamic fallacy of composition” to infer that a link exists between total job destruction and creation that could be characterized as total job “reallocation.” Put another way, job “reallocation” would be higher if job destruction rose now and fell later while job creation stayed constant, but
BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW 25it would not be true in this case that job losers were reallocated to new jobs.
Caballero cites evidence from his own research that the surge in total job destruction during recessions is more than offset by a decline in destruction during the subsequent expansion. He calls this latter effect “chill,” where job destruction falls below the rate associated with the “normal” underlying level of job turnover in the economy. He argues that it is important to understand that this chill can arise from market imperfections and produce technological sclerosis as a result of insufﬁcient turnover. This argument contrasts with theories earlier this century that suggested that all job turnover is healthy for the economy.
Caballero believes “it is a large leap to claim that reallocation shocks are a substantial source of business cycles, at least in the United States,” although he thinks they might be important elsewhere such as Eastern Europe, for example. He argues that plausible statistical models show that reallocation shocks are “substantially” less important than aggregate shocks, at least for net employment growth. He also demonstrates that such models can produce confusion about the relative importance of job reallocation, and asks whether the “fragile decomposition” of shocks as aggregate versus allocative is worthwhile, compared to focusing on observable shocks such as prices or interest rates.
In general, Caballero thinks it is a mistake at this point to focus on trying to discover whether or not reallocation shocks cause business cycles. Instead, effort should be directed toward the less debatable issue of whether “the churn [ongoing processes of creation and destruction] has a signiﬁcant effect on the economy at business cycle frequencies.” Steven Davis shares the ambition of Schuh and Triest to develop new evidence on the connection between job reallocation and the business cycle. Indeed, he devotes a signiﬁcant portion of his comments to explaining why this endeavor is important. But Davis, too, challenges the claim that reallocation activity is countercyclical, and he argues further that total job reallocation is inappropriate for this analysis. He also suggests a more effective methodology for summarizing the relationship between job ﬂows and plant characteristics.
Davis provides a detailed description of the dynamic nature of job and worker ﬂows and then advances several reasons why it is important to study these ﬂows. First, “the extent to which the reallocation and matching process operates smoothly determines... the difference between successful and unsuccessful economic performance,” with European unemployment serving as a prime example. Second, successful conduct of policy requires accounting for the reallocation and matching process. Third, recent modeling of reallocation frictions and heterogeneity makes it evident that aggregate shocks have allocative consequences, and shocks to factor demand can drive ﬂuctuations in economic aggregates. Fourth, “models with reallocation frictions also help to address 26 Jeffrey C. Fuhrer and Scott Schuh some well-recognized shortcomings in prevailing theories of the business cycle.” Davis believes that Schuh and Triest err in treating gross job reallocation “as equivalent to the intensity of reallocation activity.” His criticism is that gross job reallocation does not account for the fact that movements in job creation and destruction merely may be achieving changes in total employment instead of reﬂecting a fundamental reallocation of labor across plants. Davis argues that the amount of job reallocation in excess of the change in total employment is a more suitable measure of reallocation intensity. He reports evidence that, unlike total job reallocation, excess job reallocation is uncorrelated with the business cycle.
POLICY IMPLICATIONSIn the closing session, leading economists from the public and private sectors discussed the implications for government policies of the conference’s analysis of the causes of recessions. Panelists focused especially on the important role of vulnerability in setting the stage for unanticipated or adverse events. Each argued that governments should implement policies to reduce the economy’s vulnerability and exposure to risk, provide more and accurate information to private agents about the extent of risk, and—if necessary—aid the recovery of economies that plunge into crises.
Henry Kaufman believes that sweeping structural changes to ﬁnancial markets in recent years have signiﬁcantly altered the linkages between ﬁnancial markets and the real economy. Among the developments he identiﬁes are securitization, derivatives, globalization, and leveraged investing. Several themes pervade his analysis. First, global ﬁnancial markets are becoming increasingly sophisticated and complete.
Second, this maturation process increasingly makes ﬁnancing available to borrowers who would not have been able to obtain it previously. Third, and a consequence of the ﬁrst two points, ﬁnancial markets are becoming increasingly volatile, as risk-taking becomes easier while accurate risk assessment becomes more difﬁcult. Altogether, these changes increase the likelihood that ﬁnancial market turbulence will make economies more vulnerable to shocks and recessions.
Kaufman believes the changes increase the difﬁculty and reduce the efﬁcacy of monetary policy. Monetary policy is more difﬁcult because traditional monetary factors—monetary aggregates, debt aggregates, and the like— have become less reliable indicators of the stance of monetary policy and the state of money markets. Monetary policy is less effective because increased availability and easier acquisition of credit mean that short-term interest rates must increase more to achieve the same real response. Furthermore, increased volatility in asset prices (wealth) leads
BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW 27to greater volatility in aggregate economic behavior. Thus, he argues, the Federal Reserve should take asset price developments explicitly into account in formulating monetary policy.
Internationally, Kaufman sees a need for increased supervision of ﬁnancial markets. Paradoxically, he notes, when ﬁnancial markets become deregulated and “freewheeling,” the need for more accurate, timely, and complete information increases, particularly about the risks in which ﬁnancial entities are engaging. He decries the poor job of oversight and information gathering done by ofﬁcial institutions thus far and proposes several reforms. In particular, he recommends a new body he calls a Board of Overseers of Major Institutions and Markets, which would set a code of conduct, supervise risk-taking, and harmonize capital requirements.
Kaufman also favors reforms to two international economic organizations. First, the IMF should be reorganized to specialize in a narrower set of core functions. The new IMF would continue to facilitate lending to countries in ﬁnancial distress and to press for reform in government policies in these countries. But it would also be charged with rating the creditworthiness of countries, by assessing economic and ﬁnancial conditions, reviewing extant government policies, and demanding remedial action where needed. Kaufman also argues that the G-7 must be restructured to account for the European Monetary Union and its euro currency.
Martin Zimmerman provides perspective from one of the largest and most cyclical components of the U.S. economy: the automobile industry. He explains how the auto industry, speciﬁcally Ford Motor Company, views the unfolding of a recession— how consumers postpone their car purchases, how auto makers respond to weakening sales, and how interest rate policy is an important determinant of the economic fortunes of the auto industry. But ultimately he argues against the central theme of the conference. That is, Zimmerman believes it is impossible to go “Beyond Shocks.” The economy is always subject to shocks, according to Zimmerman.
For the auto industry, a shock is anything that causes consumers to suddenly alter their normal plans to purchase new cars. Zimmerman tells the story of how the 1990-91 recession unfolded. As late as June 1990, economic forecasters were predicting conﬁdently that there would be no recession, only a slowdown. But Iraq’s invasion of Kuwait and the U.S.
military response caused a precipitous drop in consumer conﬁdence and sales of cars to consumers. The shock of the Kuwait invasion, like all shocks, by deﬁnition was not forecastable, says Zimmerman (an assessment that was not well-received by his employers, he adds wryly).
Although shocks are pervasive, the central question is whether the shocks will tip the economy over into recession. Here, he asserts that not all shocks do, in fact, trigger recessions. The economy must already be vulnerable when the shocks hit. Absent this vulnerability, the economy 28 Jeffrey C. Fuhrer and Scott Schuh may be able to withstand shocks. Likewise, absent shocks, vulnerability may never result in a recession.
What is the role of policy in a world of vulnerability and inevitable shocks? Zimmerman notes that every precipitous drop in auto sales has been associated with an increase in interest rates, so he tends to associate monetary tightening with the emergence of economic vulnerability (weak growth). But because not every increase in interest rates was followed by a recession, he surmises that a shock is required to turn vulnerability into recession. He asserts that monetary policy cannot prevent shocks because they are inherently unpredictable. Instead, policy should minimize vulnerability of the economy.
Agustin Carstens contributes a view of recessions and policy from the perspective of emerging economies such as Mexico. He identiﬁes ﬁve characteristics of business cycles in emerging economies that distinguish them from business cycles in industrialized economies. First, business cycles in emerging countries are closely synchronized with the fortunes of industrialized countries: “When the United States gets a cold, Mexico gets pneumonia.” Second, business cycles are more volatile in emerging economies. Third, emerging economies are susceptible to additional sources of volatility, such as terms of trade ﬂuctuations. Fourth, and more recently, increasing globalization of markets has encouraged massive capitals ﬂows into emerging countries like Mexico. But these capital ﬂows are very unstable, so emerging countries can experience sudden and massive capital outﬂows that devastate their economies. Finally, emerging economies have to deal with exchange-rate regimes and their failures.
These characteristics force emerging economies to adopt very different policies to deal with business cycles. Industrialized countries, as leaders of the world economic engine, follow policies designed to manage aggregate demand so as to achieve low inﬂation and full employment.
Such policies are countercyclical. In contrast, emerging countries follow policies designed to avoid or mitigate economic crises that break out there, often because industrialized countries are slumping and reducing their demand for emerging country exports. One essential goal of these policies is to reestablish the credibility of emerging economies, especially the credibility of their currencies and ﬁnancial markets. Often this means reestablishing the credibility of governments that have made bad policy decisions. These types of policies, then, are usually procyclical.
Carstens offers four speciﬁc policy recommendations for emerging economies to help them to reduce vulnerability and follow a more stable path. First, they must reduce their vulnerability to changes in the international prices of exports, by adopting more open trade and investment regimes. Second, they should allow market determination of interest and exchange rates so these rates can accomplish their purpose of absorbing shocks. Third, they must ensure the robustness of their ﬁnancial institutions to macroeconomic ﬂuctuations. Fourth, they should
BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW 29push forward with structural changes in order to achieve central bank autonomy, privatization of production, labor market ﬂexibility, and reduced dependence on foreign saving. In each case, more complex policies are required beyond the traditional demand management schemes followed by industrialized countries, Carstens notes.
Michael Mussa, as a leading ofﬁcial at the International Monetary Fund, offered an informed, practical—and oftentimes contrarian—view of the conference papers, the conventional wisdom about the ongoing global economic crises, and recent criticisms of international policy responses to the crises.
Mussa infers from Sims’s paper that systematic monetary policy does have a signiﬁcant, positive effect on the real economy, despite Sims’s claim to the contrary. He says Sims understates the effect of monetary policy, citing Sims’s own results showing that industrial output would have been nearly one-ﬁfth higher if the Fed had followed modern monetary policies during the Great Depression. He also points out that Sims omits the positive role monetary policy can play in avoiding banking and ﬁnancial panics by subsidizing and reforming weak banks, and by reassuring depositors that their accounts were safe. Had Sims accounted for this, and for the fact that ﬁscal policy should have been more aggressive, one-half to three-quarters of the impact of the Great Depression could have been avoided.