Understanding The “Sectoral Problem” In Business Cycles: A Note

by Mario Rizzo  

There has been some important discussion emanating from Paul Krugman’s unoriginal question implicitly about the Austrian Business Cycle Theory (as well as other sectoral theories of employment shifts both during and outside of business cycles). (See Econbrowser, Marginal Revolution, Econlog, Angry Bear, for examples.)   

His question, as Tyler Cowen states it: “…[W]hy, say, a housing boom – which requires shifting resources into housing – doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.” 

The question was asked, in more general form, in 1937 in Gottfried Haberler’s Prosperity and Depression in his analysis of “monetary overinvestment theories.” This was pointed out by Roger Garrison in 1999. 

I suggest an answer to the general form of the question: Why does the boom — which misallocates resources to certain sectors — not cause unemployment as labor moves into those sectors, and yet the bust causes unemployment as those resources are re-allocated? 

In  Hayek’s theory, the phenomenon hinges on (a) distinguishing between relative and absolute movements in the demand for labor; (b) the capital-complementarity of some labor inputs and (c) recognizing that the boom involves a temporary, but unsustainable, increase in aggregate output (that is, beyond the production possibilities frontier).  

(1) In the boom there is a relative expansion of capital goods production as the interest rate falls. This is relative to intermediate stages of production closer to consumption. But there is also increase in aggregate demand for labor. Therefore labor which “should” be unemployed (searching and the like) is absorbed into stages both far from consumption, as well as in consumption industries themselves. (The latter is due to the derived demand effect of interest rate reductions as savings decrease and consumption rises.)  

(2) In the bust there is a relative decline in production far from consumption. But there is also a decrease in the aggregate demand for labor.  

(3) Therefore in the first case labor is not so much thrown out of certain sectors and there are more opportunities for employment overall. While in the second case there are fewer opportunities overall and labor is thrown out, so to speak. 

So now why can the unemployment be prolonged?  

Labor can be specific in at least two ways. First, there can be skill-specificity. Certain workers can earn higher wages in certain industries because their skills are finely-tuned to the tasks in that industry. They will wait for things to sort themselves out before accepting lower-paid employment elsewhere. Second, there can be “capital-specificity” of labor. This is the idea that labor inputs are complementary to capital inputs. Now when the bust comes and capital goods production experiences a contraction, the relevant complementary factors are in short-supply relative to labor inputs previously employed. 

There may also be “secondary” problems as demand falls more generally due to unemployed factors of production and possible monetary contraction.  

If labor (and economists!) knew how all of these shifts would ultimately work out in detail, wages and prices would instantly adjust and there would be no business cycle as it is usually understood. But labor, capital owners, the Fed, Paul Krugman and I do not. And so we are where we are.  

(Acknowledgement: I have had some discussion of this issue with Roger Garrison of Auburn University, but he is not responsible for my errors.)

20 thoughts on “Understanding The “Sectoral Problem” In Business Cycles: A Note

  1. This is also marvelously explained by Richard Strigl in “Capital and Production” (published by the Mises Institute). His explanation, acknowledged by Roger Garrison in “Time and Money”, hinges on the idea of capital consumption in the intermediary stages of production, thus generating both higher investment in capital goods (and higher employment) as well as higher consumption during the boom. When the busts arrives, the new investment projects become unprofitable, thus generating lower productivity and higher unemployment; consumption also falls in ripple effects due to lower incomes but also higher money demand generated by uncertainty regarding future employment opportunities. The structure of production must be reset.

    Ultimately, the whole theory hinges on the role of time and, as you point out, capital specificity and complementarity.

  2. Bogdan,

    “…consumption also falls in ripple effects due to lower incomes but also higher money demand generated by uncertainty regarding future employment opportunities.”

    While this could be true, the demand in this case is not likely to be for actual money, but rather for something that can be fairly easily converted to money in the future, preferably earning interest in the meantime. Future employment uncertainty doesn’t likely produce a demand for a medium of exchange.

    Regards, Don

  3. Bogdan,

    “…consumption also falls in ripple effects due to lower incomes but also higher money demand generated by uncertainty regarding future employment opportunities.”

    While this could be true, the demand in this case is not likely to be for actual money, but rather for something that can be fairly easily converted to money in the future, preferably earning interest in the meantime. Future employment uncertainty doesn’t likely produce a demand for a medium of exchange.

    Regards, Don
    BTW I love your blog!

  4. Another way to express the point is to use the time to plan and time to build concepts developed in real business cycle theory.

    New capital takes time to plan and build and these plans are costly to change once started. Recruiting employers and job seekers must undergo a costly and time consuming process of search and matching before new vacancies are filled.

    Another aspect of real business theory that is relevent is Tim Kehoe’s work on sudden stops and output and productivity drops.

    A sudden stop of capital flows into a developing country tends to be followed by a rapid switch from trade deficits to trade surpluses, a depreciation of the real exchange rate, and sudden decreases in output and total factor productivity.

    The drop in total factor productivity arises from substantial reallocations of resources from the non-traded sector to traded sector.

    There are costs to adjusting the amount of capital and labour used in production in each sector. These adjustment costs result in drops in output. The reallocation of labor between the two sectors generates a temporary decrease in total factor productivity because of search unemployment, reduced capital utilisation, and retraining.

  5. What is necessary is to differentiate between “demand driven sectoral shifts in employment” and “loan driven sectoral shifts in employment”: the former explains what happens during the down-phase of the cycle and why there is full scale unemployment, and the latter explains the upward phase and why unemployment does not occur.

    It seems that Krugman does not recognize the existence of “loan driven sectoral shifts in employment”. What this particular type of shifts means is that when desired (or ex ante) savings do not equal actual investment (or ex post saving) (during the upward phase the latter>the former) firms do not spontaneously acquire the expanded “fake” savings and suddenly invest them. The preparation of projects and analysis of financial and cash flows allows for a gradual transformation of the structure of production, therefore the labor from one sector moves to the other in steps and once the firms have established the particular capital goods for labor to work with.

    Now, “demand driven sectoral shifts in employment” usually occur not through stages, but under the down phase they can hit quite fast, therefore firms are met not prepared and not having the necessary capital for labor to work with. Even under stationary economy, I contemplate, such “demand driven sectoral shifts in employment” would produce temporary unemployment.

  6. Jim Rose,

    I fully agree with you! Thanks for drawing my attention to Tim Kehoe’s work.

    Don Loyd,

    It depends of the channel at work and of the type of economic agent : wealthy investors anticipating bad times will hold hard liquid assets, like gold, or treasuries; but even some of them as well as the less wealthy individuals, will simply increase their money balances.

  7. The answer to why their is unemployment during the downturn, versus no such unemployment during the boom, seems in my view to require a monetary answer.

    Last October, I wrote http://tinyurl.com/7yssvy )in response to Krugman:

    “Before a boom starts, the economy can be said to be in equilibrium between the consumer goods production and capital goods production. When a central bank then pumps in new money, new demand is created for labor in the capital goods sector causing bidding for labor away from the consumer goods sector. Thus, there is no point where rising unemployment would be a factor in this part of the cycle. However, during the downturn part of the cycle, it is not a case that the central bank is pumping money into the consumer sector. What is occurring, instead, is that a transfer of money is taking place from the capital goods sector to the consumer goods sector. It is this money drain from the capital goods sector that causes the unemployment. During the central bank induced boom, money isn’t being drained from anywhere.”

    The different aggregate demand changes (as well as sectoral changes), it is true are at the core of the phenomena, but I think the best explanation must include an exact mention of the money influence that causes the differing changes in aggrregate demand.

  8. Production and employment are usually rising. Trying to think about the situation in the context of a static economy is a mistake.

    With a growing economy, shifts in the composition of output and employment can occur without anyone being laid off or the production in any sector falling. The question is how many capital goods specific to the various sectors should be produced. Sure, adding new workers means that less skilled workers are being added. Young unskilled workers are added to the production of various things. Of course.

    Some sectors grow more rapidly and others grow more slowly. Perhaps they don’t grow at all. Or they shink as capital goods wear out and workers retire. Over time, the composition of output and the allocation of labor and capital can change substantially.

    A large and rapid shift in the composition of output and the allocation of resources requires absolute reductions in the shrinking sectors. The shrinking sectors can shrink more quickly than the growing sectors can expand. Workers can be laid off and capital goods left idle. And so there is substantial structural unemployment as well as abandoned specific capital goods. Total production is depressed and only gradually recovers as labor is shifted to growing sectors, new skills are developed and new capital goods are produced.

    None of this is specific to the time structure of production. Think about a slow vs. a rapid changes in international trade.

    If there had been a sudden decrease in the demand for cars, (or drill presses) because people wanted to consume larger homes (or invest in new homes,) then there would have been structural unemployment in those shrinking sectors. But the boom in housing built up gradually over a decade. And the collapse was more rapid.

    I think much of the “Austrian” analysis of these issues fails to carefully distinguish between the reallocation of resources as the malinvestment ends and the secondary depression in expenditure. Think about the scenario where the monetary authority continues to expand the money supply, and just fails to accelerate enough to maintain the malinvestments. In that case, it is growing demand for consumer goods that pulls resources away from capital goods industries. If the adjustment is large and rapid enough, the problems described above occur.

    The answer, whatever the question remains, slow stable growth in nominal expenditure.

  9. The Austrian Business Cycle and Hayek’s theories seem to hold water in a half a century old glass bowl; but I question these theories in today’s new world economies when taking into consideration the rapid migration of skilled labor, technologies, resources, production, and capital. Their century old glass bowl seems to be cracked, the water level is falling, dollars are being flushed outside their glass walls leaving more unemployed and lower paying service jobs earning fewer dollars buying a smaller amount of goods. Capital will be retained and eventually will be reinvested, but I doubt much will be reinvested within the same walls. The capital will chase the better opportunities which lie outside, leaving us trapped within the walls with high unemployment, lower production, lower average wages and higher taxes for years to come. God help us if inflation rears it ugly head.

    I contend that the theories of Hayek and the Austrian Business Cycle were valid 65 or 75 years ago and must be considered when developing basic economic principles, but the migration of skilled labor, technologies, resources, production and capital must be considered beyond ones borders in today’s new world economy. I would also ask if education, population growth, average age, death rates, birth rates, and other important contributing factors should not be considered in modern day theories.

    My question to our distinguished economic thinkers,
    “Is not the 10% EU style unemployment here to stay in the USA?”

    Please help me understand where all these 12 million new higher paid jobs will be coming from.

  10. the period 1865 up until 1914 was known as the first great era of globalisation.

    In additional to globalised capital flows and global trade, there were the mass migrations to North America and other European ofshoots.

    Global investment flows, trade shares and migration flows have only recently recovered to the relative levels of pre-1914.

    Such was the global upheaval between 1865 and 1914, that the USA replaced the UK as global industrial leader. China or the EU may overtake in USA in this role by 2030.

  11. As has been suggested by several others, what goes on in the labor market is driven by what is happening in capital markets. As Lachman always reminded us, capital goods are heterogeneous. In a boom, the wrong combination of concrete capital goods are produced. Further, as Hayek emphasized, too much capital (savings) has gone into fixed capital goods at the expense of circulating capital. That is a classical concept, as is the implicit short-run wages-fund theory employed by Hayek. At the crisis, the economy runs out of liquid capital to complete capital projects and pay labor. What is happening in credit markets is a mirror of what has happened in the real economy. Printing money cannot solve a real scarcity of capital.

  12. O’Driscoll,

    What is “circulating capital” and “liquid capital?” And what is the “wages fund.” If these are money, then money creation can overcome any shortfall in them. On the other hand, if they are goods and services, what are they exactly? Is liquid capital nonspecific capital goods(and so “liquid?” Are we speaking of intermediate goods specific to the production of consumer goods? Is the “wages fund” consumer goods and services? Intermediate goods specific to consumer goods? Capital goods specific for the production of consumer goods?

  13. Bill Woolsey,

    The best Hayek reference would be to Prices and Production. And for Lachman, Capital aad Its Structure. You can also read the chapter on Capital in the Economics of Time and Ignorance.

  14. Thanks!

    I think I still have the Economics of Time and Ignorance on the shelf in my office. I’ll check it out.

  15. In addition to the earlier post about the high degree of international integration at the time that Austrian business cycle theory was developed, another why to explain that Austrian business cycle theory is not out-of-date is to point to the central importance of specific capital in today’s advanced economies.

    Multiple specific assets are central to Austrian business cycle theory as a whole and for how the crisis leads to resource unemployment. Specific assets must be scarped or eventually found some other use for which it is sold for at a loss.

    There is ample evidence of the dominant role of specific assets in modern economies.
    Specific human capital abounds.

    There is a vast new literature on organisational capital and firm-specific intangible capital which notes that much of this capital cannot be resold.

    Organisational capital and firm-specific intangible capital is thought to exceed the value of the physical capital of firms. Organisational capital and firm-specific intangible capital is central to several of the explanations of the 1991 and 2001 jobless recoveries.

    Human capital is the great majority of all capital. A substantial part of all human capital is specific to jobs, firms, industries and occupations. The great century long decline in job turnover and the proliferation of occupations is evidence of this.

    As I recall, Hayek suggested that Austrian business cycle theory has less to say about the under-developed countries because of their lack of capital.

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