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What is an Economy?

An alternative theory of the Great Recession.

2:12 PM, Aug 9, 2010 • By MATTHEW CONTINETTI
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Whatever Arnold Kling writes, I read. So I made sure to read his essay in AEI's American, "When Labor is Capital." So should you!

Kling's article is about two theories of what constitutes an economy. For Keynesians, "economic activity consists of spending," also known as aggregate demand. Hence, "when economic activity slows down, their prescription is to increase spending by government, businesses, consumers, or all three." The Fed's monetary response to the recession has had that goal in mind. The government's fiscal stimulus operated under the assumption that increased government spending would spur consumer spending and thus help the private economy indirectly.

Obviously, things have not worked out as advertised. How to explain it? One answer is that the response has not been commensurate to the challenge before us. This is Paul Krugman's answer: To keep the balloon inflated, government must spend more, much more, and the Fed must increase the money supply.

Kling has a different answer, which derives from his alternative theory of economies. For Kling, "economic activity consists of sustainable patterns of specialization and trade," not the total amount of spending. The financial crisis and Great Recession, therefore, are the consequences of unsustainable patterns. Here's Kling:

The economy was suddenly caught in an unsustainable pattern of production, which involved too much housing construction in the “sand states” of Florida, Nevada, and California as well as too much financial activity related to mortgages and mortgage securities.

The suddenly unsustainable housing and mortgage boom comes atop the ongoing obsolescence of various patterns of specialization, as the Internet and globalization continue to foster new forms of organization and competition. The result of the boom-bust cycle superimposed on the ongoing obsolescence is to overload the market's ability to reconfigure production patterns so that workers are fully employed.

The market needs to undertake a recalculation in order to deploy workers in a new, sustainable pattern of specialization and trade. The process involves gradual, decentralized trial and error. Firms need to be launched by entrepreneurs, who will make risky investments in employees. The failure rate will be high, but eventually the successes will have a cumulative effect that brings about more economic activity.

The challenge is made difficult by the increasing specialization of labor-capital. The problem of matching skills with needs in roundabout production is much more complex than the problem of adding or subtracting workers in final-stage production.

In other words, profound changes in the nature of the American economy made it unlikely that Keynesian solutions would produce a job-creating recovery. And, indeed, they did not.

Compounding the problem is the fact that government does not have a good track record determining sustainable patterns of specialization and trade. Rather, entrepreneurs use the market to determine those patterns through trial and error. Kling's prescription, therefore, is for government to align incentives for business creation. That might include a tax reform that lowers the corporate tax rate on one side and payroll taxes on the other, while broadening the overall tax base. It might include a Second Homestead Act that opens government lands to entrepreneurial developers. It might include a Henry Clay Infrastructure Bank for Internal Improvements. It might include a serious de-regulatory agenda. But above all it would mean abandoning the economic policies of the late Bush and early Obama administrations, and the zombie economy that those policies produced.

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