Tuesday, February 9, 2010

Spain, Unemployment, and Recession

One of the great weaknesses of Keynesian analysis is its lack of any coherent theory of causality. John Maynard Keynes laid the "problem" of volatile investment spending (which he claimed was the cause of sudden downward shifts in "aggregate demand") to the "animal spirits" of investors.

Now, I hate to break it to people, but the manifestation of "animal spirits" within the investment community does not count as a causal mechanism in the turn of the business cycle. It is mere gibberish.

In his recent blog post on the rising unemployment and recession in Spain, while Krugman does not resort to "animal spirits," nonetheless he gives no sense of causality as to why there is high unemployment in that country. He writes:

...Spain’s troubles are not, despite what you may have read, the result of fiscal irresponsibility. Instead, they reflect “asymmetric shocks” within the eurozone, which were always known to be a problem, but have turned out to be an even worse problem than the euroskeptics feared.

After explaining how the real estate bubble also hit Spain (not surprisingly, contributing to the boom there), he then says:

But then the bubble burst, leaving Spain with much reduced domestic demand — and highly uncompetitive within the euro area thanks to the rise in its prices and labor costs. If Spain had had its own currency, that currency might have appreciated during the real estate boom, then depreciated when the boom was over. Since it didn’t and doesn’t, however, Spain now seems doomed to suffer years of grinding deflation and high unemployment.

Here is the problem: Spain's troubles ultimately are not due to the Euro or its lack of a currency it can manipulate (as though currency manipulation is an economic solution at all). The troubles are due to the fact that the government there is hostile to productive people. Spain's policies of forcing up wages and having draconian anti-employer labor laws are the major reason that Spain is not well-positioned for a recovery.

While I don't think that so-called economic freedom indices are perfect, nonetheless I think this recent rating by the Heritage Foundation has some merit. Notice, especially, the very low rating on "labor freedom" in which Spain falls into the "repressed" category. Guess what? In a downturn, strict and inflexible labor policies are going to translate into mass unemployment. Look for Spain to have numbers well above 20 percent in the coming months and years.

Unfortunately, you will not see Krugman deal with that central issue. Instead, he will call for general debasement of the Euro as a "solution" when inflation is no solution at all.


Brent said...

"One of the great weaknesses of Keynesian analysis is its lack of any coherent theory of causality."

It is beyond that. It can't make up its mind about which incoherent theory it is going to get behind (though Keynesians always have a solution for the problems they can't explain).

JonCatalán said...

Professor Anderson,

You absolutely hit the nail on the head in regards to Spain's employment woes. High real wages, fueled by strong labor laws and anti-business regulations, have made the Spanish worker much less competitive.

Paul Krugman hints at this in one of his blog posts, where compares the cost of a German laborer to that of a Spaniard.

It seems absolutely stunning (in a negative sense) that Krugman can then suggest that the solution to Spain's "high wages problem" is monetary inflation. Sorry, since when did wages not respond to increase in the supply of money (at least, over the long-run)? So, while the Reichsbank was circulating million mark notes, were German workers still earning their original wages?

When it comes to Spain, Krugman seems to have completely lost base with reality.

William L. Anderson said...

The standard Keynesian solution is for the government to inflate the currency in order to cut wages via monetary debasement. (Keynes said that in his view, the wage earner was interested only in his "money wage," or nominal pay. Thus, he would not even notice.)

Krugman simply is continuing that line of thinking.

amartinoro said...

Great post, Mr. Anderson.
I don't really know how economists can regard him as a serious man. As you say, he doesn't explaing anything at all. He is obsessed with the issue of fiscal irresponsibility: it seems he repeats in every article the following: "we have economic problems, but don't you blame fiscal irresponsibility, please!". Ah, the deficit hawks.

Besides the lack of freedom in the labor market, there are more issues in play. Spain suffered a huge real-state bubble (more intense than the US one, according to some estimates). The necessary readjustments haven't happened yet, because banks and savings banks seem to live in a different world and don't let prices fall. Of course, government has a part of responsibility here. So, besides the high unemployment rate now, maybe the worse news is that adjustments haven't happened yet, so we will suffer a long recession and stagnation.

Also, the Zapatero administration is losing all its credibility (given that they had some previously) every time he or his colleagues speak. It may be some kind of regime uncertainty, or plainly, that investors don't believe this disastrous administration.

Congratulations for this blog!