The Economic Crisis from a Neoclassical Perspective

Abstract

This paper assesses the 2007-2009 recession using neoclassical business cycle theory. I find that the 2007-2009 U.S. recession differs substantially from other postwar U.S. recessions, and also from the 2008 recession in other countries, in that lower labor input accounts for virtually all of the decline in income and output in the United States, while lower productivity accounts for much of other U.S. recessions and the 2007-2009 recession in other countries. I also find that existing classes of models, including financial market imperfections models, do not explain the U.S. recession. This is because the 2007-2009 recession is almost exclusively related to what appear to be labor market distortions that drive a wedge between the marginal product of labor and the marginal rate of substitution between consumption and leisure, a topic about which current classes of financial imperfection models are largely silent. I discuss future avenues for developing this class of models, and I consider alternative hypotheses for the recession, including the view of John Taylor and others that economic policies intended to help manage the crisis, actually deepened the recession by increasing uncertainty and distorting incentives.

Expectations, Means-Tested Subsidies, and Economic Performance during the Recession

“…Along any path satisfying (1), (4) and (5), the sign of n  everywhere has the same sign as , and beginning from a steady state, the initial effects of a permanent and immediate increase in the replacement rate are to reduce labor and consumption, but consumption declines in a lesser proportion.…”

“…The Great Depression of the 1930's cannot be entirely attributed to a labor wedge, but [1] makes the case that a peaking of union influence was an important factor. Some recessions are associated with little, if any, labor wedge, but an extensive labor wedge literature beginning with [2] and as recent as [3] emphasize the significance of labor wedges over several previous business cycles 1 .…”

“…My approach here is to (a) select the large subset of these events that can be characterized as income-and employment-tested transfers either from the government or from lenders, and model their combination as a single subsidy program whose aggregate expenditure closely follows the combined expenditure of the actual subsidy programs and (b) model the labor supply of persons ineligible 1 See also [4], [5], and further references cited below.…”

Debt Constraints and Employment

“…Our model is also related to the work of Itskhoki and Helpman (2015) on sectoral reallocation in an open economy model with search frictions in the labor market, of Pinheiro and Visschers (2015) on endogenous compensating differentials and unemployment persistence in a labor market model with search frictions, as well as the work on house prices, credit, and business cycles of Ohanian (2010), Head and Lloyd-Ellis (2012), and the work comprehensively surveyed by Davis and Van Nieuwerburgh (2014). Finally, our work is related to the large literature on financial intermediation, dating back at least to Bernanke and Gertler (1989), Kiyotaki and Moore (1997), and Bernanke, Gertler, and Gilchrist (1999).…”

How important is the intensive margin of labor adjustment?

“…If these labor market frictions a¤ect the extensive margin more than the intensive margin, for example because EPL takes the form of hiring and …ring costs, then we would expect that in Europe a larger fraction 1 There are many other results in the paper, mostly about the robustness of …ndings in previous studies, which are interesting in their own right but which I do not discuss here. For example, Lee and Andrea show that the …ndings of Ohanian (2010) that there were remarkable di¤erences between the US and other advanced economies in the Great Recession are largely unchanged when using total hours instead of employment. They also …nd that the decline in the procyclicality of labor productivity around the Great Moderation in the US, as documented in Gali and Gambetti (2009) and Gali and van Rens (2010), was present in other OECD countries as well.…”