"... recessions are caused by shocks to business and consumer confidence.2"
"Confidence is synonymous with the self-fulfilling beliefs of market participants"
" within this framework, there is no unique natural rate of unemployment."
"...the current recovery seems so disappointing because we expect the pace of the recovery to bear some relationship to the depth of the downturn. That expectation, in turn, comes from a view of the world in which potential output proceeds in a more or less linear fashion, up and to the right. But what if that view is wrong and our potential is a sequence of more or less permanent "jumps" up and down, some of which are small and some of which are big?"
- "...a continuum of steady-state equilibria, each of which is associated with its own unemployment rate. The economy's steady state can jump from one value to another."
"Alternatively, the economy can get stuck in a socially inefficient low-employment equilibrium
for an indefinite time period."
"no self-stabilising mechanism that restores full employment."
"In contrast, new-Keynesian models, real business cycle models, and the Gertler-Trigari and Hall versions of search models all contain price adjustment mechanisms that automatically, and unrealistically, cause the unemployment rate to converge back towards a unique “natural rate.”"
"The standard way to close a model with unemployment is to use Nash bargaining to determine the wage. "
"... dispense with the Nash-bargaining equation and assume instead that firms produce as much as is needed to meet aggregate demand."
" All agents in our model are price takers."
"All agents behave rationally and have rational expectations of future prices."
" The existence of a continuum of equilibrium unemployment rates
is explained by matching frictions which lead to search externalities."
Figure 1. Unemployment and the S&P 500 index in the 1930s and 2000s
", equilibria are selected by business and consumer confidence, reflected in the value of the stock market."
" When consumers lose confidence, asset values fall and there is a contraction in aggregate demand."
"Figure 1 above
shows that there was a strong connection between the stock market and unemployment in the 1930s and the 2000s."
" a loss of confidence, reflected in the 1929 crash, caused the Great Depression."
" Similarly, the Lehman Brothers bankruptcy in September of 2008
was the trigger that caused the Great Recession."
" To operationalise ....assume that agents form an exogenous series of beliefs
about future asset prices "
"(Keynes called this the state of long-term expectations) "
".... proxy this sequence by the actual values of the S&P 500. "
"Feed this sequence into a calibrated model and back out the implied values
for unemployment, GDP, and consumption."
"Curiously, at the end of the 1930s the relationship between unemployment and the S&P 500 disappeared."
" The S&P 500 kept falling but the unemployment rate recovered"
(see the left panel of Figure 2).
"Another variable must have changed substantially in the beginning of the 1940s to produce such a fast recovery. "
" this variable was government expenditure."
" Between 1938 and 1945, government expenditure increased
from 15% to 52% of GDP"
(see the right panel of Figure 2).
" As government expenditure increased, unemployment fell."
"In earlier work, Farmer (2010a) showed that, in his model, a permanent fully anticipated fiscal expansion will have no effect on unemployment."
"... a temporary unanticipated fiscal expansion will reduce the unemployment rate."
"... the fiscal expansion that paid for WWII was both temporary and unanticipated"
", it follows that Farmer’s model can account for the wartime recovery"
Figure 2. Role of government expenditures
".. input data on the S&P 500 and on government expenditures
into a calibrated model and compute the values of private consumption expenditures
and the unemployment rate implied by the model"
".... assuming that agents’ expectations are an independent driving force of recessions. "
"The results can be seen in Figure 3."
" This Figure shows that, given its simplicity, the model does a good job at matching the actual consumption and unemployment data."
Figure 3. Model and data comparison
... the effects of fiscal stimulus on consumer welfare."
"..... holding fixed consumer and business confidence
a temporary unanticipated increase in government expenditure will decrease unemployment
in the short run."
" if government purchases have no social value
a fiscal expansion leaves consumers worse off."
" As a group, households consume less but work more."
" Given the choice, households as a group would prefer a situation
with higher unemployment but more consumption."
" ...model can account not only for the increase in unemployment during the Depression,
but also for the recovery during WWII."
" a word of caution to those who advocate additional fiscal expansion as a solution to the current recession."
" The fact that a temporary fiscal stimulus increased employment during WWII does not necessarily imply that it is the right policy in the current crisis.
- In our model, welfare would decline in response to a fiscal expansion, even as unemployment falls, unless the government purchases goods that have significant social value.
This was clearly the case during WWII – but we do not advocate solving the unemployment problem today by increasing the size of the army. A clear case would need to be made that increased expenditures have social value, for example, by building new bridges or otherwise improving the public infrastructure.
In our 2011 paper, it is critical to increase the value of confidence in the value of private wealth in order to restore jobs permanently. In the face of continued pessimistic beliefs about asset values, no amount of fiscal stimulus would be capable of restoring full employment. In our world, increased public spending can cause a reduction in private spending (economists call this crowding out) even when the economy is in the midst of a depression. For this reason, we believe that a better policy to reduce unemployment would be an asset market intervention of the kind suggested in Farmer (2009a, 2011b). Increasing business and consumer confidence by stabilizing the value of private wealth is an essential component of any recovery plan