Sunday, June 10, 2012

The Swedish Financial Crisis and the Labor Market

This may not be news to you, but it was to me. In this speech, Narayana Kocherlakota shows us how the labor market behavior in Sweden, following the early-1990s financial crisis that occurred there, looks much like what has been happening recently in the United States. This is consistent with this post, where I looked at some Canadian labor market data. Canada sailed through the financial crisis with essentially no problems in its banking sector, and the recent behavior of the labor market (or rather, labour market) in Canada looks quite different from the US. Sweden had a financial crisis in the early 1990s, and it's labor market behaved subsequently like the US labor market is behaving now.

Like Reinhart and Rogoff's book, this raises more questions than it answers. How do we define a financial crisis anyway? How do we differentiate between bad macroeconomic events that are caused by problems in the financial sector and problems in the financial sector that are caused by bad macroeconomic events? What is it about financial sector problems that could make the labor market behave in unusual ways?


  1. An interesting contrast are Sudden Stops in Emerging Economies. There, real wages dropped and labor market recovered pretty quickly (also, inflation shot up).

    Wages, inflation and other stuff, see graphs in

    Weirdly, they do not report numbers for employment, but they do mention in footnotes that it does not drop substantially and recovers pretty fast. This looks consistent with the drop in real wages.

  2. Steve, have you seen this paper by Ohanian and Raffo (2011)? They cover labor wedges during periods prior to and during the Great Recession.

  3. I haven't read the paper, but I've seen Lee talk about it. I'm not convinced that this wedge measurement is informative. The idea seems to be that the action in the economy is where the wedge shows up. But why can't the effect of a financial friction show up in a labor wedge?

    1. It can. Wedges don't tell us anything about the data, only about the model used to construct them. And that information is pretty weak, since you can tweak a model to get your friction to show up in several places.

    2. I agree. This wedge fad is a dead end.

  4. Work by Buera and Moll shows that credit frictions can show up as efficiency, investment, or labor wedges in representative agent models.


  5. "What is it about financial sector problems that could make the labor market behave in unusual ways?"

    'Credit constraints lead to reduced investment' is widely cited in research on the effects of financial crises.

    1. Yes, we have a wide array of models with private information, limited commitment, and various reduced form setups intended to capture those underlying frictions. But I'm not aware of work that ties those frictions together with labor market behavior, generates a crisis-type event using the model, and replicates the type of labor market behavior we have been observing.

  6. "I'm not aware of work that ties those frictions together with labor market behavior"

    Nor am I. On a more prosaic note, I can see why credit constraints would temporarily reduce investment, but presumably the credit constraints disappear over time (as deleveraging is completed etc.) and so I don't see why there would be a permanent reduction in investment and employment unless there were some hysteresis.

  7. If I were to guess, one problem with financial crises is that the policy response is to slow recognition of losses and keep bad debts on the books of the institutions, or to otherwise bailout bank creditors.

    This can be thought of as an additional long running tax on non-financial investors, who must support the previous financial sector creditors.

    If this were a non-financial firm, it would default on its bonds or go through a bankruptcy proceeding and the whole thing would be cleaned up much faster. The investor making the bad decision would see a loss. Future investors would not be taxed for this loss.

    If this theory is correct, then nations that quickly recognize losses and do not attempt to socialize them (directly or indirectly) will recover more quickly than nations that attempt to socialize the losses, or slowly "recapitalize" the banking system by creating higher spreads. I think that is basically correct, but whether it can account for the full difference in growth is another matter.

  8. Why do people no longer have the courage of their convictions?

    Narayana Kocherlakota makes a good case that unemployment is "likely to be highly persistent."

    Stiglitz says it better than anyone, that the economy was broken well before 2006.

    Kocherlakota also makes the case that we don't know why.

    In such circumstances doesn't the Fed have two duties:

    1) Makes credit widely available at low cost

    2) Openingly advising the President and Congress (and the American people) that the tools available to the Fed are not up to the tasks ahead.

    Or, said differently, shouldn't the Fed's first policy be an open admission of what it doesn't know and what assumptions it is making, for which there is no corroboration. Concurrently, shouldn't the Fed also state what "rules" and theorems (Taylor Rule, Barro Equivalence, gold standard) are false and not a part of its policy views?