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Arnold Kling on PSST

Economist Arnold Kling explains his idea of “PSST” – patterns of sustainable specialization and trade – in a well written article on The Wall Street Journal:

Persistently high unemployment is more severe in Europe and the United States today than at any time since the Great Depression. What is the solution?

Modern Keynesians claim the problem is that businesses and consumers are not doing their part. Borrowing and spending is a tough job, the Keynesians say, but somebody has to do it, and that somebody should be the government.

Unfortunately, this view may not be correct. Instead, I believe that the process of creating employment is explained not by the theories of Keynes, but rather by the theories of Adam Smith and David Ricardo. Smith famously described the advantages of specialization and division of labor. Ricardo pointed out the gains from trade that come from consuming goods that others produce more efficiently. From the perspective of Smith and Ricardo, real jobs emerge in the context of patterns of sustainable specialization and trade.

Unfortunately, the patterns of specialization and trade that had emerged five years ago were not sustainable. Many jobs in home construction, durable-goods manufacturing and distribution, and mortgage finance were dependent on housing markets with ever-rising prices. In the U.S. and the U.K. in particular, the finance industry expanded well beyond its true economic value. Once the property bubbles burst, these jobs were exposed as not viable. Meanwhile, ongoing creative destruction brought about by the Internet and globalization have continued to allow substitution of capital and emerging-market labor for industrialized countries’ labor in many sectors. Together, these phenomena have caused widespread dislocation.

More government spending will not bring back the days when supposedly triple-A-rated mortgage securities could be fashioned out of dodgy loans to unqualified borrowers. Doing so would not halt the ongoing improvements in productivity in manufacturing and retail trade. It would not facilitate the adjustments that are needed in the mix of skills in the labor force. The necessary adjustments can only be made by the decentralized efforts of entrepreneurs.

How are jobs created?

For Keynesians, job creation is simple. Entrepreneurs have knowledge of how and what to produce. All that is required is more demand, in order to induce them to undertake more hiring.

In contrast, in our Smith-Ricardo story, the knowledge of how and what to produce has to be discovered. Entrepreneurs have to figure out ways to utilize resources that satisfy wants in an efficient way. The market mechanism first must undertake trial and error to create production processes that exploit comparative advantage. Until these new patterns of sustainable specialization and trade are discovered, there are no job slots.

Experimenting with new patterns of specialization and trade is relatively easy. Discovering patterns of sustainable specialization and trade is much harder. Our economic well-being depends on the ability of entrepreneurs to make these discoveries.

The word “sustainable” in “patterns of sustainable specialization and trade” refers to profitability. Patterns that are profitable can be sustained. Patterns that are not profitable must eventually be shut down. That is the problem with patterns of trade created by government borrowing and spending: They are not sustainable, as has been illustrated in the U.S. by the failure of many of the “green energy” companies supported by President Obama’s stimulus package. Moreover, as European policy makers have discovered, there are limits to how much governments can borrow to fund their experimentations in specialization and trade.


Modern patterns of specialization and trade have become much more intricate and roundabout than they were a few hundred years ago. After generations of increasing complexity, these patterns would seem unfathomable to someone from an earlier era. Suppose that we had with us a time traveler from 1800. Imagine taking a random sample of a dozen people working in different office buildings and trying to explain to our time traveler how those people contribute to the production process. Try to convey the role of a web programmer, a graphic designer, a data analyst or a social-media marketing specialist. Try to explain that in the United States less than 2% of the labor force is engaged in agricultural production and less than 6% in manufacturing production.

All this dynamism and ferment is absent in the Keynesian story of aggregate demand. But it is central to the PSST story. In the PSST story, major recessions take place when too many patterns of specialization and trade become unsustainable at once. The entrepreneurial adjustment mechanism is overwhelmed, and it takes several years for the economy to adapt.

If the Keynesian demand story is not valid today, then perhaps it was not valid during the Great Depression either. The 1920s and 1930s were, like the present, a period in which major technological changes were working their way through the economy. Economic historian Alexander Field has argued that the decade of the 1930s saw more technological progress than any other decade in American history.

The PSST interpretation of the Great Depression in the United States would be that the internal combustion engine and the small electric motor disrupted patterns of specialization and trade. For example, the tractor substituted for human labor in farming, leading to a dramatic decline in farm labor and sharecropping.

By 1950, the composition of the work force in the U.S. had shifted. The high-school graduation rate reached 59%, from only 29% in 1931. The nature of work had shifted, also. With machines doing more of the lifting and shaping, human work became more clerical. With lower manufacturing and transportation costs, wholesale and retail distribution expanded to accommodate newly abundant consumer goods.


In our own time, we have seen computers and the Internet produce dramatic restructuring of economic activity. Telephone switchboard operators, a burgeoning occupation 50 years ago, have disappeared. Industries such as newspapers and music retailing have been disrupted, resulting in sharp declines in the number of firms and the number of jobs. The retail-supply chain has been dramatically altered, enabling stores to stock a greater variety of goods from less-expensive producers, turn over their stocks more quickly, maintain leaner inventories and adapt more quickly to new consumer preferences.

The Keynesian story would lead one to expect a recovery to consist of workers returning to the jobs that they held prior to the recession. That is not what happened after the Great Depression. It is not what has happened in recent recessions in the U.S., particularly the one that ended in 2009. Regaining full employment requires significant restructuring of the economy, rather than simply returning to the pre-slump status quo.

More government spending can at best create some unsustainable jobs in the short run. In the long run, it will only distort and impede the adjustments that are needed to create patterns of sustainable specialization and trade.

Mr. Kling is an American economist and author of the Adam Smith Institute’s latest paper, “Patterns of Sustainable Specialization and Trade.”


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