This is not Thomas Jefferson's economy

Statue of Thomas Jefferson by Shutterstock.com

Article Highlights

  • The US economy is vast & complex - which helps explain why the financial crisis hit so hard

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  • New research shows how interconnected US economy is

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  • Credit crunches hurt today's economy 4 times more than if it weren't interconnected

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The U.S. economy bears little resemblance to the Jeffersonian ideal populists on both left and right sometimes appear to strive towards: a nation of small businesses owned by Midwestern families, ideally headed by yeoman farmers. This has all kinds of implications.

Some are practical and obvious. For example, you are currently staring at what is probably a thin film transistor liquid crystal display that shows you a text magically transported to you through a network of tubes, instead of at a threatening mob of furious villagers demanding the invention of air conditioning. Others are more abstract and less obvious, yet crucial in shaping our understanding of macroeconomic phenomena such as the financial crisis and the ensuing Great Recession.

In a new research paper, Columbia University economists Saki Bigio and Jennifer La'O explore some of the latter. They present two different model economies: one resembles the Jeffersonian model, in which firms use inputs to produce final goods that they sell in the marketplace. The other one is a more "vertically" organized in which firms also produce intermediate products that different firms use in their production process, creating a network of intertwined supply chains that connect more specialized firms, meant to mimic the U.S. economy.

To illustrate how important these links are, the figure below (from Bigio and La'O's paper) shows how different sectors in the U.S. interact with each other. Each row shows how much usage a given sector makes of the products of firms in other sectors: the warmer the color, the higher its usage. As you can tell from the substantial number of red columns, some industries produce products that are important to pretty much all other industries – these turn out to be mostly manufacturing industries.

Now, Bigio and La'O use these two model economies to compare how a credit crunch impacts a simple economy versus a more interconnected, networked one. When firms face problems securing financing and working capital, both economies suffer -- but in different ways and, importantly, to a different extent. The yeoman farmer who is suddenly unable to pay his farmhand to sow the seeds for the next harvest is, of course, hurt. He will have to let his worker go, and before you know it President Obama finds himself in Iowa, complaining about the price of arugula at Whole Foods.

But when the chemical manufacturer in the networked economy cannot secure enough credit, many more things happen. It's not just the chemical manufacturer who suffers, but the firms that rely on its compounds and the firms that dig up its inputs from planet Earth's interior now have to deal with higher prices for the inputs they need and lower prices for the stuff they sell. And suddenly companies everywhere have to scale down production and adjust their production processes to deal with the new realities surrounding it.

What Bigio and La'O go on to show is how big the impact of this chain reaction is – and here is one of the advantages of using quantitative models as opposed to mere narratives. When a credit crunch occurs in the U.S. economy, its impact is four times bigger than it would be without all the interconnectedness that allows for the specialized firms and products we see around us. The industries that are hardest hit are, unsurprisingly, the ones that serve practically all other industries: manufacturing firms that produce metal products and chemical products, for example, and mining companies.

The way I see it, the government can address these problems by stepping in to provide liquidity, as the Federal Reserve has done since the onset of the recession; what this research helps us understand is why it has had to go to such extraordinary lengths to provide enough of it.

Stan Veuger is an economist at the American Enterprise Institute.

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