Creating a double whammy at the Fed
Two strikes
The U.S. worker has two economic problems at the moment. One of them is related to inflation, but it isn’t inflation. It is the overreaction by monetary authorities to creeping supply-side inflation. The other is competition from low-wage manufacturing in China. Note that, since the supply-side inflation is caused by rapid Chinese expansion, they are both caused by China’s growth surge.
The third major economic problem for the US is the dollar overhang: the threat represented by East Asian countries piling up unreasonably high levels of dollar-asset reserves in an attempt to keep their manufacturing sectors more competitive. Because those reserves eventually will be sold, the true long-run equilibrium level of the dollar is considerably lower – numbers like 30% and 40% are being thrown around by reputable wonks with models.
It is interesting that all of these three problems stem from China’s rise, which, arguably with the issues of the deficit and the impending retirement of the Baby Boomers, represents the gamut of major economic problems in the US today. It is time to think seriously about how to help China make its adjustments without disrupting the rest of the world.
First, let’s think about overreaction.
The problem is tight commodity prices due to the rapid Chinese expansion. Supply of commodities except fossil fuels can keep up with the demand by more efficiently extracting from less convenient sources. But they are currently in a bottleneck because producers did not expect the huge new demand that is materializing. (All of this I have posted before, including the next paragraph or two). Over 3 to 5 years new supplies will come on line and keep ordinary commodities such as copper and cotton from getting scarcer. In the same way, substitutions like hybrids, smaller cars and less efficient sources will gradually move in to moderate hydrocarbon price rises, though stabilization may come at $100 per barrel and the equivalent in coal and natural gas.
The question is what the US (and, implicitly, well managed economies facing the same situation) should do about it. The monetarist response would be to tighten the money supply because inflation is inflation, and it is pointless to accept some in a fruitless effort to maintain demand momentum. If wages are falling relative to overall prices there is going to be a painful adjustment process and inflation will not prevent it even if it can delay it.
My intuition is entirely different. First, a recession would push major firms like GM and Ford over the edge into bankruptcy, and disrupt health benefits and pensions for these firms rather than allowing them some breathing space to find ways to cope, which would in turn cause financial repercussions that build an unnecessary risk premium into interest rates that is much larger than the inflation premium being created by this commodity boom. Call this the Financial Katrina effect.
Second, a recession would cost potential growth that will never be made up. This is a pure Keynesian argument for which I do not apologize. We learned from the 70s that trying to lead the economy with more demand when supply is an effective constraint will lead only to higher inflation, and to pain when we engineer recessions to wring the inflationary expectations out of the economy. Based on generalizing that insight to every case of rising inflation rates, relying on naïve beliefs about the nature of General Equilibrium, monetarists conclude that it never pays to allow inflation (ignoring the distinction from creating inflation) and macroeconomic policy can only stabilize prices.
Not your father’s inflationary cycle.
In fact today’s situation is very different from the 70s. For example, there is plenty of available labor, both still in unemployment (a small amount) and in jobs either that represent underemployment, like Wal Mart, or that are facing elimination due to international competition. More significantly, labor supplies rarely represent an effective constraint on the economy these days anyway. In this case the supply restriction is coming from natural resources.
While tightening commodity supplies do represent a supply shock, they are part of a larger pattern of increasing Aggregate Supply as they feed the growth of the manufacturing behemoth in China. If you believe there are no backstops, of either supplies or substitutes, then you could plausibly argue that high world demand will just move us further up the vertical part of the Aggregate Supply curve until financial realities take hold and some sort of crash results. But talk to a natural resource economist if you want to get some perspective on that thought. The Julian Simon forecast is still in operation, even as oil production passes its peak and large scale investment is needed to adjust to its increasing scarcity.
If we fail to maintain economic momentum, not only will the reduced incentives translate into slower investment in substitutes and other supplies, but the long term growth outlook will unnecessarily slow, and the guess of a supply constraint will become self-fulfilling as investment slows in general. Call it the Tobin Effect, for James Tobin’s call in the mid-90s for the “interesting experiment” of pushing unemployment rates below the supposed Natural Rate of 6%.
The third reason not to follow narrow monetarism is that another Jobless Recovery is just around the corner. The connection between renewed demand growth and renewed hiring has become very tenuous as workers become less involved in the production of goods. Most services do not experience sharp demand falls in a recession, and those that do, notably retailing, have a very loose connection between number of workers and rate of output. The cyclical jobs now represent mainly investment, (think about Marketing, Strategic Planning, and even engineering in the development of new versions of products to keep up a strategic competition, as the more extreme end of the spectrum). And that means US firms are getting skittish like European firms about hiring when demand growth is uncertain.
Just to connect the dots, the implication is that an unnecessary recession creates long lasting unnecessary pain. And if you buy any long-run Keynesianism at all, it creates permanently lower output due to the lost demand in the meantime. The proper name is hysteresis, but call it the Jobless Recovery effect (maybe policy makers will remember 2001 and 2 with a shudder, or even 1992 and 93, and think twice about listening to bond market traders to set monetary policy).
So that’s the problem of overreaction. It may seem strange for me to warn about recession when growth in product markets is hitting unusually high rates. But watch the housing markets, where there is probably an overhang of supply created by slightly bubbling demand, and watch consumer confidence, and watch long term bond rates. If the Fed fails to move immediately when long term rates fall, mimicking the failure of 2001, it could easily turn the slowdown being engineered into a serious rout.
Wages set in Beijing.
The other problem for American workers is Chinese competition. Even the threat from Japanese cars is ultimately about Chinese competition, since Toyota and Honda have maintained their competitiveness partly by moving a share of their manufacturing to China. As the number of educated workers in China (not to mention India, Brazil and Southeast Asia) reaches a critical mass of ability to upgrade quality and manage strategic competition, we are going to find upper incomes under pressure as well. (This may sound like a Lump of Labor fallacy, but if we do not believe in expanding capacity in times of low equilibrium real interest rates, we impose a kind of Lump of Labor Limit – demand growth will be limited. As a result, rapid increases in “effective” labor supply will drive down wages in both countries. The old Keynesian term of “Absorbtive Capacity” for Aggregate Demand captures the idea very well.)
Since firms almost always choose to let workers go rather than to lower nominal wages, this emerging phenomenon of labor demand falling across the wage spectrum represents the surest sign of inadequate Aggregate Demand. Workforce reduction will hit extra hard if policymakers choose this time to fight inflation in product markets. Workers get hit with a Double Whammy, so to speak.
Not only will the labor market(s) have to find new equilibria, finding the parts of the economy where returns are best for the redundant labor, but it will have to find them blindfolded by falling demand. Cyclical parts of the economy will not be in on the bidding, and other parts will not recognize either the full potential of hiring or the full incentive to put in place productivity enhancements. Perhaps, as Gene Grossman asserts, there will be opportunities opening up for educated labor to move strategically into higher valued occupations, as more grunt work of the service sector is outsourced. But these marvelous opportunities will not be easy to find, assess or exploit.
(The same thing was supposed to happen with unskilled labor in the 80s and 90s, but frankly I am skeptical whether it has. Using indirect evidence the Trade Theoretical wing of the economics profession has declared that the problem was an increase in “Labor Saving” technology, from container ships to ATMs to word processing software to self-serve gas pumps. But even if this tenuous evidence is giving a true picture, they have to admit that the shift to High Value Added production did not produce a shift to High Value Added jobs for the unskilled. The Labor Economist wing emphasizes lost bargaining power due to globalization.)
Not your teacher's Product Cycle.
I believe we are in a situation that is related to the Product Cycle model (for which Raymond Vernon was cheated of a well deserved Nobel Prize) in a way similarly to how Push Migration is related to Pull Migration. Krugman’s equilibrium version of the Product Cycle has rapid innovation creating high costs, which in turn shift low value manufacturing to low cost locations. This brings everyone’s wage up. It is a trade version of Pull Migration, the situation where the labor moves into high demand areas (instead of the production moving out). However, if factor supplies are expanding rapidly we get Push Migration, in which the growing population in the economically limited countryside causes workers to move to the city and push down wages there also. What is happening in tradable goods markets is somewhat different: the cost force moving production out of high income areas is being reduced, but by a rapid increase in the rate at which production can profitably shift into the low demand areas. Wages in the high income areas fall, but in the low income areas they rise. Whether you believe this will increase the rate of innovation in the high income areas, by lowering costs and raising world demand, is more a matter of theology than economic experience. But if you want to look at relevant experience, you need only to examine the results in Japan when corporations figured out that they had to move much of their manufacturing offshore to maintain competitiveness. They call it the Lost Decade, and it was closer to 15 years.
The answer to expanded factor supplies (and push migration), for development economists, is supposed to be to expand capital rapidly. Indeed it would appear that China is doing so. But the result for labor markets is not to rapidly expand overall labor demand so much as it is to bring Chinese workers into more and more direct competition with American workers. The revolution in digital data transmission in the 90s is doing the same thing with outsourcing services to India and Southeast Asia. In essence, the obvious answer turns out in this case to make the problem worse.
But if rapid expansion of capital goods is not alleviating the wage competition effect, it does not follow that the solution is to make capital scarcer. Monetarists will try to convince us that the real factors determining incomes will not respond to overall liquidity. If they succeed, it will be a tragic example of re-fighting the last war, by trying to deal with the effects of rapid expansion in the underpaid countries as if they were due to excess liquidity.
A surprise? No, just a glut.
The key question is, as it ever has been, whether ex post real interest rates have been held down in the short term by unrealistic expectations about the effects of unexpected money creation. Whatever your views about money creation in Japan and China over the last 15 years, it is hard to argue either that it was unanticipated or has created inflationary surprises. It is much more convincing to argue, as Bernanke did just last year, that the world is experiencing a savings glut. Savings rates in China, Japan and Europe are high, as is the functionally equivalent profit rate in US firms, and interest rates have clearly been held down by high real supplies of finance. As I have emphasized in my last few blogs, you only have to look at the flat yield curves in the US and EU (but not Tokyo, significantly). Watch what the bond people do with their money, not what they warn about when Washington asks.
In my view the Savings Glut is created because many of the best opportunities for capacity expansion outside China, and probably a substantial share of those within China, have continued to look too scary to industrialized country firms and money lenders.
The last week made this point with excruciating clarity as stock prices plummeted in Japan and emerging markets. Supposedly this is caused by skittish hedge funds seeing the upcoming Flight to Quality, (it happens in recessions), and frankly I think this is very likely. But it is also very depressing, because it represents the effects of a thoroughly wrong-headed reading of the world economic situation, and even more because this represents a lack of faith by Ben Bernanke in his own reading of that situation.
Stock prices don’t usually hurt anybody whose welfare matters. But the double whammy to US workers, and the lost opportunities in developing countries, will create real and possibly very lasting pain.
The U.S. worker has two economic problems at the moment. One of them is related to inflation, but it isn’t inflation. It is the overreaction by monetary authorities to creeping supply-side inflation. The other is competition from low-wage manufacturing in China. Note that, since the supply-side inflation is caused by rapid Chinese expansion, they are both caused by China’s growth surge.
The third major economic problem for the US is the dollar overhang: the threat represented by East Asian countries piling up unreasonably high levels of dollar-asset reserves in an attempt to keep their manufacturing sectors more competitive. Because those reserves eventually will be sold, the true long-run equilibrium level of the dollar is considerably lower – numbers like 30% and 40% are being thrown around by reputable wonks with models.
It is interesting that all of these three problems stem from China’s rise, which, arguably with the issues of the deficit and the impending retirement of the Baby Boomers, represents the gamut of major economic problems in the US today. It is time to think seriously about how to help China make its adjustments without disrupting the rest of the world.
First, let’s think about overreaction.
The problem is tight commodity prices due to the rapid Chinese expansion. Supply of commodities except fossil fuels can keep up with the demand by more efficiently extracting from less convenient sources. But they are currently in a bottleneck because producers did not expect the huge new demand that is materializing. (All of this I have posted before, including the next paragraph or two). Over 3 to 5 years new supplies will come on line and keep ordinary commodities such as copper and cotton from getting scarcer. In the same way, substitutions like hybrids, smaller cars and less efficient sources will gradually move in to moderate hydrocarbon price rises, though stabilization may come at $100 per barrel and the equivalent in coal and natural gas.
The question is what the US (and, implicitly, well managed economies facing the same situation) should do about it. The monetarist response would be to tighten the money supply because inflation is inflation, and it is pointless to accept some in a fruitless effort to maintain demand momentum. If wages are falling relative to overall prices there is going to be a painful adjustment process and inflation will not prevent it even if it can delay it.
My intuition is entirely different. First, a recession would push major firms like GM and Ford over the edge into bankruptcy, and disrupt health benefits and pensions for these firms rather than allowing them some breathing space to find ways to cope, which would in turn cause financial repercussions that build an unnecessary risk premium into interest rates that is much larger than the inflation premium being created by this commodity boom. Call this the Financial Katrina effect.
Second, a recession would cost potential growth that will never be made up. This is a pure Keynesian argument for which I do not apologize. We learned from the 70s that trying to lead the economy with more demand when supply is an effective constraint will lead only to higher inflation, and to pain when we engineer recessions to wring the inflationary expectations out of the economy. Based on generalizing that insight to every case of rising inflation rates, relying on naïve beliefs about the nature of General Equilibrium, monetarists conclude that it never pays to allow inflation (ignoring the distinction from creating inflation) and macroeconomic policy can only stabilize prices.
Not your father’s inflationary cycle.
In fact today’s situation is very different from the 70s. For example, there is plenty of available labor, both still in unemployment (a small amount) and in jobs either that represent underemployment, like Wal Mart, or that are facing elimination due to international competition. More significantly, labor supplies rarely represent an effective constraint on the economy these days anyway. In this case the supply restriction is coming from natural resources.
While tightening commodity supplies do represent a supply shock, they are part of a larger pattern of increasing Aggregate Supply as they feed the growth of the manufacturing behemoth in China. If you believe there are no backstops, of either supplies or substitutes, then you could plausibly argue that high world demand will just move us further up the vertical part of the Aggregate Supply curve until financial realities take hold and some sort of crash results. But talk to a natural resource economist if you want to get some perspective on that thought. The Julian Simon forecast is still in operation, even as oil production passes its peak and large scale investment is needed to adjust to its increasing scarcity.
If we fail to maintain economic momentum, not only will the reduced incentives translate into slower investment in substitutes and other supplies, but the long term growth outlook will unnecessarily slow, and the guess of a supply constraint will become self-fulfilling as investment slows in general. Call it the Tobin Effect, for James Tobin’s call in the mid-90s for the “interesting experiment” of pushing unemployment rates below the supposed Natural Rate of 6%.
The third reason not to follow narrow monetarism is that another Jobless Recovery is just around the corner. The connection between renewed demand growth and renewed hiring has become very tenuous as workers become less involved in the production of goods. Most services do not experience sharp demand falls in a recession, and those that do, notably retailing, have a very loose connection between number of workers and rate of output. The cyclical jobs now represent mainly investment, (think about Marketing, Strategic Planning, and even engineering in the development of new versions of products to keep up a strategic competition, as the more extreme end of the spectrum). And that means US firms are getting skittish like European firms about hiring when demand growth is uncertain.
Just to connect the dots, the implication is that an unnecessary recession creates long lasting unnecessary pain. And if you buy any long-run Keynesianism at all, it creates permanently lower output due to the lost demand in the meantime. The proper name is hysteresis, but call it the Jobless Recovery effect (maybe policy makers will remember 2001 and 2 with a shudder, or even 1992 and 93, and think twice about listening to bond market traders to set monetary policy).
So that’s the problem of overreaction. It may seem strange for me to warn about recession when growth in product markets is hitting unusually high rates. But watch the housing markets, where there is probably an overhang of supply created by slightly bubbling demand, and watch consumer confidence, and watch long term bond rates. If the Fed fails to move immediately when long term rates fall, mimicking the failure of 2001, it could easily turn the slowdown being engineered into a serious rout.
Wages set in Beijing.
The other problem for American workers is Chinese competition. Even the threat from Japanese cars is ultimately about Chinese competition, since Toyota and Honda have maintained their competitiveness partly by moving a share of their manufacturing to China. As the number of educated workers in China (not to mention India, Brazil and Southeast Asia) reaches a critical mass of ability to upgrade quality and manage strategic competition, we are going to find upper incomes under pressure as well. (This may sound like a Lump of Labor fallacy, but if we do not believe in expanding capacity in times of low equilibrium real interest rates, we impose a kind of Lump of Labor Limit – demand growth will be limited. As a result, rapid increases in “effective” labor supply will drive down wages in both countries. The old Keynesian term of “Absorbtive Capacity” for Aggregate Demand captures the idea very well.)
Since firms almost always choose to let workers go rather than to lower nominal wages, this emerging phenomenon of labor demand falling across the wage spectrum represents the surest sign of inadequate Aggregate Demand. Workforce reduction will hit extra hard if policymakers choose this time to fight inflation in product markets. Workers get hit with a Double Whammy, so to speak.
Not only will the labor market(s) have to find new equilibria, finding the parts of the economy where returns are best for the redundant labor, but it will have to find them blindfolded by falling demand. Cyclical parts of the economy will not be in on the bidding, and other parts will not recognize either the full potential of hiring or the full incentive to put in place productivity enhancements. Perhaps, as Gene Grossman asserts, there will be opportunities opening up for educated labor to move strategically into higher valued occupations, as more grunt work of the service sector is outsourced. But these marvelous opportunities will not be easy to find, assess or exploit.
(The same thing was supposed to happen with unskilled labor in the 80s and 90s, but frankly I am skeptical whether it has. Using indirect evidence the Trade Theoretical wing of the economics profession has declared that the problem was an increase in “Labor Saving” technology, from container ships to ATMs to word processing software to self-serve gas pumps. But even if this tenuous evidence is giving a true picture, they have to admit that the shift to High Value Added production did not produce a shift to High Value Added jobs for the unskilled. The Labor Economist wing emphasizes lost bargaining power due to globalization.)
Not your teacher's Product Cycle.
I believe we are in a situation that is related to the Product Cycle model (for which Raymond Vernon was cheated of a well deserved Nobel Prize) in a way similarly to how Push Migration is related to Pull Migration. Krugman’s equilibrium version of the Product Cycle has rapid innovation creating high costs, which in turn shift low value manufacturing to low cost locations. This brings everyone’s wage up. It is a trade version of Pull Migration, the situation where the labor moves into high demand areas (instead of the production moving out). However, if factor supplies are expanding rapidly we get Push Migration, in which the growing population in the economically limited countryside causes workers to move to the city and push down wages there also. What is happening in tradable goods markets is somewhat different: the cost force moving production out of high income areas is being reduced, but by a rapid increase in the rate at which production can profitably shift into the low demand areas. Wages in the high income areas fall, but in the low income areas they rise. Whether you believe this will increase the rate of innovation in the high income areas, by lowering costs and raising world demand, is more a matter of theology than economic experience. But if you want to look at relevant experience, you need only to examine the results in Japan when corporations figured out that they had to move much of their manufacturing offshore to maintain competitiveness. They call it the Lost Decade, and it was closer to 15 years.
The answer to expanded factor supplies (and push migration), for development economists, is supposed to be to expand capital rapidly. Indeed it would appear that China is doing so. But the result for labor markets is not to rapidly expand overall labor demand so much as it is to bring Chinese workers into more and more direct competition with American workers. The revolution in digital data transmission in the 90s is doing the same thing with outsourcing services to India and Southeast Asia. In essence, the obvious answer turns out in this case to make the problem worse.
But if rapid expansion of capital goods is not alleviating the wage competition effect, it does not follow that the solution is to make capital scarcer. Monetarists will try to convince us that the real factors determining incomes will not respond to overall liquidity. If they succeed, it will be a tragic example of re-fighting the last war, by trying to deal with the effects of rapid expansion in the underpaid countries as if they were due to excess liquidity.
A surprise? No, just a glut.
The key question is, as it ever has been, whether ex post real interest rates have been held down in the short term by unrealistic expectations about the effects of unexpected money creation. Whatever your views about money creation in Japan and China over the last 15 years, it is hard to argue either that it was unanticipated or has created inflationary surprises. It is much more convincing to argue, as Bernanke did just last year, that the world is experiencing a savings glut. Savings rates in China, Japan and Europe are high, as is the functionally equivalent profit rate in US firms, and interest rates have clearly been held down by high real supplies of finance. As I have emphasized in my last few blogs, you only have to look at the flat yield curves in the US and EU (but not Tokyo, significantly). Watch what the bond people do with their money, not what they warn about when Washington asks.
In my view the Savings Glut is created because many of the best opportunities for capacity expansion outside China, and probably a substantial share of those within China, have continued to look too scary to industrialized country firms and money lenders.
The last week made this point with excruciating clarity as stock prices plummeted in Japan and emerging markets. Supposedly this is caused by skittish hedge funds seeing the upcoming Flight to Quality, (it happens in recessions), and frankly I think this is very likely. But it is also very depressing, because it represents the effects of a thoroughly wrong-headed reading of the world economic situation, and even more because this represents a lack of faith by Ben Bernanke in his own reading of that situation.
Stock prices don’t usually hurt anybody whose welfare matters. But the double whammy to US workers, and the lost opportunities in developing countries, will create real and possibly very lasting pain.