Wednesday, 14 October 2009

Jobless Recoveries and Asset Market Bubbles

Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’1. Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser:
As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.
Others are more cautious, and would like to see a rebound in employment data before removing policy accommodation. Here’s the St Louis Fed’s James Bullard:
We’ve got this short term deflation risk; if we get into that trap it’s going to be hard to get out of, and that’s why we want to avoid the Japanese style outcome right now.
We know labor markets are going to lag, but we’d at least like to see them go in the right direction and start to improve. We’d like to see positive results in labor markets.
You want some jobs growth and you want to see unemployment coming down. That’s a prerequisite [for an increase in interest rates].
This entire debate misses the point. In my opinion the emphasis on labor markets is overdone, simply because we are not likely to see a rebound in the employment data – payroll expansions or wage increases – any time soon. The mechanisms for robust and rapid growth in payrolls and wages just do not exist any more.

Thanks to a lowering of international trade barriers, thanks to outsourcing and off-shoring, and thanks above all to Chinese labor’s entry into the global marketplace, workers in the first world have no bargaining power any more2. Gone are the days of strong unions and collective wage agreements.

It is no coincidence that the last few recessions – specifically, those after China’s entry to world commerce – have been followed by jobless recoveries.

Source: Calculated Risk

Indeed, the shape of the world’s labor market today is such that ‘jobful’ recoveries are guaranteed not to happen. A policymaker who waits to see such a recovery before raising rates will have waited too long.

If the flood of liquidity provided by central bankers does not go into the labor market, then where does it go? Into asset markets. It is also no coincidence that the last few recessions and jobless recoveries have been followed by asset market bubbles, first in technology stocks, then in housing.

Thus the conventional wisdom, that China ‘exports deflation’ to the world, is only partly true. Over the last twenty-odd years, China has indeed exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.

Of course, there is no guarantee that the Federal Reserve will go down the same path this time around. Policymakers today are very sensitive to the charge that they kept rates too low for too long in the early 2000s, and thus inflated the housing bubble; they will be keen to avoid repeating this mistake. But policy is inseparable from politics, and it will be difficult if not impossible for the Fed to completely ignore labor market conditions when making its next few interest rate decisions3. These will be interesting times indeed.


# 1‘Exit strategy’ is the currently fashionable euphemism for the painful process of raising interest rates. In the 2004 hiking cycle, the euphemism of choice was a ‘measured removal of policy accommodation’.

# 2If anything, this lack of bargaining power is even more obvious, and its effects even more pronounced, during economic downturns. Corporations increasingly take advantage of recessions to make dramatic cuts to payrolls, cuts that they would find politically inexpedient to make in good times. When the recovery comes (as it eventually must), the replacement hires are, more often than not, made overseas. Thus cross-border labor arbitrage – the gradual replacement of first-world workers with their cheaper third-world counterparts – is not a smooth process but a step function.

# 3Personal opinion: while I sympathize with the intent of those seeking to alleviate the condition of the working middle class, who have been hammered hard in recent years, I can’t help but feel that monetary policy is absolutely the wrong tool for the job. If you want to improve the employment data, implement deep-structural changes (investments in education, infrastructure, research and technology; a better tax code; incentives to save and invest rather than consume; and so on – all easier said than done, of course) designed to bring about that outcome; don’t count on the Federal Reserve to come to the rescue. In any case the Fed can, at best, merely buy a few years of breathing space; it cannot change the underlying fundamentals, and it would be foolish to expect otherwise.

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