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The Uses of Adversity
Aug 17th 2006 (The Economist) Subscription Required
Why some people think a recession could be good for America
IN 1871 America added about 6,000 miles of track to its railways, an endeavour that occupied a tenth of its industrial labour force. But by 1875 track-building had fallen by more than two-thirds, and employed less than 3% of America's workers.
According to Brad DeLong, an economic historian at the University of California, Berkeley, the violent ups and downs of the railway industry help to explain the popularity, before the Great Depression and John Maynard Keynes, of a fatalistic view of the business cycle. Recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year's 6,000th mile of track) as an essential prelude to redeploying them elsewhere. “Depressions are not simply evils, which we might attempt to suppress,” wrote Joseph Schumpeter. They represent “something which has to be done”.
In Schumpeter's day, this fatalism was shared by many at America's Federal Reserve. But today's Fed acts quickly to suppress recessions, which it recognises are mostly due to a lack of demand, not an excess of track. For the Fed, recessions are good for one thing, and one thing only: curbing inflation.
Unfortunately, this task is now an urgent one. According to figures released this week, core consumer prices rose by 2.7% in the year to July—too fast for comfort. In theory, curing this inflation could be painless. If the Fed's commitment to price stability is credible, and if people look forward, not backward, when settling their wages and setting their prices, they will respond to the Fed's promises. Unfortunately, in practice, inflation suffers from strong inertia. Hence cutting it typically requires a slowing of the economy as well as a lowering of inflationary expectations.
Like pagans sharpening their knives, economists debate the size of this “sacrifice ratio”: the number of people who must lose their jobs to appease the gods of price stability. Some models, including one of many that guide the Fed's deliberations, put this ratio as high as 4.25, which means that unemployment must rise by one percentage point (or 1.5m people) for 4.25 years to reduce inflation by one percentage point. But other, less bloodthirsty economists suggest the ratio is more like 2 or 2.5.
Ratios like these mean that for the first time in years America's domestic economists, who track their country's inflation and unemployment, are as worried about the future as its international economists, who fixate on the country's external imbalances. The internationalists have long feared that a recession might lie ahead should foreigners abruptly abandon the dollar. The prospect of a more conventional downturn—engineered not by foreign central banks, but by America's own—suggests the cart and horse belong in a different order. A recession might bring about a reversal of the current-account deficit, rather than the other way around. Recessions were, after all, part and parcel of Portugal's current-account reversal, which began in 1982, Britain's from 1989 and Spain's from 1991.
In principle, again, current-account deficits can be closed without a slowdown in production. America's gross domestic purchases of its own and foreign goods are currently running at about 106% of gross domestic product. In other words, there is enough domestic demand to buy all of America's output and more. In principle, these purchases could fall by six percentage points of GDP, eliminating the deficit, without anyone in America needing to fall out of work. America would not suffer a recession. But it would feel like one: every man, woman and child would have to curtail their spending by $2,600 a year.
Without import tariffs, however, it is not possible to curb consumers' purchases of foreign goods without slowing their purchases of everything else too. When domestic demand falls, it tends to decline across the board. In some models, such as the one offered by Maurice Obstfeld, also at Berkeley, and Kenneth Rogoff, of Harvard University, the price of non-tradable goods falls by however much is necessary to clear the market and keep everyone at work, producing an undiminished amount of traded and non-traded goods.
Euthanasia of the realtor
In reality, however, America's deficit is unlikely to close without its industrial structure changing substantially. Only about a quarter of what it now produces can be sold across borders. Andrew Tilton of Goldman Sachs has calculated that to boost exports and narrow its deficit to 2.5% of GDP by 2010, America would need to increase its manufacturing capacity by about 17%. But until this year, it was housing, a non-traded good par excellence, which has attracted extra labour and capital. In 2005 the share of construction workers in payroll employment was the highest in 50 years, and residential investment accounted for the biggest chunk of GDP since 1951. Schumpeter, no doubt, would call this “maladjustment”.
Might a recession do for housing what it did for late-19th-century railways? The last downturn was accompanied by substantial restructuring, according to a widely cited paper by Erica Groshen and Simon Potter of the Federal Reserve Bank of New York. Workers who lost their jobs in the 2001 recession did not return to the same industry during the recovery. Instead, those who did not leave the labour force altogether slowly migrated to new industries. Companies, the authors wrote, saw the recession “not as an event to be weathered but as an opportunity—or even a mandate—to reorganise production permanently, close less efficient facilities and cull staff”. Schumpeter could not have put it better himself.
Recession is not inevitable. But if a 2007 slowdown curbs inflation, narrows the trade deficit and clears space for an American manufacturing revival it will prove a surprisingly fruitful period of dearth.
AntiSpin: While it's all well and good to quote Schumpeter, one must be careful to select those of his ideas that best apply to current circumstances. Since 1999, we've been promoting the idea that the Bubble Cycle that started in the 1970s will end with an inflationary recession brought on by a slowdown or reversal in foreign net aquisition of US financial assets.
We are facing the culmination of 30 years of asset bubbles, not the end of a typical business cycle, therefore the "restructuring" of "maladjustment" may be far more severe than, "an opportunity—or even a mandate—to reorganise production permanently, close less efficient facilities and cull staff." The "adjustment" will be more along the lines of The Great Depression, perhaps as severe but entirely different. While the antecedents are similar -- an out-of-control and misunderstood credit system -- the outcome and character of the "adjustment" are more likely to be inflationary versus deflationary.
Here we quote from an except from Schumpeter's Business Cycles, 1939, writing about The Great Depression, before the revisionist historians Friedman and Schwartz convinced the world in 1963 that the Fed could have in the 1930s simply printed its way out of the mess that it had previously printed its way into:
Aug 17th 2006 (The Economist) Subscription Required
Why some people think a recession could be good for America
IN 1871 America added about 6,000 miles of track to its railways, an endeavour that occupied a tenth of its industrial labour force. But by 1875 track-building had fallen by more than two-thirds, and employed less than 3% of America's workers.
According to Brad DeLong, an economic historian at the University of California, Berkeley, the violent ups and downs of the railway industry help to explain the popularity, before the Great Depression and John Maynard Keynes, of a fatalistic view of the business cycle. Recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year's 6,000th mile of track) as an essential prelude to redeploying them elsewhere. “Depressions are not simply evils, which we might attempt to suppress,” wrote Joseph Schumpeter. They represent “something which has to be done”.
In Schumpeter's day, this fatalism was shared by many at America's Federal Reserve. But today's Fed acts quickly to suppress recessions, which it recognises are mostly due to a lack of demand, not an excess of track. For the Fed, recessions are good for one thing, and one thing only: curbing inflation.
Unfortunately, this task is now an urgent one. According to figures released this week, core consumer prices rose by 2.7% in the year to July—too fast for comfort. In theory, curing this inflation could be painless. If the Fed's commitment to price stability is credible, and if people look forward, not backward, when settling their wages and setting their prices, they will respond to the Fed's promises. Unfortunately, in practice, inflation suffers from strong inertia. Hence cutting it typically requires a slowing of the economy as well as a lowering of inflationary expectations.
Like pagans sharpening their knives, economists debate the size of this “sacrifice ratio”: the number of people who must lose their jobs to appease the gods of price stability. Some models, including one of many that guide the Fed's deliberations, put this ratio as high as 4.25, which means that unemployment must rise by one percentage point (or 1.5m people) for 4.25 years to reduce inflation by one percentage point. But other, less bloodthirsty economists suggest the ratio is more like 2 or 2.5.
Ratios like these mean that for the first time in years America's domestic economists, who track their country's inflation and unemployment, are as worried about the future as its international economists, who fixate on the country's external imbalances. The internationalists have long feared that a recession might lie ahead should foreigners abruptly abandon the dollar. The prospect of a more conventional downturn—engineered not by foreign central banks, but by America's own—suggests the cart and horse belong in a different order. A recession might bring about a reversal of the current-account deficit, rather than the other way around. Recessions were, after all, part and parcel of Portugal's current-account reversal, which began in 1982, Britain's from 1989 and Spain's from 1991.
In principle, again, current-account deficits can be closed without a slowdown in production. America's gross domestic purchases of its own and foreign goods are currently running at about 106% of gross domestic product. In other words, there is enough domestic demand to buy all of America's output and more. In principle, these purchases could fall by six percentage points of GDP, eliminating the deficit, without anyone in America needing to fall out of work. America would not suffer a recession. But it would feel like one: every man, woman and child would have to curtail their spending by $2,600 a year.
Without import tariffs, however, it is not possible to curb consumers' purchases of foreign goods without slowing their purchases of everything else too. When domestic demand falls, it tends to decline across the board. In some models, such as the one offered by Maurice Obstfeld, also at Berkeley, and Kenneth Rogoff, of Harvard University, the price of non-tradable goods falls by however much is necessary to clear the market and keep everyone at work, producing an undiminished amount of traded and non-traded goods.
Euthanasia of the realtor
In reality, however, America's deficit is unlikely to close without its industrial structure changing substantially. Only about a quarter of what it now produces can be sold across borders. Andrew Tilton of Goldman Sachs has calculated that to boost exports and narrow its deficit to 2.5% of GDP by 2010, America would need to increase its manufacturing capacity by about 17%. But until this year, it was housing, a non-traded good par excellence, which has attracted extra labour and capital. In 2005 the share of construction workers in payroll employment was the highest in 50 years, and residential investment accounted for the biggest chunk of GDP since 1951. Schumpeter, no doubt, would call this “maladjustment”.
Might a recession do for housing what it did for late-19th-century railways? The last downturn was accompanied by substantial restructuring, according to a widely cited paper by Erica Groshen and Simon Potter of the Federal Reserve Bank of New York. Workers who lost their jobs in the 2001 recession did not return to the same industry during the recovery. Instead, those who did not leave the labour force altogether slowly migrated to new industries. Companies, the authors wrote, saw the recession “not as an event to be weathered but as an opportunity—or even a mandate—to reorganise production permanently, close less efficient facilities and cull staff”. Schumpeter could not have put it better himself.
Recession is not inevitable. But if a 2007 slowdown curbs inflation, narrows the trade deficit and clears space for an American manufacturing revival it will prove a surprisingly fruitful period of dearth.
AntiSpin: While it's all well and good to quote Schumpeter, one must be careful to select those of his ideas that best apply to current circumstances. Since 1999, we've been promoting the idea that the Bubble Cycle that started in the 1970s will end with an inflationary recession brought on by a slowdown or reversal in foreign net aquisition of US financial assets.
We are facing the culmination of 30 years of asset bubbles, not the end of a typical business cycle, therefore the "restructuring" of "maladjustment" may be far more severe than, "an opportunity—or even a mandate—to reorganise production permanently, close less efficient facilities and cull staff." The "adjustment" will be more along the lines of The Great Depression, perhaps as severe but entirely different. While the antecedents are similar -- an out-of-control and misunderstood credit system -- the outcome and character of the "adjustment" are more likely to be inflationary versus deflationary.
Here we quote from an except from Schumpeter's Business Cycles, 1939, writing about The Great Depression, before the revisionist historians Friedman and Schwartz convinced the world in 1963 that the Fed could have in the 1930s simply printed its way out of the mess that it had previously printed its way into:
"It is of the utmost importance to realize this: given the actual facts which it was then possible for either businessman or economists to observe, those diagnoses -- or even the prognosis that, with the existing structure of debt, those facts plus a drastic fall in price level would cause major trouble but that nothing else would -- were not simply wrong. What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way."
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