Why has the recession lasted so long?
Most post war recessions were V shaped, a sharp drop in GDP followed by just as sharp a rise. Not this time. Consumers are not spending, firms are not hiring, households are paying off debt, corporations are sitting on piles of cash, banks are cautious about lending, governments are hoping to reduce their deficits. We are stuck in a self-perpetuating feedback loop. Since consumers aren’t opening their wallets, firms have no reason to hire or invest and if firms are not hiring then workers will continue to be cautious about spending. Almost four years after the recession officially ended, we still find ourselves stuck with high unemployment, slow growth, a stagnant economy.
Two explanations, both depressing. First, this isn’t your father’s recession. Most post-war slowdowns did not spring up organically but instead were manufactured by policy makers. In order to fight inflation (in 1980) or strengthen the currency (in 1992), the central bank would raise interest rates, lowering GDP by putting downward pressure on investment and consumption. Once they achieved their goals (or decided the economy has suffered enough), central bankers could cut those rates and so allow GDP to spring back.
But central banks did not create this recession. When the banking sector panicked, in August 2007 and again in September 2008, the central banks did everything they could to reassure markets. They immediately cut interest rates and flooded the system with liquidity. Such tactics had worked before (in 1987, 1998, 2000) but not this time. We remain in the doldrums despite the lowest interest rates in human memory. With fiscal policy politically unpalatable and monetary policy maxed out, the government is unable to break this pernicious feedback loop.
If that’s not bad enough, the other explanation is deeper, darker, and more discouraging. The Reagan and Thatcher political economy paradigm, created thirty years ago, has reached its sell-by-date. Most explanations of the current quagmire go back to 2008, when Lehman Brothers went bust, or 2005 when real estate prices in America started falling, or 2000 when Alan Greenspan cut rates in reaction to the dot com bust. I suggest, to understand the real roots of our dilemma, we go back to the days of disco, the 1970s and Reagan and Thatcher’s response to labour militancy, inflation, and declining corporate profits. And to understand the ‘70s, we need to remember the Golden Age, the greatest period of growth the world has ever seen.
Between 1950 and 1970 workers
in America saw their real wages more than double. Workers in France, Germany,
Japan and the UK did even better. As
income rose, so did spending. Increased demand spurred corporate profitability,
which stimulated investment. Barry
Eichengreen suggests that the basis for Golden Age growth was a social pact
between labour and capital. Workers
promised not to demand wages increases greater than productivity growth, while
capital promised to reinvest profits
rather than taking them out as dividends.
Proving that cooperation is more productive than conflict, this social
pact worked out brilliantly for everyone. During the Golden Age, both workers
and owners saw their living standards improve more then either could have
imagined. The good times lasted for
close to thirty years.
It all fell apart sometime around 1973. Perhaps it was the OPEC wage price hike. Perhaps it was global manufacturing oversupply. Perhaps workers, who in the early post war era had been grateful for a steady job and a regular wage, started expecting more than they deserved. In the 1970s the happy pact between labour and capital broke down. 1970s inflation can be seen as a battle between labour and capital, each trying to shift the pain of adjustment of slower growth onto the other. In the 1970s, labour won. Real wages went up more in 1970s America than they have any decade since. Capital on the other hand, had a dreadful decade. Corporate profitability nosedived. The stock market lost ¾ of its real value between 1966 and 1982. Bonds did even worse. Negative real interest rates confiscated wealth kept in bank accounts.
The 1980s and Reagan-Thatcher were the counterattack of capital, righteously enraged by the depredations of labour. To squash inflation, both here and in America, central banks raised interest rates, creating the deepest and longest recession since the 1930s. As unemployment soared and bankruptcies skyrocketed, labour and business leaders pleaded for leniency but Volcker and Thatcher were not for turning. They knew pain was required in order to staunch inflationary expectations and labour arrogance. They claimed to be monetarists, merely concerned with limiting the money supply but in effect they engaged in a hardhearted Phillips curve trade off between inflation and unemployment. It worked. As unemployment rose, inflation fell. After all, no union leader insists on a cost of living wage increase when his membership is about to lose their jobs.
With inflation vanquished, Reagan and Thatcher attacked the legal basis of union power. When Reagan fired the air traffic controllers and planes did not fall from the sky, when Thatcher took on the miners and made them pay for their intransigence, the rest of the working class recognized they too were replaceable. Power on the shop floor returned to management, as did rewards. Since 1982, labour’s share of the national income has inexorably shrunk. Productivity increases, which used to translate almost immediately into wage increases, now benefit only shareholders, CEOs, and consumers. More and more of us work freelance, with no job security, with no benefits. The endemic job insecurity that is a normal part of modern life would have been unfathomable to the generation that won World War II.
This shift in power from labour to capital sparked a long bull market, both in equities and in bonds. In August 1982 the Dow Jones Industrial Average was at 770. Today it is 20 times higher. The 10 Year Treasury yielded almost 16%. Today it is barely over 2%. Meanwhile, wages have stagnated. The median male real wage in America is lower today than it was in 1973. By letting their currencies appreciate, Reagan and Thatcher encouraged the decimation of their countries’ manufacturing sector.
Inflation, 14% in 1980 fell to 2.5% in 1983 and has rarely been over 4% since. Volcker and Thatcher smashed inflationary expectations with their early ‘80s’ recessions but what has kept it down since is globalisation. Globalization is fundamentally a deflationary phenomenon. During the first great era of globalization, 1870 to 1914, almost infinite supplies of land, in America, in Argentina, in Australia, drove down the price of food all over the developed world. Argentine ranchers made fortunes, and for the first time ever, meat became an ordinary part of working class Londoners’ diet, but for European farmers from East Anglia to East Prussia the competition was devastating. The price level fell 35% between 1870 and 1896.
This time around, it has been the almost infinite supply of labour in China and the developing world that dramatically lowered manufacturing costs. We can buy flat screen TVs or cotton clothes for shockingly low prices. The flip side is that western manufacturing (other than in Germany) has taken a brutal hit. Inflation has remained low because firms have lost pricing power, as have workers. You can’t raise your prices (or demand higher wages) if someone in Guangzhou or Bangalore will do it for cheaper.
The reason this era of globalization, unlike the first one, has not been actually deflationary is the spectacular increase in the money supply. Back in the 19th century, the creation of money was limited by the supply of gold. Once Nixon closed the gold window in 1971, money supply was only limited by banks predilection to lend. Global M3, the broadest measure of money, has risen twentyfold since 1970. Despite Milton Freidman’s predictions, this didn’t spark goods inflation, but all that money chasing a limited quantity of investments did create massive asset price inflation.
On a micro level, for its corporate sponsors, the Reagan Thatcher revolution was a success. Corporate profitability, even during this slowdown, continues to rise. Pay workers less, shareholders get to keep more. On a macro level, however, since workers are also consumers, lowering wages creates a dilemma. Stagnant wages have a negative effect on aggregate demand. Your workers, after all, are also my customers. Pay them less, they spend less in my store, forcing me to cut wages, so that my workers spend less in your store. In a growing economy, demand has to grow as well. If wages are stagnant where will that demand come from? During the Golden Age, demand grew organically, as wages rose at the same pace as GDP.
Feminism solved part of the problem. Household income could go up, for a while, even as male wages shrunk, by increasing female participation in the labour force. The bigger answer though was debt. First, this required a shift in public attitudes. Thrift used to be lauded, debt somewhat shameful. Today no one is embarrassed by borrowing. In the wake of 9/11, George W Bush didn’t demand sacrifice from the American people, but rather suggested they go shopping.
It is relatively easy to understand why underpaid workers would want to borrow and so consume more than they earn but why have banks been so happy to lend? The answer: rising asset prices. Here we see the heart of the Reagan Thatcher revolution, a redistribution from workers’ wages to owners’ assets. As wages stagnated, asset prices rose, so that wealth effect and borrowing could replace demand that workers’ salaries used to provide.
On my block in London, houses that sold for £5000 in 1975 are now worth over £1 million. Shares that used to sell for 8 times earnings now have P/E ratios of 30. As asset prices go up, so does the value of collateral and that is what makes banks willing to lend more. Of course, banks like to believe borrowers will be able to repay their loans but what gives them confidence to lend is strong collateral they can take should borrowers default. Ever increasing value of collateral made banks feel it was safe, as well as profitable, to continually increase the size of their loan book.
And the government helped. Anytime, financial markets got in trouble, in 1987, in 1998, in 2000, central bankers would cut interest rates. It used to be that the function of central banks was “to take away the punch bowl just as the party gets going”. But it seems over the past generation, the actual task of the central banks has shifted, from the teetotal shrew to the enabling drug dealer. Rather than taking away the punch bowl, the central banks have been spiking it whenever financial markets seem to sputter. Perhaps the defining moment in Alan Greenspan’s tenure at the Federal Reserve was his interest rate cut in the wake of the August 1987 stock market crash. The bull market quickly resumed its upward climb and traders became more and more confident that a “Greenspan put” limited the downside of riskier investments.
Here’s the chain of causality: globalization, by shifting jobs and production to lower wage countries, kept inflation under control. That allowed central bankers to enact a loose monetary policy. Whenever a bubble in asset prices threatened to pop, central banks could cut rates, stimulating another bubble. Cutting interest rates, because of their effect on discounted cash flows, inevitably raised asset prices, thus strengthening the value of collateral thus allowing further lending.
Higher asset prices did have a wealth effect and stimulated consumer spending but more important they raised the value of collateral and that gave banks confidence to keep lending. All that extra borrowing not only kept asset prices rising further, it also created more cash for consumption. And debt fuelled consumption acted like adrenaline on the global economy. Through home equity loans, ever-higher real estate prices allowed many to increase consumption despite stagnant wages. We used our houses like ATMs. And as long as banks were willing to keep lending the perpetual motion machine didn’t tip over. Debts could be rolled over, creating paper profits for banks, and seemingly free money for the rest of us.
But this progression was ultimately untenable. It relied on a willingness by the banks to lend evermore. Were they ever to deleverage, were they to call in loans rather than roll them over, then asset prices, no longer buoyed by an ever-growing money supply, would begin to fall, which would reduce the value of collateral, which would further reduce bank willingness to lend. The feedback loop would go into reverse. And that financial feedback loop would spread into the real economy. Without easy credit, consumer spending would decrease which would then prompt firms to layoff workers, creating in the real economy the same feedback loop Keynes observed in the 1930s.
The party lasted a long time. Anytime a bubble burst, policy makers sparked a new one. But it could not last forever. At some point, our debts would be too high, asset prices too divorced from reality, the income to loan ratio unpalatable to even the most optimistic lender. At some point, inevitably, these debts would have to be repaid and then the debt fuelled consumption feedback loop would go into reverse.
In the fall of 2005, house prices in suburban America stopped rising. Soon borrowers began to default on their loans. By the summer of 2007, several hedge funds invested in sub prime securities went bust. On August 9, 2007, fears that banks had overvalued the asset side of their balance sheets sparked a run by the shadow banking system. Greed turned to fear. Wholesale lenders, who had been happy to lend to other banks, decided to hold onto their extra cash. As deposits shrank, banks had to sell assets, further lowering their value. Deleveraging from wholesale lenders led to deleveraging by commercial banks and that finally forced households to reduce, rather than increase their debts.
Ever since the Great Depression, it has been clear that over production, or its equivalent, insufficient effective demand, is the Achilles heel of capitalism. Back in the 1930s, as today, factories were Idle not because of some supply shock but rather because workers could not afford to buy all the products they made. Unsold goods on shop shelves lead to firms reducing production and laying off workers, which of course leads to more unsold goods on shop shelves. A recession, after all is a lack of aggregate demand, when the economy produces more than what it can afford to purchase.
The political economy of Reagan Thatcher depended on lowering labour’s share of the economic pie in order to restore corporate profitability. But cutting wages meant decreasing demand. Ever increasing levels of debt, financed by higher asset prices, replaced that demand that had earlier been created by rising wages. When assets prices finally fell, so did bank willingness to allow more borrowing and then demand no longer was sufficient to stimulate growth. And that is where we are today.
Since the Great Depression the key macro economic question has been how to maintain demand at a level sufficient to absorb potential supply. From 1940 to 1945 we solved that problem with war. It was World War II that brought America out of the Depression. GDP more than doubled from 1938 to 1945. Unemployment, almost 20% in 1938, fell to 1% in 1944. After the war, it was rising wages, and increasing investment that bridged the gap. Since 1982, it has been debt-fuelled consumption, financed by rising asset prices. When asset prices stopped going up, when banks no longer were as eager to throw money at punters, the edifice fell apart, and that is why a relatively minor collapse in real estate prices in California, Nevada, and Florida may end up causing a lost decade or more in much of the developed world.
What is to be done? Perhaps we need to take a page from the Golden Age textbook. The economy grows as productivity grows. If productivity increases were reflected in wage hikes, then demand will grow organically at the same rate as does supply. Reagan and Thatcher were redistributive. Workers lost. Owners of assets won. This has gone too far. If labour does not start getting a larger share of the pie, then the pie will stop growing. Guaranteeing a basic income, which will restore bargaining power to workers, could be a useful first step.
 Interest rate cuts stimulate asset prices because of their effect on the present value discount of future cash flows. The value of an asset is the value of all future cash flows that asset will create but those cash flows need to be discounted to give present value. Since the discount rate is generally the risk free interest rate, cutting interest rates almost inevitably raise asset values.