Bubbles, Employment and Recalculation
Calculated Risk has a post out today called Bubbles and Employment. The gist of the post is that interest rates play a role in creating bubbles as demonstrated by data on employment and common property yard-sticks like price-to-rent and price/earnings ratios. The graphs presented make the case quite well.
CR finishes the article saying:
Since the recovery in residential construction will probably be sluggish, and private non-residential construction spending is declining rapidly – construction employment will probably continue to decline even with more public spending.
A construction industry group is now arguing that almost one-in-four construction workers is unemployed. But that reality is many of these jobs are not coming back any time soon because the bubbles in residential and non-residential investment pushed construction employment up way too high – and now many of these "unemployed" construction workers will need to develop new skill sets and find alternative employment.
This wasn’t the workers fault – they were just responding to the market demand, and construction employment was probably the highest paying job available. However this does suggest that the Fed needs to consider asset bubbles when trying to follow their dual mandate of price stability and maximum sustainable employment. Asset bubbles play a key role in employment, and trying to clean up after the bubble is short term thinking and is not promoting sustainable employment. [Emphasis in original]
This is exactly the kind of language I used last week to end my article “Looking at structurally high unemployment as recalculation.” What we have in the housing sector is malinvestment gone bad, and with it a loss of jobs and structurally high unemployment until those who invested their lives in this malinvestment can turn things around.
looking at demand only in ‘aggregate’ misses the fact that supply and demand vary across sectors of the economy for goods and for labor. Supply of and demand for nurses is not the same as it is for builders and contractors. So [Arnold] Kling is right to distinguish between the recalculation of society’s industrial organization and total demand in the aggregate [in a recent essay of his].
…nurses are coveted and in demand because of our aging population and general need for healthcare. On the other hand, due to the massive bust in housing starts, builders and roofers are not as sought after. Right now, ‘structural’ unemployment is higher because of recalculation – the restructuring of our society’s industrial organization.
Unemployment will stay higher for longer because the misallocation of resources in the boom was so large. When economists let Bernanke and Greenspan off easy for recklessly low interest rates, they are missing the effect this policy has on the internal organization of capital and labor within our society. People built lives around and started careers because of the boom in real estate over the last decade. Now, that’s all gone bust – and those people need to re-tool and find a job somewhere else. Some of them will never re-attain their previous earnings power. Many will be unemployed for years. That’s the reality today, just as it was in 1982 as the manufacturing sector left the U.S. en masse.
It was recklessly low rates which created this malinvestment. So, while the Fed is not entirely at fault in this mess, its policymakers needs to take on much of the blame, something Ben Bernanke is unwilling to do. As we move forward, it would also be nice to see someone realize that propping up bankrupt companies in finance, autos or housing only serves to perpetuate the misallocation of resources and makes things worse. [emphasis added].
So, while my colleague Marshall Auerback focuses on regulation in his recent article “The housing bubble: In Bernanke’s defense?,” I see interest rates as central to this credit bubble. And it was a credit bubble – not a housing bubble which we have suffered, as evidenced by the excesses in private equity, the low credit spreads in high yield debt, and the large increases in leverage all around.
The question for policymakers is how to deal with bubbles. On the one hand, you have a lax regulatory environment – what I would call easy money. On the other hand, you have low nominal interest rates – what I would call cheap money. In isolation either is noxious, but in combination, they are a toxic brew that led to a gargantuan asset bubble – and not just in housing, and not just in the United States. Ask the Latvians, Irish, Spanish or British.
What I would like to know is this: is cheap money the pre-condition that any- and everywhere leads to an unsustainable boom bust or is it easy money? Or is it the combination of easy and cheap which is so deadly? Answering that question will go a long way in guiding the policy response. And studying previous boom-bust cycles across asset classes, time, and geography would be revealing in coming to a determination.
At a minimum, however, government must establish rules and laws and set policies which ensure an environment relatively free of distortions that harm its citizens’ financial health. And, government has not done so. I don’t want government telling business how to run their companies, but I do want it setting limits on harmful, immoral or illegal actions. This is where government has failed.
your questions are great, but i’d posit this:
the reason the US, UK, spain, ireland, latvia etc experienced both cheap and easy money is ultimately that they ran large current account deficits. these are balanced of course by corresponding capital account surpluses — and this return flow of funds, being intermediated by the banking systems of the subject countries, was the fuel for the credit boom in all its forms.
it was the intense availability of these funds that drove down rates, particularly on the long end of the curve, pushing investors to seek yield on the one side and making mortgages cheap on the other. the availability of these funds gave a huge incentive to invent and pursue securitization, and to roll back the law to do so (see alternative net minimum capital rule for broker dealers!)
i think both you and marshall are right as far as it goes — the fed was often permissive with rates, and regulation was all but nonexistent. but both of those were really results of monster C/A imbalances. and i think the bubble would’ve taken off even if the fed had been tighter and regulation better — perhaps it would’ve manifested differently, but there would still have been a credit bubble.
so where is the headwater of these C/A imbalances? i think china, japan, asian tigers and germany managing their monetary policies and currencies for mercantilist advantage, which went unchallenged by the deficit nations as the cheap money rolled in.
i’d further argue the same problems arose when the world dumped the gold standard to finance the first world war between 1914 and 1925. while enabling the extravagant financing of total war, the result was also to create massive imbalances between europe (deficit) and the US (surplus) during and after the war. when ultimately discipline returned as the war powers came back onto gold, it set into motion the unwind which then lasted until the next war.
I really liked what Michael Pettis wrote a year ago because I think it’s spot on:
Excess liquidity growth typically occurs for two reasons: First, financial innovation or new money sources can lead to sharp increases in underlying money – for example the development and expansion of joint stock banks in the 1820s, the securitization of mortgages in the 1980s, or large gold or silver discoveries in the 19th century. Second, massive global imbalances are recycled – like German reparations in the 1920s or petrodollars in the 1970s.
During the period of excess liquidity growth several factors set the stage for the subsequent crisis – asset prices rise as money flows into asset markets, risk appetite rises as risk premia decline and risky investments prove profitable, and the perceived value of liquidity declines as trading volume surges. When this happens, regulatory attempts to reduce risk in the financial system generally fail. When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.
The recent explosion of derivatives – incorrectly blamed for the current crisis – was simply an efficient way to accomplish all three, and was no more the real “cause” of the current crisis than investment trusts were in the 1920s or out-of-control real estate lending was in 1980s Japan. The financial system was simply adjusting, as it must and always does, to surging liquidity and rising risk appetite.
The recent liquidity surge, to which the current crisis is the inevitable denouement, had its roots in the 1980s, when the securitization of US mortgages converted a huge pool of illiquid assets into highly liquid securities, and was subsequently reinforced by the recycling of the Japanese trade surplus with the US in mid-decade. The process took off, however, after 1998. During this time US household savings declined to rates never before seen and the US trade deficit, which until then had rarely exceeded 1 percent of GDP, rose to levels never matched in US history.
Also during this period several Asian countries, led by China, began running policies aimed at generating trade surpluses and accumulating foreign currency reserves, to the extent that net capital flows from developing countries soared to the highest recorded levels in history. It’s notoriously difficult to sort out causality in balance-of-payments relationships, but the fact that this process seems to have begun in 1998 suggests that it may have been a reaction to the Asian crisis of 1997, a shocking event for Asian policymakers to this day.
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