Some thoughts on systematic central bank policy errors
A recent post by Matthew Klein on central banks over at FT Alphaville that dovetails with some of the themes I have been writing about here at Credit Writedowns for the past decade is what preciputated this post. Let me summarize my thesis and tell you why it matters. Here are the bullet points – focused here mostly on the US:
- Globalization has been a net benefit to inflation targeting central banks. It has removed the illusion of excess demand that the postwar period’s rebuilding created (see post here). That excess demand pushed up inflation, particularly after the world went off the gold standard. Instead, we are now awash with excess supply, particularly labor supply. And in a world of global labor arbitrage where companies can arbitrage wages in developed economies against much lower wage workers elsewhere, that works against high cost labor in developed in economies and in favour of emerging market labor.
- Global labor arbitrage has dented underlying demand growth in developed economies. If you look at US wages over the past 40 years, adjusted for inflation, there is no growth. In fact, real wages declined precipitously until the early 1990s before rebounding somewhat. But they are still much lower than before globalization (see charts here). This fall in real wages reduces demand.
- This attenuation in demand was first covered up by the influx of women into the labor force. Fortunately the loss in wages – particularly in manufacturing – was more than made up for by the addition of more women into the labor force – particularly in the service sector. This allowed US households to maintain spending. In 1948, the US female labor force participation was only 32%. By the time real hourly earnings peaked in January 1973, participation had grown modestly over 25 years to 43.7%. But it grew even further afterwards, hitting a peak over 60% by 2001.
- Central banks also reacted by lowering interest rates. Since 1982, interest rates across the business cycle have come down persistently. This gave households relief on debt interest payments, aiding households in weathering economic downturns.
- The lower rates built up private debt, which allowed economic growth to continue at unsustainable levels. And while the lower rates added growth by allowing households to leverage up, only after 2001 was the interest rate factor so important. Labor force participation of women started to decline after 2001. And so rising debt, particularly in mortgages, helped the economy through one more business cycle.
- This all ended when we hit the zero lower bound in 2008. A modest private sector releveraging has happened. But it has not been enough to power robust growth. And labor force participation has mostly declined. Moreover, capital investment has been weak exactly because growth has been weak. Why would you invest when the prospects of demand for your products and services are tenuous?
What has happened is that a host of factors have combined to shift the world from one dominated by excess demand to one dominated by excess supply. This shift has lowered inflation and central banks have reacted by lowering rates.
Some people are calling this a policy error. In effect, central banks were fooled by the decline in inflation into policies that skewed capital allocation. They ended up reducing rates so much that they increased incentives for investment in interest sensitive projects – contributing to even more oversupply and even lower inflation. That’s the gist of a recent speech by Claudio Borio, Head of the Monetary and Economic Department, at the Bank for International Settlements – the central bankers’ bank.
Why this matters: populism in Europe and the US is a direct outgrowth of these events. The numbers say that our economies are back on track — that economic growth has returned. But ordinary folks don’t feel that way. And the reason is clear: we are in a lower growth trajectory and a lot of the gains from growth have gone to the wealthiest. You combine this with the pre-existing insecurity due to global wage arbitrage, pressure on pensions and retirement, a risk shift in health care costs, the inability to take on more debt, the lack of house price inflation and add to all of this fears about domestic terrorism and you have the makings of an environment primed for populist candidates.
Thinking back to the last debt crisis in the developed economy, lets rewind to 1992 or thereabouts, after a major economic crisis in the US, Scandinavia and the UK. You still had interest rates and labor force participation to give a lift. Moreover, the opening up of the Soviet Union and Eastern Europe added to optimism about the future. By contrast, today none of these positives exist.
Now, if the thesis above is correct, the underlying downward growth trajectory will remain intact without any mitigating role from the central banks. One could argue that the Fed is reloading its monetary policy gun that will enable it to fire bullets when the next downturn hits. Let’s see how much that helps.
My view here is that the pre-existing economic paradigm is still largely intact and it is not flexible enough to deal with declining household consumption growth. It is built on open, anti-interventionist, even anti-government market-based solutions that do not compensate electorates for losses from global wage arbitrage. Without the mitigating factor of central banks’ aiding releveraging in the up-cycle and interest expense relief in the down-cycle, electorates have felt the full measure of globalization in terms of job insecurity and stagnating incomes.
As a result, I see populism as a major political force to be reckoned with for the foreseeable future.