Wednesday, October 14, 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.


  1. Thanks for taking the time to illuminate some of these (at least to readers like me) opaque subjects. Relating to your Footnote #3, I was wondering as to your thoughts about the relative rise of the cost of higher education in America compared to the rate of inflation. Although not an "asset" in the traditional sense, can the cost of a degree fall victim to irrational price escalation and lead to a risky level of both institutional and personal debt-burden?

  2. If the flood of liquidity provided by central bankers does not go into the labor market, then where does it go? Into asset markets.

    While this seems to be an empirically true statement, it is hardly an explanation. What good are stocks when unemployment is stifling production and consumption?


  3. To Anonymous #1 at 6:10am:

    The price of higher education in America is certainly rising faster than the rate of inflation. Insofar as this higher price is justified by higher post-school earnings (eg. Ivy League versus community college), the rise is actually rational, at least from the point of view of the buyers (students).

    But at some point (either the price rises too high, or the post-school earning expectation drops, or the amount of leverage required becomes imprudent) this will no longer be true, and we'll be in an irrational market. Could this actually happen? I suspect the answer is no, for at least a couple of reasons:

    1. Higher education cannot be "resold" by the buyer. The possibility of resale (perhaps to a "greater fool") is in my opinion a necessary condition for a true bubble to form.

    2. It's very easy for a university to increase the "supply" of higher education. All bubbles eventually end because of oversupply.

    These are just a couple of thoughts off the top of my head, maybe I'll write a longer post about the subject later.

    Thanks for reading!

  4. To Anonymous #2 at 8:49am:

    You ask: "What good are stocks when unemployment is stifling production and consumption?"

    The answer is, not much good at all. But then why have stock prices gone up so much? And the answer to that is, don’t confuse the nominal price of a stock with the underlying value of the company.

    What we call the price of a stock is merely the rate at which we exchange one commodity (a claim on the assets and future earnings of a given company) for another (a piece of paper with Uncle Sam’s picture on it).

    Now, in the recent past, the supply of these pieces of paper has gone up (thanks to easy monetary policy). The supply of labor and of retail goods has gone up (thanks to China). The only thing that hasn’t gone up is the supply of corporate claims. The ‘exchange rate’ has adjusted accordingly: stock prices appear to have gone up relative to everything else (asset inflation), but this is merely a nominal effect, and has nothing to do with the underlying fundamentals.

    A vivid illustration of this effect is the performance of the S&P500 over the last bull market. Measured in dollars, the index went from a closing low of 798 in July 2002, to a closing high of 1565 in October 2007, an increase of 96%. Over the same dates, gold went from 320 an ounce to 736 an ounce, an increase of 130%. Thus, measured in gold terms, stocks actually decreased in value over the course of the bull market! (And this is using dates specifically chosen to maximize stock performance).

    To my mind, this proves that the last bull market was not, in fact, driven by improved corporate valuations; it was driven by a decline in the worth of the ‘pieces of paper’ used to denominate these valuations.

  5. I am 70. If I outlive my mother I will reach 100. My little stock portfolio was halved. My savings earn zip and are losing value as the dollar deteriorates. I am being herded into the flock that thinks maybe, even though it went badly last go-round, I'd better take risks with my little nut because otherwise I'm toast. Fed policy of zero interest puts those at the end of their worklife in a terrible bind. Speculate or sit tight... either way I can look forward to Catfood Casseroles.

  6. While you are correct that globalization likely means a significant number of those jobs will never come back, I respectfully submit you are incorrectly talking about the phenomenon.

    Globalization is not something you can put back in a box. Neither unions or protectionism would have stopped it or saved the economy or made us better off. They would have made any market correction worse.

    The issue is clearly one of government / banking inefficiency with its attendent problems of high taxation and devaluation of the dollar.

    Fixed income and the poor are hit hardest by these looming calamities, necessitating a never ending cycle of burgeoning expansion of the New Deal, ultimately making the issue worse.

    When Wall St. and the government are forced to make a contributive ROI on their expenditures the country will be better off.

  7. To Whiskey Jim at 7:47am:

    My original post was meant to be descriptive, not normative. I was not making any value judgments or offering any policy prescriptions; I was merely describing the way I think the world works. In particular, I was trying to highlight a link between the labor market, global trade flows, and asset price bubbles, a link that (as far as I know) has not been highlighted elsewhere.

    Regarding your specific points, I agree with you that globalization cannot be put back in a box (though I fear very much that protectionist politicians on both sides of the ocean and both ends of the political spectrum will try their best to do just that). I also agree that the ongoing devaluation of the dollar will do far more long-term harm than short-term good, despite what the government thinks. And I am in no way advocating a return to the unionized, stagflationary, sclerotic 1970s.

    However I’m not sure what you mean when you talk about “banking inefficiency” or “a contributive ROI on [Wall Street’s] expenditures”. From where I sit, the banking industry seems to be pretty efficient at its primary task, viz., making bankers rich.

  8. Regarding your specific points, I agree with you that globalization cannot be put back in a box (though I fear very much that protectionist politicians on both sides of the ocean and both ends of the political spectrum will try their best to do just that). I also agree that the ongoing devaluation of the dollar will do far more long-term harm than short-term good, despite what the government thinks. And I am in no way advocating a return to the unionized, stagflationary, sclerotic 1970s.
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