Peter Radford / Economics / banking, deflation, jobs, Minsky, recovery, stimulus /

What Happens Next?

February 15, 2010

There is no news today, so the sluggish economy is matched by the sluggish flow of data. Things will perk up later in the week, but now seems like a good time to try to envisage what happens next.

The economy has undoubtedly bounced up from the deep trough it hit last year. A whole slew of the big picture type of reports and statistics tell us the same thing: sometime late last year enough activity turned upward to end the recession and get the economy growing again. But so what? In a number of very substantial ways, not least the job market, the economy remains stuck firmly in neutral if not reverse. For every month the goes by without a strong surge in growth to kick start things, the risk increases that we will fail to generate much of a recovery. The much talked about and feared ‘jobless’ recovery is becoming a very real possibility. This is something we need to avoid at all costs.

The reason that such a scenario is so feared is not just because of its overt economic consequences, slow employment growth, weak wages growth, poor profit and growth prospects for business and so on, but because of the deeper rooted social and political problems that are usually associated with it. In particular periods of prolonged unemployment and underemployment have a very serious impact on social discourse: the tone of politics becomes strained and the invective rises to crowd out sensible debate; reasoning gives way to raw emotions; violence increases; politics becomes heavily populist and extreme; and alienation from family, government, and other institutions rises. In short society gets nasty quickly.

The primary cause of this ‘nastiness’ is unemployment.

There is ample evidence that students who graduate in a poor jobs market never catch up – they remain stigmatized as ‘under performers’ because they show none of the ‘normal’ growth in their early careers. Their incomes lag behind other graduation cohorts, and they risk becoming a ‘lost generation’. At the same time those graduating from ‘top’ schools suffer far less. On the contrary they may face even more intense competition for their services since businesses concentrate their hiring attention on fewer schools during recessions. As a consequence income inequality increases and exacerbates the problems that existed before the recession.

Keep these kinds of things up for any length and society begins to fray.

I am not arguing that this necessarily bleak future is baked into our current outlook, but the risk is there. Which is why making headway on employment is so crucial to us all.

A corollary to all this is the impact that the finance industry has had on society over the last twenty to thirty years. After the deregulation of banking and the increasing concentration of the industry amongst fewer and much larger players, finance contributed an ever increasing share of GDP and corporate profits. At one point that share had doubled and was as high as 43%. The relevance of this is, again, a deeper issue.

The social purpose of finance is to move money around the economy so that society as a whole uses it as efficiently as possible. On a small scale this means acting as a depository system so that people don’t have top keep cash piled up at home; it means running a payment system so that we can use things like checks rather than cash to pay for things; and it means taking our cash and lending it out so that investors, small businesses and entrepreneurs can generate profits, jobs and opportunities that we, individually could not finance. In other words finance acts as an intermediary enabling the economy to move and grow in ways not possible without it.

The problem arises when banks and finance companies stop moving money around, but keep it for their own uses. Since deregulation this switch to ‘proprietary’ trading has happened in spades. The reason is that a worldwide glut in savings generated far too much capital compared with the demand for investment in ‘real’ things like factories and inventions. That glut spurred efforts within the financial industry to invent new ways to trade, invest, and move money that had no impact on the real economy. Gradually the returns in this financial realm overtook those available in the real economy, and so money was increasingly concentrated in pure finance rather than being used to fund productive capacity like new factories, schools, entrepreneurs etc. Finance uncoupled itself from the real economy and became a world unto itself. As its profits soared so did the rewards it could pay to its employees: one of the wonders of finance is that it can create huge profits with a relatively small workforce, so pay per worker can rise above other ways of making a living. This attracts talent and drains brain power from manufacturing and other parts of the real economy. Eventually everything becomes focused on the financial world: society obsesses over stock prices; houses are viewed as investments; debt levels rise as new ways of borrowing cater to more lifestyles; and finance dominates the way in which businesses value and manage themselves.

The longer term problem with all this is that finance is inherently unstable. It always suffers from bouts of over-reach where debt repayments are not made from sustainable cash flows but from inventive refinancing and mortgaging of assets. Inevitably those assets drop in value rendering whole swathes of the economy insolvent. Asset values then spiral down and, as the bubble bursts, the real economy finds itself suffering huge penalties imposed upon it by the financial sector as the latter seeks to right itself. This process was accurately described by the economist Hyman Minsky, with the infamous tipping point at which asset markets implode now referred to as a ‘Minsky moment’.

There are two parts of this latter story that relate to my opening comments on unemployment and social division.

First: finance has, in the scenario I just mapped out, acted in a strongly anti-social manner. It has stopped playing a supporting role – which is its true place in the hierarchy of production – and is now the end in itself. This means that socially beneficial allocation of money is no longer taking place and the risk of collapse has grown. Long term productivity has been sacrificed for short term gain in obscure and volatile financial markets. The economy has been starved, while finance has bled out profits for itself.

Second: directly as a consequence of this, the long term potential of wealth generation in society has been reduced. New factories have not been built to replace old ones. New machinery has no been added. Training programs have been cut. The future has been gutted to pay the present.

Which returns us to the ‘jobless’ recovery. One main contributor to this malaise is the anti-social role played by finance. As long as the financial industry continues to dabble in proprietary activities rather than acting as an intermediary and expeditor the longer our capital base is distorted and the fewer new pathways to wealth are explored. One only has to look a the dearth of engineers and scientists we train as compared to the number of financial wizards graduating from our universities to realize that the distortion runs deeply backward into every aspect of our economic system. We rely on importing talent for our factories and laboratories. I doubt that’s because we have insufficient students. It is because our students all want to make a killing in finance.

At a policy level the options are clear: we need to reorient finance back on its more modest, but vital, role of non-proprietary capital allocation; and we need to fend off unemployment by whatever means we can. There are very few options to choose from and all require spending by the government. While that must be extremely distasteful for many, fiscal conservatives especially, the alternative is even more distasteful: a full blown ‘Japanese decade’ of deflation, underinvestment, and lost opportunity. Japan muddled through the last two decades, and has not recovered – even today it announced it had dropped back into deflation – but its social structures were rigid enough to prevent extreme consequences. America would not be so resilient: we rely on being the land of opportunity. Extinguishing opportunity here for any length of time would place a far greater strain on our politics and society at large.

So it comes down to balancing long term costs against short term costs; and specifically the cost of limiting the damage that our over emphasis on finance has done.

My own guess is that we have spent about half the amount necessary to get our economy growing at anything close to the speed we need if we are to avoid a lost decade. The sooner we all realize that the better. Time is not on our side.