Fisher

Who knows?

Most likely nothing but issue a statement designed to let us know that they are still vigilant.

The problem is that the Fed is now highly divided between the fiscal hawks, and the newly energized deflation worriers. Under normal circumstances the Fed airs its differences around the table and not in public, but as the economy stalls – and there is no doubt it has turned down – a much more open argument has broken out.

And the stakes are extraordinarily high.

In many ways we have had an oddly asymmetric recession and pseudo recovery. We are now suffering from an all time record number of long term unemployed. As a percentage of all unemployed, those out of work for 26 weeks or longer is now almost twice its previous post-war record. That’s an astonishing level, and one that explains the enormous cost of the unemployment relief programs throughout the crisis. Any attempt to understand the Federal budget deficit must include an acknowledgement that much of the swing deeper into the red has been directly a result of unemployment relief payments. Normally this far into a recovery those payments would be shrinking rapidly and thus reducing the deficit. This time any reduction is more due to workers falling off the unemployment rolls because they have exhausted their support rather than having found work.

This stubborn refusal of unemployment to drop has re-opened a lively debate about the nature of the labor market. There are those who argue that the problem remains lack of final demand – I am in that camp – and there are those who suggest that we are experiencing an unusual level of ‘structural’ inflexibility in the market. The structuralists argue that we have a very large number of workers whose skills are inappropriate for what jobs the economy is generating, and thus they are unemployable rather than simply unemployed. I have pointed out in the past that this structural argument should be supported in the data by sectoral lumpiness: there should be some industries with very high rates of unemployment and others with little unemployment. The lumpiness results from the oversupply in the declining industries and the undersupply in the newer or emerging industries. Obviously, so this argument goes, not all skills in the declining industries are transferrable, so some workers find themselves unsuited to the kinds of jobs that are available. And with abundant labor supplies there is no or very little incentive for firms to hire unsuitable workers and then train them. Hence the long term unemployment problem.

While the structural argument may have some truth to it, in my mind it fails to explain the enormous level of long term unemployment we now have. Besides the sectoral data doesn’t have the kind of lumpiness in it that I think should be there to validate the argument.

A far better explanation for our ills is that final demand is just too weak. Yes it has perked up somewhat, but we are still suffering from a lack of demand sufficient to get us moving again.

And it seems to be getting worse again.

Plus, as I have argued here before, there are worrying signs that we are slipping into a Japan style deflation. That can only make matters worse. Much worse.

It is in this context that the Fed is now riven through. Long gone is any semblance of unanimity with respect to policy. Behind the scenes the staff is now more worried about deflation than inflation, but at the top of the house there are still hard line deficit hawks peddling the bond market crunch and imminent inflation threat theories. Bernanke himself seems to be in the deflation fears camp, or at least he ought to be based upon his academic research, but he has to balance the two factions.

Policy freeze is a likely outcome, pending more data.

I suspect one thing is certain though: there will be no tightening any time soon.

The war inside the Fed mirrors the war being played out in economics generally. And that war is eerily reminiscent of the 1930’s, when almost exactly the same arguments were being made.

Lest you think that the 1930’s were simply a case of Keynes versus the rest, let me draw your attention to a paper written by Irving Fisher, a giant of early 1900’s economic theorizing, in 1933. Entitled “The Debt-Deflation Theory of Great Depressions” its policy analysis is strikingly relevant to today’s problems and is very Keynesian at the same time.

The most notable part of the Fisher paper is his suggestion that it is the combination of a debt driven collapse, as in the case of an asset price bubble driven by borrowing, along with a subsequent bout of deflation that inevitably causes depressions. Unless the government steps in to bolster demand. Looking at Fisher’s paper today I am struck by how prescient it seems. It also fits well with Minsky’s analysis of financial instability being the root cause of crises. There can be no more vicious threat to our wellbeing than the combination of a banking/debt crisis followed by a steady downward spiral into deflation: debtors can never catch up with their debts and are thus driven to keep on liquidating assets to pay off creditors. This drives asset prices even lower, which means that the next round of asset liquidation yields less. And so on. In Fisher’s phrase: “The more debtors pay, the more they owe”. Since deflation means that cash gains in value in real terms, and since steady liquidation of assets reduces the value of assets with respect to cash, debtors can never catch up. They are doomed to end up in default, which undermines the banks and causes further panic.

While we are not yet in the cold grip of such a deflationary cycle, its potential presence should be enough to cause the Fed to act to head off the problem.

Anyone who is arguing against an anti-deflationary policy is most likely doing so on the basis of an ideological stance rather than an economic theoretical stance. Such a division along ideology rather than economic theory are exactly what Michael Kalecki spoke about in his 1943 paper “Political Aspects of Full Employment”.

Kalecki and others argued that perpetual government deficits are an essential feature of any economy running at full employment, and that any argument to reduce of eliminate such deficits was more driven by ideological than economic factors. Kalecki, unlike Fisher, seems outdated in light of the subsequent history, but there remains a kernel of truth in his position: those who are arguing for deficit reduction are almost always on the right in politics and pro-business rather than pro-worker. Such people do not fear radical crises since it strips workers of bargaining power and opens up opportunities to reduce wages relative to profits.

Lest you all gasp at the implied ‘class’ struggle nature of that argument allow me to point out a simple fact:

Profits are strong. Even in this crisis, firms have been able to protect earnings and avoid widespread bankruptcies. Indeed, despite the headline counter examples like GM, this cycle has been very benign for most businesses. They have stripped down their workforces and maintained payouts to investors. Cost cutting has protected business from the extent of the damage suffered by households. And this is not new. As I have described before, the Bush administration saw the same phenomenon: jobs were hammered, but profits rose.

It is this dichotomy, where some parts of the economy are doing well even in the depths of crisis, while others are being crushed, that gives Kalecki a glimmer of relevance. There is a clear political bent to the economic argument. We have long passed the point where the policies that helped the economy had no political ramifications, and thus little political controversy.

It will be interesting to see how the Fed reacts. My bet is that nothing much will be done. Things will have to be worse before the political gridlock breaks in the face of greater crisis.