The US economy ended 2015 with improvement in the labour market. Jobs grew by 284,000 each month on average in the last quarter and if you squint pretty hard at the data you can see a mild acceleration in the pace of nominal wage growth.
There will be plenty who will claim this justifies the Federal Reserve’s decisions to raise short-term interest rates for the first time since 2007, and who will argue further that the economic concerns raised by the great recession and its aftermath can now be reshelved. They would then conclude that the focus can return to policy perennials like the need to reduce deficits and ensure that wage and price inflation do not spiral out of control.
However, this view that the economy – in the US as elsewhere – has achieved escape velocity is not just premature, but dangerous. In a recent article, Joseph Stiglitz, Nobel laureate in economics, picked up an earlier warning of his fear that the world was falling into a “great malaise”. Stiglitz described an “economics of inertia” and reasserted his view that the obstacles facing the global economy “were not rooted in economics, but in politics and ideology”.
Even in the years before the great recession, the data indicated that it’s become harder and harder to sustain the growth necessary to keep the economy at full employment. You’ve probably heard of this debate – former US treasury secretary Larry Summers has borrowed the term “secular stagnation” (from economist Alvin Hansen) to describe this chronic demand shortfall. As much as I approve of learning from Hansen (the “American Keynes”), the “secular stagnation” term has mostly just been confusing to many following this debate.
In simple terms, what has caused the chronic demand shortfall? There are plenty of answers, but prominent among them is the rising inequality that strangles demand growth. Basically, in the last generation we have shovelled lots of money up to the households at the top of the income distribution, which tend to save a much larger share of it than other households. These savings need to be channelled into investments in productive capacity in order not to create demand shortages. But this translation of savings into job-creating investments has required lower and lower interest rates over time. But when short-term rates slam into zero, that seamless transition of savings to job-creating investments grinds to a halt.
For decades, the economy – at least according to the ruling presumptions – naturally tended to move quickly not just towards full employment but tried to overshoot full employment and spark economic overheating. It was thus the policymakers’ primary job to keep this in check.
So, for example, in the US the Fed had to be ever vigilant about keeping inflation tame – both wage and price inflation. If the economy was always tending towards ever lower unemployment rates, this would embolden workers into making wage demands that employers had no choice but to accommodate, but which the underlying productivity of economy just couldn’t deliver.
So firms raised prices to accommodate higher labour costs, which just spurred empowered workers to demand higher nominal wages to make up for the higher prices they faced…and we were off to wage/price spirals. And in this world where aggregate demand never ran behind supply, any trade deficit that emerged could only occur due to the failure of American households, businesses and governments to save enough.
These were the ruling presumptions that macroeconomic policymakers followed, presumptions that led to the savage early 1980s recession engineered by interest-rate increases being applauded as brave and necessary. These presumptions also led to an entire generation of fiscal policy analysts across the political spectrum being preoccupied with reducing budget deficits as a way to insure interest rates would not soar and crowd-out productive private investment.
Episodes where demand growth unambiguously fell behind supply growth – normal people call these “recessions” – happened, for sure. But these recessions were thought to be naturally short and shallow – or at least short and shallow so long as interest rates came down for a spell.
None of this describes the world we’re in right now. Wage and price inflation is worryingly low, not high. Far from acting as a vigilante that punishes government profligacy, today’s bond markets are positively begging for more government debt to absorb. And exchange rates are pushed around by influences far removed from Americans’ savings decisions, and the trade imbalances that result from exchange rate movements matter a lot for nations’ economic health.
It’s worth a quick detour here to ask whether or not the ruling policy presumptions of macroeconomics that I’ve described above were ever right. Between 1979 and 1995, for example, the Federal Reserve kept the unemployment rate well above even its own (probably too conservative) estimate of the “natural rate”. As a result, wage and price inflation rates fell significantly and continuously between those years. A key casualty was the pay of the vast majority of American workers, which either stagnated or fell for the bottom 70%.
The late 1990s saw a rapid “tightening” of labour markets (that is, in crude terms, plenty of people were in work; and the economy was “good”). This episode really should loom much larger in US policymaking than it seems to today. In the mid-1990s, for example, a range of economists across the political spectrum confidently proclaimed that the unemployment rate could not go below 5.5% without setting off an acceleration of wage and price inflation. Then unemployment started falling below that and stayed there for a significant time. However, the result was not an acceleration of wage and price growth. Instead workers saw the first across-the-board increase in inflation-adjusted hourly wages in a generation.
These results should make today’s policymakers much greedier for the benefits of aggressively plumbing the depths of how low unemployment can go without sparking unsustainable inflation. If the mid-1990s consensus had been followed instead of discarded (and credit for this one goes to Alan Greenspan, then chair of the Fed), millions of Americans would have had no work opportunities in the late 1990s, and tens of millions would have missed out on the first pay rises they would see in their lifetime.
The sources of the tight labour markets in the late 1990s are similarly instructive, in a less happy way. They were built on a bubble – the IT and stock market bubble. When it burst in 2001, an inevitable recession followed. And while the 2001 recession was short and shallow, the recovery and expansion that followed was positively anaemic – the worst in post-second world war history. And the main source of this weakness was clear – a deficiency of aggregate demand that was so extreme that by 2003 Ben Bernanke (when he was a Fed governor but before he was the Fed chair) gave speeches trying to reassure people that the Fed could indeed push back against outright deflation if the need arose. In short, by the early 2000s it should have been crystal clear that demand-generation was a huge problem.
The post-2001 recovery and expansion finally gained some steam – but only when aided by a $7 trillion bubble in housing wealth. Even with this boost, the unemployment rate and other measures of labour market health never got very close to the 1990s peaks. Inflation-adjusted wages for the bottom 70% fell in the last years of the expansion.
In the end, the housing bubble burst, causing a financial crisis and (more important for most Americans and others) leaving a large hole in aggregate demand as households could no longer support consumption by borrowing against the value of their homes. This hole was never adequately filled in, leaving the recovery slow and still-incomplete a full seven years after the recession began.
This leaves a key question: what does it all mean for policymaking?
The chronic demand shortfall has lots of implications. Most immediately, the Fed needs to stop thinking that the US economy is constantly on the knife-edge of setting off wage and price inflation spirals if interest rates are kept too low for too long. The biggest wage problem in the US economy in recent decades is not they’re always surging ahead, it’s that it’s quite hard to make them rise. Interest-rate tightening can wait until actual inflation is seen in the data.
Policymakers need to resist putting deficit reduction above all other goals. Budget deficits do no damage when run during times of slack demand. When the economy is at the zero lower bound – when the interest rate is at or near zero – they boost demand in a system positively starved for it.
Further, it’s not like there’s a shortage of reasonable public investment projects to undertake. For example, we still don’t price carbon in this economy, so private investments in energy efficiency and emissions mitigation are radically under-provided. Further afield, as Stiglitz noted, “the entire world needs to retrofit itself to face the reality of global warming”.
Given this, why not ramp up public investments in this area? The marginal return on the first billions we spend on such investments is near infinite in the insurance value it provides in protecting against climate disasters.
Finally, we circle back to the rise in inequality that is a root cause of the chronic demand shortfall. The main reason (and a sufficient one) to try to check or even reverse the rise of inequality is simply that it’s the most reliable way to boost the living standards of low- and moderate-income households. But it also turns out that if we reverse this rise in inequality, we may well go a long way to reversing the problem of chronic demand shortfalls.
This is an ambitious, long-run project. The rise in inequality is at its root a decline in the bargaining power of low and moderate-wage workers. Reversing it will not happen through one-off increases in the minimum wage or the generosity of the wage subsidies. (Though I’m in favour of both! And this year already in the US, five states and nine cities are considering raising the minimum wage to $15 an hour.)
A real reversal will occur only if there is a sustained, durable shift of economic power to low- and moderate wage workers. This in turn will happen only with policy levers across a wide range being pulled: expansionary macroeconomic policy to keep jobs markets tight, labour policy to set wage-floors and other protections for workers and to police violations.
Then there’s tax policy to make it less profitable for chief executives and highly paid managers to rig the rules of the game to tilt more money their way, regulatory policy to insure that the financial sector does not become a drain on economy-wide productivity in other areas. Also, we should look at international policy to ensure aggregate demand is not exported away to countries that manage the value of their own currencies for competitive gain. Finally, a restoration of workers’ rights to form unions and to bargain collectively.
Ambitious, yes, but worth doing, not just for the sake of fairness, but for the sake of economic growth and stability.
Josh Bivens is the director of research and policy at the Economic Policy Institute in Washington
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