Just thought I’d share this. It’s just a bit of evidence I’ve addressed before, but its more clearly stated and charted here.
But, also, the new study is educational as Krugman indicates – that the free flow of capital – and the reversals that can thus occur – appear to have a disproportionately large effect on underlying economies.
The point of the post is to stress that independent monetary policy (as opposed to being chained to an “external” currency such as the euro – or gold) allows economies to recover more effectively. It’s useful to consider why or how this happens – especially in contrast to the counterstatement – why does being on an inflexible, external currency impose an economic burden?
The answer arises from contrasting the classical free market ideal with what really happens. In the ideal, the capital inflows increase the quantity of money available locally (eg if German banks loan to Spanish house-buyers, the money “lands” in Spain), and this has the usual macroeconomic effect of causing a wage-price upward spiral – only here it happens locally (eg, in Spain). The result is increasing “uncompetitiveness” (in Spain). At some point, the capital flow slows and/or reverses – and regardless of the cause of this reversal, the effect could be countered if the local economy could somehow induce a proportionate wage-price downward spiral that kept up with the reversal of the capital flow. But there are several barriers that make this pretty much impossible.
First, no one knows what the capital flows are doing (quantitatively) in real-time, nor does anyone know their “place” in that flow. For instance, the US balance of payments might fall in one quarter, but the balance of payments to Mexico might have increased in the same time period – and if you are a manager at a company that derives 50% of your supplies from Mexico, and 20% from Thailand, it isn’t clear how you “ought” to adjust your prices (or wages paid) based on any particular change.
Second, no one wants to be the first to accept a wage decrease or cut their prices when they believe someone else might benefit by decreasing less or cutting less. However, anyone that believes their position (and the rest of the market’s position) has already lost support for its current prices will want to cut prices first so as to clear their inventory first, and “lose the least” in the slashing. This is what Lehman Brothers did to the MBS derivatives market in the summer of 2008. They realized that price volatility was exceeding sustainably profitable viability, so did a one-day fire-sale of as much of their MBS derivatives as possible. This allowed Lehman to survive a little longer, and killed the market for everyone else. They also sold assets to their customers that they knew would be drastically falling in price not just in the near-term, but by the end of the day.
The point I’m trying to highlight, however, is not merely the “sticky wages” problem, but that “fire-sales” are a mirror-image of the “sticky prices” and “sticky wages” problem. In a declining economy, sellers don’t want to lower their prices first because they don’t want to be earning lower profits than their competitors – but only if they don’t already have a large inventory (relative to revised run-rate expectations [aka, demand]). A fire-sale is what a seller does when they realize that they have “too much inventory” – which really just means that their carrying-costs exceed the time-weighted selling price of that asset – or even more abstractly – the virtual flow of costs (over time) associated with a position exceed the virtual flow of profits of that position, over time.
Employee wages work the same. From the employers standpoint, cuts in either wages or working time are necessary when the position (x employees at y wage rate) exceeds the time-weighted profitability of those employee’s productive capacity – and a “fire-sale” of sorts arises in the form of layoffs when the employer knows that incremental cuts in wages or working time will actually cause a herd-ish-exodus that leaves the employer with too little of the needed asset (workers and/or skills). So employers tend to layoff (zero-out) the wages of particular employees, while keeping the retained employees at the former wage (price) level. This kind of action reduces capacity to match demand, but doesn’t significantly reduce this employer’s prices because the remaining wages are more or less unchanged (productivity [per employee] usually doesn’t change, so output per wage-hour remains about the same).
The only reduction in prices can occur if the prices were already inflated by high profit margins – but any price reduction that cuts profit margins ultimately must reduce someone’s “wage” – even if it all falls on the owner(s). Employers are biased toward cutting only as much of their workers as they “must” cut, relative to their run-rate, inventory, and future sales estimates. Since it would be foolish to intentionally cut your workforce by more than will be needed by your current demands and current expectations, there is always a bias to maintain a slightly positive balance of workforce relative to need (ie, slightly more workers and wage-hours than would be needed to meet expected current orders). The owner just hopes that the remaining “unused-capacity” can be made up. Alternatively, the owner could cut workers and wage-hours below current orders, and just tell workers (which might include the owner herself) to increase their productivity somehow. But this is just a verbal reformulation. In this situation, the owner knows they are forgoing any new or current orders that can’t be met by “work-harder” productivity increases – which is the same thing as having a bias just slightly higher than current expected orders.
It is this bias that creates an analogue to the “floor” created by the zero interest rate that affects central banks. When multiplied throughout the economy, the effect is to see a whole bunch of businesses with reduced capacities, but wages of retained employees at roughly the same rate they used to be at, and thus prices remain mostly unchanged (crucially: not lowered), with a large fraction of retained employees making the same wage they had been making before, while the laid-off employees are essentially making “$0” (until they are re-hired somewhere).
The classical ideal response is that these re-hired workers will be hired at a lower wage-rate, and this effect allows overall wages to be diluted down, allowing prices to fall. This does certainly happen, but only if the unemployed workers are re-hired. If all the businesses cut their workforces to just slightly more than they expect to need in the near-term, who would do any hiring? If the macro economy isn’t experiencing growth, then for every business that is growing (hiring) for external reasons, there is a business that is laying-off or simply failing (100% layoffs) for external reasons, so this forces the question, where can the hiring come from?
Eventually, new hiring does trickle in, even if some of it comes in the form of employers laying-off their senior or retiring employees and replacing them, in-effect, with similarly skilled new-hires (at lower wages). The fact that humans die, then, goes a long way to saving us from the Faustian choice of permanent economic stagnation or rampant wage-skill-arbitrage (which would tend to cause a downward-spiral bidding-war on wages when economies are depressed).
The high-level effect that arises when most of the agents in an economy are operating along these lines is to see a high rate of unemployment, a large percentage of long-term unemployed, a very high fraction of “zero-change in wages,” and very small change in prices, biased in the positive direction (ie, no deflation, but low inflation), and this state can persist for a surprisingly long time if external capital flows or some external factors do not come along to change expectations. This is what Keynes meant when he said that an economy at the optimum is a special-case. (I don’t have the exact quote). This is exactly what we’ve been seeing in our current economy.
The role of an inflexible currency in resolving this is to have no role. The price of gold may fluctuate – and even nucleate into a bubble – in the short-term, but it doesn’t have any expected increase in long-term value relative to any other long-lived good or asset, so is the most inflexible of available “currencies.” In fact, since gold is a stable value in a depressed economy, agents will flock to it, creating a price bubble. This increase in the “cost of money” (if gold is your money) is equivalent to a central bank that raises interest rates in the face of economic stagnation. Either action is beneficial to those that hold larger amounts of the currency, but as we’ve seen in the current economy, having money and being able to lend it at a profit doesn’t induce lenders into wide-scale capital investment because the conditions where you want this to happen always co-exist with conditions of reduced incomes and increased debt-to-income ratios, on average, meaning that the pool of credible borrowers is decreased more than the increase in rates that can charged for lending out currency. As a result, few new loans are created. In fact, the reason the “natural rate of interest” (the rate of interest where the number of borrowers that will take a given loan at that rate is the same as the number of borrowers that would refuse it) has been negative and probably continues to be negative is because a depressed economy necessarily sees an increase in most debt-to-income ratios, prompting many people to seek to lower their debt (since their income isn’t going to increase). The result is a lot more people taking out no new loans, most people just maintaining their debt payments, if possible – defaulting, if not (which also is a deleveraging act) – with a very small population taking out relatively modest loans. In the aggregate, a population of agents doing this results in a decrease in the amount of debt: deleveraging – and the only interest rate that can balance takers and refusers is a negative one.
The Euro behaves like a gold-backed currency for Euro-Area nations because the EU central bank refuses to accommodate the struggling national economies at the expense of, well, Germany.
Olivier Accominotti and Barry Eichengreen’s paper, this chart – and Krugman’s post – indicate is simply that capital flows trigger a kind of inflation (or bubble) that, when stopped or reversed, results in a depressed economy caused by inflexible wages and prices – and the most direct method of getting back to normal is flexible monetary policy. A gold-backed-currency is not helpful, at all. And if the bubble was big enough to cause the resulting natural rate of interest to be negative, then unconventional monetary policy is called for (QE), or – better yet – some kind of fiscal stimulus. More precisely, in these conditions, a good fiscal stimulus tends to pay for itself, while refusing fiscal stimulus costs the economy in very, very large forgone opportunity costs.
A key point here, however, is not merely to defend monetary and fiscal stimulus, but to point out that free capital flows are not rational – not if by “rational” you mean, “accurate in their long-term valuations,” else no capital bubbles would occur. Rather (obviously) capital moves around the globe based on both intrinsic valuations as well as in response to expectations, which are subject to self-referential predictions of further capital flows (ie, “Buy mortgage-backed securities because the market is so huge that they are one of the safest assets you can find!”). Therefore, we can either keep experiencing bubbles caused by capital flows and flights, or we can establish an international system of capital controls to bring some sanity – some long-term-ism – to this “market” for where to place your excess cash (a problem that is getting bigger as a result of rising income- and wealth-inequality).