Thomas Palley on "America’s Distorted Expansion"

Economist Thomas Palley has a very interesting post today on our current economic conundrum, and he traces the problems to blind faith in globalization rather than permissive monetary policy or out of control financial innovation.

Palley starts from an earlier point than most do, noting that our recent expansion has been unbalanced. He sees the big problems as record trade deficits (the result of an overvalued dollar), and (related but somewhat separate) the erosion of manufacturing.

The emphasis on the role of manufacturing is interesting and credible. When you consider the lead times, inflexibility, and transportation costs of manufacturing in Asia (remember, even goods like furniture, which involve round-trip shipping, are often made in China) one has to wonder how we screwed up, particularly when I hear from clothing designers that the reject rate on Chinese garments is typically 50%.

One would think there would be a role for at least for highly-flexible, high quality manufacturing that took advantage of geographic proximity, ability to do small runs at competitive prices, and high reliability. It would never be as large as China’s output, but it would cream the high end of the market and also keep core skills at home. And the US is still competitive in highly capital intensive and highly demanding manufacturing, such as coated paper (unlike newsprint, coated paper production is very difficult to keep running at the near-constant output level that its huge capital base requires).

Part of the problem, as we have discussed earlier, is that we have taken a naive stance in trade negotiations. We seem seduced by the idea of open markets, when in fact what we have is a system of managed trade. And our trading partners, who for the most part are keen to preserve employment, protect certain key industries, and have trade surpluses, seem to have achieved better outcomes than we have.

A recent article in the Wall Street Journal, “Is Productivity Growth Back In Grips of Baumol’s Disease?” supports Palley’s hypothesis about the value of manufacturing:

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet — there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can’t get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise….

Sectors where productivity is high and average labor cost low “are those things that can be automated and mass-produced,” Mr. Baumol, now in his mid-80s and still teaching, said in an interview. “And things where labor-saving is below average are things that need personal care — these are health care, education, police protection, live stage performance… and restaurants.”

Uh-oh.

U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government….

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much

Palley argues that the Fed, despite giving lip service to global imbalances, is in fact operating from and supporting a flawed paradigm.

From Palley:

The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been persistently fragile and unbalanced. That is now coming home to roost in the form of the sub-prime mortgage crisis and the bursting house price bubble.

As part of the fallout, the Federal Reserve is being criticized for keeping interest rates too low for too long, thereby promoting credit and housing market excess. However, the reality is low rates were needed to sustain the expansion. Instead, the root problem is a distorted expansion caused by record trade deficits and manufacturing’s failure to fully participate in the expansion.

If the Fed deserves criticism it is for endorsing the policy paradigm that has made for this pattern. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.

By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Beginning with an extended period of jobless recovery, private sector job growth has been below par through most of the expansion. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.

This gloomy picture justified the Fed keeping interest rates low. However, it begs the question of why the economic weakness despite historically low interest rates, massive tax cuts in 2001 and huge increases in military and security spending triggered by 9/11 and the Iraq war?

The answer is the over-valued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion, equaling 6.5 percent of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing’s weak participation in the expansion. Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have reduced investment owing to weak demand or have moved their investment to China and elsewhere. These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened job creation.

The evidence is clear. Manufacturing has lost 1.8 million jobs during the expansion, which is unprecedented. Before 1980 manufacturing employment hit new peaks every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. This business cycle it has fallen during the expansion. The business investment numbers tell a similar dismal story, with spending being much weaker than in previous cycles.

These conditions compelled the Fed to keep interest rates low to maintain the expansion. That policy worked, but by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5 percent of total employment, has provided over twelve percent of job growth. Meanwhile, higher house prices have fuelled a borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.

The overall picture is one of a distorted expansion in which manufacturing continued shriveling while imports and services expanded. This pattern was carried by an unsustainable house price bubble and rising consumer debt burdens, and that contradiction has surfaced with the implosion of the sub-prime mortgage market and deflation of the house price bubble.

The Fed is now trying to assuage markets to keep credit flowing, and it will likely soon lower interest rates. On one level that is the right response and it may even work again – though it does increasingly seem like sticking fingers in the dyke to prevent the flood. However, the deeper problem is the policy paradigm behind the distorted expansion, which is where the Fed is at fault and where it deserves criticism.

The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the White House and Treasury’s unbalanced expansion policies. The Fed’s professional economics staff also seems to have dismissed domestic manufacturing’s significance and endorsed corporate globalization in the name of free trade. Consequently, the Fed has tacitly supported the underlying policy paradigm that has given rise to America’s distorted expansion. Despite talk about reducing global financial imbalances, the Bernanke Fed still seems locked in to this paradigm and that is where constructive criticism should now be directed.