Summary:
Edmund Phelps (Columbia University, 2006 Nobel prize in economics) on the causes of the employment downturn. Present downturn not due to a shift in aggregate demand, but the result of structural shifts in the economy. Usual response of gearing the money supply to attempt to prop up employment would generate ever-rising inflation. Structural shift is the result of a number of forces impacting on the economy, through non-monetary channels: loss of construction jobs due to end of housing bubble, overextension of credit and bad loans on the books of banks, perception of productivity slowdown and steeper prices of imported oil and commodities. Last three forces increase the shadow price of additional units of business assets. Forces act through an additional channel: exchange rate. When asset prices drop, resulting declines in plant and equipment demand and in consumer demand weaken the real exchange rate. Stimulates exports, but also shields domestic firms from overseas rivals, acting more like monopolists. Jobs may suffer as a result. Prospects: there will be a bout of inflation. Employment will be weak. Much investment will go abroad. Innovation may hold up. Phelps believes we need an economy of even greater dynamism to regain prosperity. (Published: 21/07/08)
Notes:
- employment downturn
- usually due to fall of aggregate demand
- if true, problem could be addressed at zero cost through rate cuts and the ensuing rise in the money supply
- present downturn is probably the effect of structural shifts in the economy, not a shift in aggregate demand
- forebodings of "stagflation" - lower employment without the solace of lower inflation
- gearing the money supply to attempt to prop up employment would generate ever-rising inflation
- inflation expectations would break loose from their moorings and the attempt would fail
- What are the primary forces of a structural nature?
- And, crucially, what are the non-monetary channels through which these forces have structural impacts on the economy - on the size of the labour force and the natural rate of unemployment?
- Loss of construction jobs due to collapse of housing bubble
- the thirst to own more houses has been met and boom come to an end
- market is giving back the excessive part of the rise in real house prices - the part not justified by rentals
- home building must then subside to the level needed to replace old properties and house fresh increases in population
- construction workers and loan officers will then suffer job losses even as market prices and rentals on houses remain high
- ongoing slide in prices is causing a further structural contraction in the demand for labour in the housing and banking industries
- with the loss of jobs in construction, which is extremely labour-intensive, a net reduction in total employment must result, since a full re-employment elsewhere would require wage cuts that would exceed what some workers would accept
- Overextension of credit, largely subprime mortgages, and loans of declining and uncertain value on the books of the banks
- result is a reduced capacity to lend for business investments and
- general increase in the uncertainty premium that is required on loans for innovative projects
- Perception of a productivity slowdown during the past couple of years
- this damps companies' expectations of the productivity growth they might obtain from any new methods or products.
- Steeper prices of imported oil and commodities
- These last three forces all lower the value, or "shadow price", that businesses place on having one additional unit of their business assets
- the customer, trained employee and office space
- effect is to cut investing and further lower real wages and jobs
- Same forces exert structural effects through an additional channel in open economies: the exchange rate
- When asset prices drop, resulting declines in plant and equipment demand and in consumer demand weaken the real exchange rate.
- Higher prices on foreign oil and commodities weaken the exchange rate very directly.
- Exports are stimulated.
- But: domestic companies, now better shielded from overseas rivals, will act more like monopolists
- raising their mark-ups and cutting their supply
- jobs may suffer
- exchange rate effect is not yet fully realised
- suggests that the unemployment rate is still short of its newly increased medium-term natural level
- if so, monetary policy in the US is odd
- past policy was to set interest rates higher, not lower, when the unemployment rate was seen as below its medium-term destiny
- We will have a bout of inflation. Employment will be weak. Much investment will go abroad. Innovation may hold up. Yet I believe we need an economy of even greater dynamism to regain prosperity.
