Monetary Policy for a Profits Recession (excellent)
By David Ingram
07/11/01 8:00 AM ET
(really well described tough Fed policy issues, with my comments)
The earnings season is upon us, and preliminary reports suggest that it may be another bumpy ride. Retailer Federated Department Stores, chipmaker AMD and data storage provider EMC have already offered a gloomy hint of things to come with earnings warnings for the second quarter. Next up: technology icons Motorola and Yahoo! are not likely to fare any better.
Motorola was lousy, Yahoo was ok
The weak profits of the second quarter are reflected in the deterioration in the labor market, which recorded the first quarterly contraction in employment since the last recession. Further, the data indicate that the weakness in the manufacturing sector is spreading to services, which displayed anemic numbers during the last three months.
Financial service sector is at risk now... layoffs at brokerage houses, some banks... most pain so far has come from american mfg heartland midwest and dotcom/tech centers in california... that soon could shift to northeast where clean economy thrives
As has been documented in detail by the Dismal Scientist (see Walking the Tightrope), the profits recession is being driven by a cyclical contraction in productivity which increases unit labor costs. Firms are finding that wages, which were negotiated in past years when productivity growth was strong, are now inconsistent with the cyclically lower level of output, resulting in rising unit labor costs. The squeeze between softer demand and higher costs per unit of output then produces unexpectedly dismal profits, and motivates layoffs.
productivity numbers have declined, worrying Greensperm... he knows the great tech engines offset inflationary strains in wages and from energy
The central bank can help engineer a smoother transition from a low-growth profits recession to a recovery, if it is willing to tolerate more volatility in inflation. To understand why, consider first a scenario in which the central bank places a greater emphasis on price stability than employment and output stability. This would entail a more laissez-faire policy, where the market mechanism shoulders the burden of facilitating an economic adjustment. According to this scenario, those industries that promulgated the worst excesses during the late 1990s must now suffer the largest contraction, with little in the way of support from expansionary policy. As such, the firms that negotiated the largest pay raises in the belief that productivity increases were going to continue unabated, will suffer the largest cyclical rise in unit labor costs and contraction in profits. It is at these firms where the labor market adjustment will be concentrated in the form of layoffs.
this scenario is playing out on widespread basis now... layoffs... which will relieve some pressure on costs, but not much
The profits recession, then, will progress in a firm-to-firm, idiosyncratic manner, as corporate losses mount and staff is cut. The ultimate resolution of the recession under this scenario involves wages falling to a level that is consistent with lower productivity, which would allow unit labor costs, profits and employment to stabilize. Unfortunately, the mechanism by which wages fall involves the creation of a pool of unemployed labor who are then willing to be rehired, most likely at another firm, or even in another industry, at a lower wage rate.
nice idea, but dreamy for implementation... wages take a long time to resolve... people dont get pay cuts typically... they do get forced vacations sometimes
This process is exacerbated by the prevalence of staggered wage contracts, or the phenomenon in which only a fraction of wages are negotiated in any given time period. Because contracts are signed for multiple periods, wages become sticky. That is, they can only adjust after contracts have expired, and even then, they don't all adjust at once--just that fraction of contracts that are due for renegotiation at any given time period.
some companies have annual salary reviews at individual anniversary dates... Digital did this... but the norm is for salary reviews at given time each year for all
If wages will not adjust downward, a firm's only recourse is to terminate the position and then rehire later at a lower wage that is more consistent with productivity. If all wages were negotiated at once, they could all be simultaneously renegotiated at a lower level that is consistent with productivity and demand, and the size of the labor market adjustment--the increase in the number of unemployed--would be smaller.
such corporate decisions are slow in coming... costly to rehire and retrain, so slow to cut valuable people... often entire business lines are abandoned, eliminating productive people and slackers in one swoop
Unfortunately, because wage contracts are staggered, just a small fraction of wages adjust to productivity levels at any given time, and the labor market adjustment is slower and is characterized by a higher level of unemployment. In the end, the economy will adjust, though over time, it will be characterized by output and employment volatility that exceeds price level volatility.
very key point: production and jobs volatile, prices steady
A central bank can facilitate this adjustment, however, with the use of expansionary monetary policy. By expanding liquidity, the monetary authorities support demand, which allows firms to pass higher unit labor costs on to consumers. A rise in the general price level reduces real wages across the economy, even as nominal wages remain fixed by contract. As a result, real wages are reconciled to productivity, which obviates the need for layoffs.
other key point: punish all with inflation (socialist response)... curiously this is the choice preferred by most people, who are unaware of how inflation hurts them... in the entire 1980 decade, workers did NOT get ahead
In this manner, monetary policy solves a coordination problem for the economy. That is, rather than having the market mechanism coordinate the recovery via idiosyncratic layoffs in the labor market--which tends to be a rather protracted affair--the central bank affects a contraction in real wages across the entire economy. Thus, the pain of the labor market adjustment is spread across the whole of the labor force, in an action that amounts to a simultaneous renegotiation of all wage contracts. Since the central bank is willing to accommodate higher inflation, comparatively smoother employment and output, and more volatile prices characterize the course of the economic adjustment under this scenario.
inflation for the greater good, keep order, minimize individual pain
At issue, then, is which policy is preferable. A noninterventionist would argue that the former policy is desirable because it allows the economy to wring out inefficiencies that accumulated during the asset price bubble of the late 1990s/early 2000. One could make the case that some portion of economic activity--including firm investment and household consumption--associated with irrational valuations of dot com ownership was an inefficient use of resources and should be reversed. The mechanism by which the economy corrects from its excesses, then, is a slowdown and/or recession, and that process should not be corrupted. While the process may be painful, the end result is a more efficient and sustainable economy.
I love free markets, so prefer layoffs and pain... heck, I have had pain from reality... Fed aint gonna replenish my stock account
Alternatively, some economists would argue that the emphasis on economic efficiency over human welfare is callous. Further, the adjustment will harm those who possess the lowest levels of education and income and, as a result, are least able to weather an economic downturn. The policy prescription from this camp is clear; a rise in the general price level will confer positive externalities by smoothing the adjustment in output and employment.
callous shmallous, this is a cruel country... check out the homeless
Both arguments possess merit, and the Fed will likely walk a middle ground between two poles. Indeed, the central bank has already accommodated an increase in the core rate of inflation. Divining further action is complicated by the institution's twin mandates of promoting full employment and price stability. Still, in practical matters, the emphasis is generally placed on the latter, suggesting that the market mechanism will play a relatively larger role in working out the imbalances that currently plague the economy.
the Fed is trying both policies, but interesting how we almost never hear about their OTHER prime directive: maximum employment... we will see job losses from stupid rate hikes last year and goosed inflation in near future from needless explosion in money supply this year
/ Jim |
