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(Volume 2003: Issue 2) September 9, 2003 Note: To print a hard copy of this newsletter, click on the following link for a PDF download… Newsletter Volume 2003 Issue 2 Complete.pdf DEFLATION For the past couple of years, a variety of pundits have voiced fears of impending deflation, declaring it vastly more dangerous than inflation. Even the Fed, on a number of occasions, has joined the chorus and fanned the flames. The last time the U.S. economy experienced any serious and prolonged deflation was during the Great Depression of the 1930s. Deflation is the phenomenon in which the weighted-average of prices is falling (Note: this is different than disinflation, which means that while prices are still inflated, the rate of increase in prices is falling). The deflationary period of the 1930s was caused by a collapse in demand and by gluts in many markets; recent deflationary pressures come from a far different source (See Figures 1 & 2). The inflationary bias, marking the post World War II American economy, has gradually subsided and given way to encroaching competition - it is the increasing presence and pervasiveness of competition that has contributed the most to our current experience with deflation. Competition… The essential argument of the New Paradigm in Economics is that as competition in markets increase, the power to control price by firms in those markets decreases. A number of markets in the U.S. have been going through this process since the Second World War, when cartelism had reached its zenith. Over past decade or two, the U.S. economy has experienced a tremendous up-tick in competitive pressure. Among these transformed markets/industries are telecommunications, automotive, computer and steel. In the distant past, as the product markets became less competitive, so did the labor and capital markets that served them. The Big Three in the auto industry saw the rise of the United Auto Workers; Ma Bell saw the growth of the Communication Workers of America; and the cartelization of the steel industry led to formation of the United Steel Workers. The surplus profits realized in the early days of these industries provided incentive for labor unions to organize with the objective to obtain surplus compensation. In the economic literature, surplus reward to productive resources such as labor and capital is termed economic rent: the reward to productive resources in excess of their opportunity costs that which must be paid to bring them into employment from their next best competitive alternative and keep them employed. …the reader will note from the preceding and following charts that the inflationary bias in the economy resides in sectors such as education and medicine, while the increasingly competitive sectors such as computers and autos exhibit deflationary tendencies. It must be understood that all resources including the suppliers of debt capital, suppliers of equity capital, as well as suppliers of labor, must all earn their opportunity cost. When the rate of return to equity investors falls below the opportunity cost level (when the investor can realize a better return elsewhere in the equity markets), those firms will either have to raise their prices, restructure to lower costs or gradually shrink in size and exit. In the past, many firms and industries were able to exercise market power such that they were able to raise prices and reduce output in order to increase their profits and their rate of return on equity. As markets become increasingly competitive, the option of raising prices to increase revenue and profits up to at least their opportunity cost profit levels (and correspondingly, required rate of return on investment) no longer works. As competition spreads through markets, price increases become less and less revenue enhancing, eventually these price increases will cause revenue to fall. In economic analysis, the relationship of price, units sold, and revenue is called price elasticity of demand. As surplus profits disappear and fall below the level affording a reasonable rate of return on investment in equity capital, costs must be lowered through restructuring to return to reasonable profitability. Simply put, equity capital requires a reasonable return on investmen;t yet another form of opportunity cost. Automation, outsourcing, contract labor, and moving to geographic regions with lower cost structures (labor compensation, taxes, energy costs, etc.,) will occur until profits are restored to a level where they yield a reasonable rate of return to equity investors. As competitive forces push prices downward, firms, to remain viable, must respond by cutting costs, including labor. A rise in productivity results when the same or fewer labor hours employed produce more output - the increase in labor productivity often cited by the media occurs for this reason. In the case of automation, less labor works with more capital to achieve the increase in productivity (throughput). A lesson in the importance of productivity and job security as measured by unit labor costs… Harry V’s contribution due to his effort alone and net of other productive resource contributions, is 20 units per hour. Harry’s total compensation per hour is $ 40. When we divide his hourly compensation by the units he alone produces, it is called the unit labor cost, which in this case is $ 2.00 per unit. If Harry’s productivity rose by 10% to 22 units per hour while his total compensation remained the same ant $ 40 per hour, the unit labor cost will fall to just under $ 1.82 per unit. The firm would be better off and Harry would have more job security. The cause of this increase in labor productivity could come from a variety of sources. Harry may have increased his human capital by attending workshops or additional courses. Harry could be working with more or better physical capital such as CAD/CAM; this latter case would be called automation. Some of Harry’s colleagues could have been laid off permanently and Harry has picked up the tempo. There are many reasons but they all lead to a rise in productivity and a fall in unit labor cost. Let us go back to the original case where unit labor cost was $ 2.00. Now assume that productivity is constant and Harry’s compensation per hour rises by 10% to $ 44.00 per hour. The unit labor cost will rise to $ 44 divided by 20 units or $ 2.20 per hour. The firm is worse off and while Harry’s compensation per hour rose, he has less job security. If Harry’s firm is in a very competitive industry like autos and the firm has no power to raise the price, profits and return of investment to the equity capitalist will fall. If it falls to a return on investment that is less than the opportunity cost level, the firm will eventually shrink or may exit entirely. To stay in business, the firm must restructure and cut costs - in this case, unit labor costs. The general rule is that as long as the percentage increase in labor productivity is greater than the increase in labor compensation, unit labor costs fall. When the percent increase in labor compensation exceeds the percent increase in labor productivity, unit labor costs rise. When the percentage increase is the same for both, unit labor costs are constant. …Restructuring Happens Buying the labor indirectly through outsourcing can effectively reduce unit labor costs. Typically in the auto industry, labor compensation is significantly lower at supplier firms and hence there is much incentive to outsource production rather than make it in house where labor costs can be double that incurred by supplier firms. Many firms have relocated to lower cost areas. It is not always labor costs that cause similar decisions to be made. Energy costs, taxes, and environmental compliance costs can also affect the decision-making process. When deflation is occurring because increasing competition is putting downward pressure on prices, it tends to force a reduction in economic rent or surplus rewards to productive resources. The lower prices consumers pay increases what economic literature calls… Consumer Surplus…at any given level of "money" income consumers earn, they can buy more goods and services in real terms as deflation occurs - it’s not what you earn, but what you can buy with what you earn. In societies like ours, there is a widely held majority view that the income distribution coming from the market is too unequal; to address this perceived problem, higher income people are taxed and the revenues are transferred to lower income people (i.e., transfer payments). The personal income of the poorer segment of the population is greater than the income they actually earn in the market - the opposite is the case for the higher income portion of the population. This is the effect of the tax-transfer payment process. Since the entire population are consumers, and the portion of the population that supplies productive resources is smaller than whole, then increasing competition passes the productivity dividend along to the consumers in the form of lower prices and higher consumer surplus rather than back to the productive resources in the form of economic rent, or producer surplus: income distribution is more equal as competition increases in markets, even without the tax-transfer payment process. Increasing competition, restructuring, and the real rate of economic growth One of the reasons for publishing this newsletter was to interpret current economic behavior and the data reflecting that behavior through the eyes of the New Paradigm in Economics. Most are painfully aware of the down side of this landscape change in the American economy, namely a very large number of well qualified and experienced workers that are structurally unemployed. Many do not fully realize the reasons for this phenomenon nor do they realize the long-term beneficial effects of this landscape change. This is especially true of the impacts of the New Paradigm on the income distribution and the rate of potential real economic growth. While a complete understanding of these impacts requires knowledge of very difficult economic theory, the next paragraph will attempt to explain the benefits in simpler terms. The restructuring that has been going on for several years has accelerated in recent years. In fact, since the economy has been in a recovery/expansion phase for over seven quarters, most of the remaining unemployed (plus discouraged) workers no longer looking for work, are structurally unemployed, not cyclically unemployed. (See previous issue of this newsletter for a distinction between various types of unemployment.) These structural layoffs of workers are usually necessary for firms to survive. In the case of automation, e.g. CAD/CAM, labor productivity increases and causes the unit labor costs of this less labor intensive production mode to decrease. For society, however, the productivity dividend is not achieved until the structurally laid off workers are reemployed. Until that occurs, the additional output that would come from the employment of this labor is aborted and no dividend occurs to society. This not only means that a higher rate of real economic growth can be achieved, but that it is in fact required so that the structurally unemployed are re-deployed for us, as a society, to receive this painfully achieved productivity dividend. In simple terms, this restructuring means: a higher per capita standard of living once the structurally unemployed are back to work. (Volume 2003: Issue 1) August 6, 2003 What Recession? I am constantly amazed by students and the public at large when they ask about the recession we are in. Of course as the data from the Bureau of Economic Analysis shows in Figure 1, we are not in a recession and have not been for over one and one-half years. As you can see in Figure 1, the recovery began in the fourth quarter of 2001 and has continued through the first quarter of 2003. All indications are that when the data of the third quarter of 2003 comes out, it will show that this last quarter was a continuance of the recovery /expansion. (Parenthetically, after over one and one half years of recovery, the exalted National Bureau of Economic Research declared that the recovery had begun in November of 2001. There is nothing like timeliness to add credibility to an organization’s pronouncements.) Data from Bureau of Economic Analysis, National Income and Product Accounts (U.S. Dept of Commerce) When I tell my students that and show them the data, they invariably wag their fingers at the unemployment figures. I then distinguish between the cyclical unemployment, of which there is very little, and structural unemployment, of which there is a significant amount. Structural unemployment is the flip side of rapid increases in labor productivity that result from restructuring. The old jobs are gone and will not come back with expansion; new jobs must therefore be created. To a great extent, these increases in productivity are a result of restructuring. This increases the competitive ability of firms. It tends to lower their unit labor costs. Unfortunately for society, the productivity dividend to the public at large does not occur until the structurally unemployed are re-deployed into new jobs, sectors, etc., producing additional goods and services. None of this was possible before the restructuring occurred since the redundant labor was buried in the cost of the given product. We need a stimulus, not to recover from a recession, but to reap the productivity dividend by re-employing the structurally unemployed in newly created jobs. As the New Paradigm argues, we can experience a faster real rate of economic growth without serious inflation re-emerging. Let us hope that the Federal Open Market Committee (FOMC) has learned a lesson from the ill advised policies of 1999-2000. The greatest defense against inflation is significant competition in the market place. Data from Bureau of Economic Analysis, National Income and Product Accounts (U.S. Dept of Commerce) THE NEW PARADIGM In my public presentations, going back a few years and in my classroom lectures, I began to find the existing macroeconomic analysis of increasing irrelevance. That analysis is usually referred to as Keynesian demand side macro. I had similar misgivings about monetarism and its explanation of inflationary episodes. It seemed that the economic landscape had been gradually evolving and a new perspective was needed. As I argued several years ago, and has become increasingly apparent of late, the gradual increase in the strength and pervasiveness of competition has been causing profound changes in product and resource markets. It appeared that firms in a growing number of industries were losing their price power. Resources such as labor were experiencing declining job security. Terms such as globalization, privatization, deregulation and commoditization were seen more and more in the literature of business. As economic analysis has always argued, the presence of increasing competition reduces the ability of business to raise revenue by raising price. As Alfred Marshall pointed out many years ago, that when firms face little competition and thus have monopoly power (when demand weakens), they do not cut price, they cut output. When John Maynard Keynes developed his new paradigm, published as his GENERAL THEORY (1937), its centerpiece was the downward inflexibility of prices, caused by declining competition in markets. As I point out in Chapter 12 of my text, THE NEW PARADIGM IN ECONOMICS, downward price rigidity in markets due to lack of significant competition causes a bias toward frequent and severe episodes of inflation and recession. Prices will rise but rarely fall in markets with little competition; an inflationary bias results. The U.S. was experiencing the growth of cartelistic capitalism from the late 1800s through the Second World War, in both product and resources markets such as labor. The auto, steel, telecommunications, and lumbering industries all experienced the rise of "big labor" in the form of the UAW, USW, CWA, etc. The markets no longer worked as argued in the neo-classical economic tradition. The late 1920s and much of the 1930s proved that prosperity was not just around the corner. Keynes’ writings were really geared toward explaining the Macroeconomics of cartel-laced free market capitalism. Incidentally, that era of cartelism began to decline after the Second World War. Re-globalization or world trade was reborn with GATT and the IMF fixed exchange rate system. Deregulation began and continues today. The Hot, Cold, and Space Wars caused rapid technological change, undermining any efforts to control many markets. Privatization continues to bring competition into areas such divergent services as garbage collection and education, all formerly the domain of government ownership. We are increasingly experiencing an evolution toward competitive free market capitalism. Growing competition reduces market power of both firms and the resources they employ. As costs rise and profits decline, the old remedy of raising prices to increase revenue becomes less and less effective in raising revenue and restoring profits. Economic theory tells us that as competition increases, price elasticity of demand at each price increases. The rationality of price increases in terms of maximizing profits declines. When competition increases, prices become more flexible downward as firms lose their control over pricing. As prices become less rigid downward and firms have less power to raise prices, the inflationary bias weakens. As firms lose their power to protect price by reducing output, and output cuts are moderated by falling prices, the recessionary bias is lessened. This means that episodes of inflation and recession become less frequent and when they do occur, they are less severe in terms of duration and depth. This moderation of the business cycle also logically means that past patterns of significant and prolonged periods of accelerating inflation like the 1970s are much less likely to occur. The fears of inflation re-igniting in 1998-2000 were unjustified in the light of the New Paradigm. Increased competition in many formerly cartelistic markets did not bring about the demand pull inflation characteristic of years back when the economy was experiencing strong and sustained growth. A recent Ford Motors Economics Staff presentation at a DABE meeting showed that auto prices adjusted for content, have been drifting downward for many years, especially the last five years. This is a far cry from the sticker shock years of the past, when two price increases per year were common. Given the huge increase in market share of the transplants, and the corresponding increase in competitive pressures, the reason for the loss of price power by firms in that industry is apparent. Since the FED engineered recession of 1980-82, we have experienced only two mild recessions. Bear in mind that FED policies in the 1970s were designed to allow adjustments for two massive oil price shocks, in the hope of avoiding devastating effects on employment. Unfortunately this led to an inflation rate in 1979 of nearly 15 percent and an annualized inflation of greater that 20 percent in the last two months of that year. The FED, under Paul Volcker, then made a one hundred and eighty-degree policy turn, and made eliminating inflation their number one policy goal. Twenty years ago, the economy was less competitive than it is now. Fighting inflation when prices were more rigid downward resulted in a deep and relatively long recession. Since then, more extensive deregulation, privatization, globalization, and commoditization have reduced a good amount of that downward price rigidity as competition has since become more extensive and significant in markets. The reduced severity of the two recessions since then can be seen in the BEA data. The most recent recession, in the first three-quarters of 2001, was swamped by the recovery in the fourth quarter of that year, and positive growth for the 2001 calendar year over all. Data from Bureau of Economic Analysis, National Income and Product Accounts (U.S. Dept. of Commerce) WRONGFUL ECONOMIC POLICIES AND THE RECESSION THAT SHOULD HAVE NEVER BEEN This last recession, short and shallow though it was, should have never occurred. There are two smoking guns, so to speak, that caused it. The first was the steady rise in the effective tax rate from 1993 through 2000 as can be seen in the chart (Figure 3). In an Internal Revenue Service report in 2002, the IRS shows that effective tax rates, Federal Income Taxes as a percent of both Adjusted Gross Income and Taxable Income had risen each year from 1977 through 2000. They go on to say that in the seven years prior to and including 2000, six of those years showed a similar rise in the effective tax rate. Old Paradigm or New Paradigm, taxes depress the economy by reducing Disposable Personal Income. In 1998 and throughout 2000, the FED through its spokesman, Alan Greenspan, kept saying that the growth rate being experienced could not be sustained without a significant re-igniting of significant inflation. Furthermore, Greenspan cited irrational exuberance as causing an excessive growth rate in personal consumption. A major culprit he cited was the Wealth Effect. And in turn, a major cause of this the wealth effect was the suspicious growth rate in the stock market. This should have warned all stockholders, institutional or individuals that stock prices had to suffer. The inflation indices, especially the core rates did not really support such dire comments. As the tax burden continued to rise, The FED (FOMC) began a policy of severe monetary constraint in 1999 continued it through 2000. Give this two pronged constraint of fiscal and monetary policy, the economy began a collapse in mid-2000 and then turned negative in the first quarter of 2001 and stayed negative through the third quarter. The Fed more or less said it was a pre-emptive action. The lesson of the New Paradigm has apparently escaped the understanding of the fiscal and monetary authorities. The threat of inflation is much reduced as competition became more pervasive and significant in many markets. To make things worse, the power of monetary policy re revive an economy that it has caused it to fall into a recession, is indisputable. That power is somewhat lessened in an economy where prices have become much less rigid downward. The problem is that the FED’s power to revive an economy is much weaker than it is to slow it down. Primarily through open market operations, it controls the capacity of depository institutions such as commercial banks to create money and credit. Restrictive policies cause the capacity to create money and credit to grow more slowly than the demand for money and credit by the public. This increasing scarcity of money and credit is what causes interest rates to rise. But the FED cannot conversely force demand for money and credit to rise in a weak economy even when they attempt to flood the system with excess reserves. Unless profitability in credit creation is there, monetary stimulus fails. The power of the FED’s monetary policy is asymmetrical. This is why the long string of the FED actions aimed at lowering interest rates has done little to bring us back to a more robust economy. Heavy tax rates also reduce the demand for credit. Until more robust growth is achieved, the productivity dividend from restructuring is aborted. To reflect this unfortunate reality, a new term has been coined, Duppies. It stands for Depressed Urban Professionals. Several former students of mine are among this involuntary cohort. In an article by Haggin Geary, a CNN/Money staff writer, appearing on June 17, 2003 examples of the hundreds of thousands of former high-income individuals, once earning upwards of $200,000, are now lucky to earn $20 per hour ($42,000). Many remain unemployed or have turned to entrepreneurial endeavors.
