In my last post in this series, I said "inducing misallocation of resources appears to be an important part of why inducing lenders to take greater risks does not sustain itself for the long term and may be a key to evaluating the longer-term impact of aggressive monetary policies." Now it is time to see whether low-interest-rate policies do in fact cause misallocation of resources - and therefore lower productivity - by inducing investors to seek higher yields, as well as whether such misallocations of resources may be a key reason that credit-induced booms do not last.
I cannot offer definitive answers to these questions, but recent work by scholars at the Bank for International Settlements, or BIS, provides a foundation for making more educated guesses.
Recent work on productivity in times of easy money
Recent work by lead economist Claudio Borio and his colleagues at the BIS is persuasive to the effect that easy monetary policies lead to reductions in productivity growth. And since the work comes from the central bankers' bank, and was led by its chief economist, it has a presumption of probity when it criticizes the impact of prevailing central bank policies.
Here is what the authors said in their abstract:
First, credit booms tend to undermine productivity growth by inducing labour reallocations towards lower productivity growth sectors. A temporarily bloated construction sector stands out as an example. Second, the impact of reallocations that occur during a boom, and during economic expansions more generally, is much larger if a crisis follows. In other words, when economic conditions become more hostile, misallocations beget misallocations.
The data are summarized by a single chart that shows labor reallocation is what reduces productivity in a credit boom and thereafter:
It is axiomatic that some economic sectors are more productive than others. That is, workers in some sectors produce more than workers in other sectors. That is how productivity is measured - production per hour of human labor.
Given the way that productivity is defined, any policy that induces growth of less productive segments that is greater than the growth it induces in more productive segments must reduce overall productivity. And any policy that induces more growth in the more productive sectors must result in greater productivity. (These effects may be moderated if the policy changes the relative productivity of the sectors. That is a factor to be followed. But such changes-reversals-are relatively rare.)
Where are new jobs created?
One would think that economic policies should be designed to create more demand for labor in the more efficient sectors (without making them less efficient) so that overall productivity and output could increase. But that does not appear to be the impact of low interest rates used to stimulate economic growth. It appears that low rates encourage greater growth in less efficient sectors, thereby lowering overall productivity, or at least moderating its increase.
But if it is not possible to create significantly more jobs in the high productivity sectors, it may be that policies that increase jobs in lower-productivity sectors are appropriate, and that using conventional productivity measures to evaluate success is misleading, so long as more jobs are the policy goal.
To take a potential example, it may be that using low interest rates to induce investment will not make Google - a high productivity company that engages a great deal in R&D - hire many more people because its issue is not funding but need for people in order to carry out its ideas. The same policy, however, might induce a homebuilder - a lower productivity company - to hire many more people because the cheap financing of homes makes them cheaper and more salable. So long as overbuilding of homes does not take place, the policy may be beneficial despite its negative measured impact on productivity growth. (I will return to the overbuilding question later - the overbuilding possibility may be a reason that low-rate-induced booms are self-limiting.)
Contrasts in worker productivity
The contrasts in productivity (as measured) can be enormous. Revenue per employee at McDonald's is $65,000 and at Wal-Mart $220,000, but at Apple it is $1.9 million (not including, of course, its outsourced suppliers), at Google $1.2 million, Facebook $1.3 million, and at asset-heavy Exxon, it is (or was when the oil price was higher) $5.2 million. (All based on 2013 figures from S&P IQ.) Productivity does not ask about profitability, but if we were to ask about that to round out the picture, the range is from a low of $7,000 per employee at Wal-Mart to $11,000 at McDonald's to $269,000 at Google, $319,000 at Facebook, $407,000 at Apple, and $434,000 at Exxon. Measured productivity increases (decreases) in the economy as a whole, therefore, depend to a great extent on where new jobs are created and where jobs are eliminated rather than on whether new technologies are making jobs in the aggregate more productive.
Who needs jobs?
We can call the creation of low-productivity jobs misallocation of resources. But if we look at who needed the jobs, we might change our minds. As you can see from the following graph by Calculated Risk, the unemployed were and are the less skilled, who by definition are less productive. That is who needed the jobs, both in the boom time and in the aftermath of the bust. It would not have been possible to decrease unemployment significantly by creating jobs for college graduates. Productivity growth figures, it appears, may be measuring the wrong thing. In fact, perhaps decreased productivity may be a sign that policy is having its intended result - that is, creating jobs for less skilled people.
Adam Davidson wrote an interesting piece in The New York Times Magazine, published February 17, 2016, in which he said:
Productivity growth, at its simplest, means that people can achieve more in a given amount of time than they used to be able to. It's the only way that human beings, as a group, can become better off.
I agree. Therefore, education is the key - and maybe the only key - to people becoming better off.
Technology has displaced workers for centuries
Theory would say that efficient use of capital will target investments that will increase what an individual worker can produce. But the workers who benefit from those advances in productivity may not be the workers who lack skills. That would not be a new phenomenon. In the 20th century, farmers gradually used more and more automation. That automation enabled each farmer to produce vastly greater amounts of food than previous generations of farmers could do. But, of course, that also caused the farm population to shrink to less than a tenth of its former number. The former farmers had to become something else or starve.
Fortunately for the former farmers, factories were creating jobs that former farmers could do quite readily. And the use of capital at factories made those jobs fairly productive. (Unions did play a role in the price of labor, of course.) In the 21st century, the workers displaced by automation or competition and without new skills have to compete with too many other workers in similar positions of skill-deficiency. And efficient capital is moving either in the direction of replacing the less skilled worker entirely (as farm automation did) or creating new higher-level jobs that require skills that the skill-deficient worker cannot readily acquire.
Men's educations have not kept up
Seen in this light, the negative impact on productivity growth that Borio et al identified is merely an incidental and inevitable result of what easy monetary policy intends to do - that is, induce a higher level of employment for less skilled workers. If policy wants to provide both more jobs and higher productivity, then it has to focus more closely on education. In order for economic growth to provide real benefits to middle and lower class Americans, that growth has to come from more education and higher skill levels. However, since the late 1960s, men have not kept pace educationally. For the previous 60 years, men were gradually becoming better educated. That came to a stop, and wage stagnation accompanied that stop. I did not expect to be writing about that issue in this post, even though it is the central subject of my book, The Education Solution (see the-education-solution.com), which contains data to support this paragraph and others about education.
To counteract men's lack of educational progress, credit-induced employment of the less skilled appears to be a poor substitute.
The reason is that both the misallocation of resources and the "policy is accomplishing its employment goals" hypotheses appear to be correct at the same time. By that I mean that although jobs are being created in the only sectors where jobs reasonably can be expected to be created, those sectors fairly quickly get overbuilt as a consequence, and when that occurs, the debts incurred to support the new jobs becomes difficult for the borrowers to repay. That happened in the 2003-2006 housing boom, it has happened in China to its debt-fuelled infrastructure and construction boom, it happened in 1997 to the Thai construction boom, in the late 1980s to the Japanese construction boom, in 2015 to the U.S. shale boom, and to countless others that are in the data base that Borio et al used in their recent paper and that Reinhart and Rogoff had in their data base for This Time Is Different. Because the sectors being supported by cheap credit are not the most productive, the cheap credit, by its nature, causes overbuilding or overproduction that eventually leads the boom to end with a credit crash.
If that finding is correct, then one would have to conclude that the policy of encouraging employment by lowering interest rates is self-limiting and doomed to reverse itself unless the government is prepared to bail out the lenders and borrowers responsible for the overbuilding - and to do so time and time again. In other words, policy cannot create long-term employment for inefficient workers on a large scale.
Many, including most Keynesians, will reject that finding. A perpetual boom they think is possible, if only government would manage the economy right. That seems to me not a reasonable hope in the real world. And seeking to maintain full employment for less skilled workers seems to be one reason that credit cycles eventually (often within a bout five years-see graphs in my last post in this series) turn against the intended full employment goal. Borio and his co-authors say:
If loose monetary policy contributes to credit booms and these booms have long- lasting, if not permanent, effects on output and productivity, including through factor reallocations, once the bust occurs, then it is not reasonable to think of money as neutral over long-term policy horizons...
Nor is it surprising if monetary policy may not be particularly effective in addressing financial busts. This is not just because its force is dampened by debt overhangs and a broken banking system - the usual 'pushing-on-a-string' argument. It may also be because loose monetary policy is a blunt tool to correct the resource misallocations that developed during the previous expansion, as it was a factor contributing to them in the first place.
If a boom is followed by a financial crisis, Borio et al find, the misallocations persist for longer and deepen because: "during busts, the interaction between financial crises, the scarcity of credit, slow balance sheets repair and the need to reverse the previous resource misallocations linked to temporarily bloated sectors."
"Put differently," they say, "it is the combination of a financial crisis with past misallocations that generates the largest and most long-lasting damage to productivity."
What should monetary policy do to respond to these findings?
These findings are challenging to the use of monetary policy as a primary tool to implement a social policy of full employment. At the least, the findings should cause central banks to place less faith in their long-term ability to effectuate full employment. At best, monetary policy can do so only by fits and starts.
Longer-term mechanisms to encourage full employment are needed. Perhaps they can come from fiscal policies that create productive work for the less skilled. That would work for a period of time as long as the projects undertaken were useful. But such mechanism cannot go on for a long period of time without causing its own misallocations of resources, which also would have negative consequences, as it is having in China contemporaneously.
I, therefore, come back to education again. The stagnation of middle class and lower incomes began when men stopped improving their educational levels. Those levels have again begun to improve in the last few years. But there is a lot of catching up to do. For how to catch up, please see the-education-solution.com. For the long term, improved education is the only way to encourage the economy to perform at close to full employment. The misallocations created by easy credit policies confirm that monetary policy is not a path to a sound long-term full employment policy.
Implications for investors
The natural implication of this analysis for investors is that in the U.S., credit probably has induced all the low-skill hiring it is going to induce, and the employment level is likely to stagnate or decline as credit for riskier businesses becomes tighter, as I described in the last post in this series. That suggests to me slow or negative growth over the near term, continued low relative interest rates (though higher rates for riskier credits, as we have been seeing for about a year already). In this environment, medium-grade credits such as those that populate iShares iBoxx High Yield Bond ETF (NYSEARCA:HYG) may, in the aggregate, outperform other investments because they carry a reasonable yield (around 6%) with less default probability characteristics than lower rated credit. But I see this as a time to be cautious, despite the sell-offs in many markets, because monetary policy is played out, balance sheet repair again is coming to the fore for lower rated credits, large employers such as Wal-Mart (NYSE:WMT) are facing headwinds, and social forces designed to increase the earnings of the less skilled will naturally cause lower employment levels for a period of time.
Disclosure: I am/we are long HYG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.