A new concern about the economy has surfaced recently. This new concern has to do with the changing structure of the economy and the impact this change might have on the outcome of government policy.
Specifically, the argument is that the United States economy, and that of the world, is currently going through a transitional change that only occurs once or twice every century. This is the transition that takes place in the productive structure of the economy—a sort of “tipping point”.
There is no doubt that the structure of automobile production is going to be different in the next ten years from what it was over the past fifty years or so. This shift will affect dealers, suppliers, and many other companies that are peripheral to the car-making process. But, changes are also taking place in the way that different forms of energy are going to be provided. Information technology continues to change and we still don’t know what the future looks like in this area. And, these are just a start.
The point is that the world has changed. People that are facing unemployment due to the collapse of the auto industry are not going to find the same employment opportunities in the future that existed in the past, even if the stimulus and bailout packages work. There will be a different focus in energy with new types of jobs becoming available and the old types being less plentiful. Openings in health care are going to be different. And, what about employment in financial services? New jobs might be much more plentiful in government service. And some people are calling for a re-instatement of the military draft.
This changing structure is going to impact many, many people who will need to change jobs, change where they live, and change skills. During times like these, what is called the non-inflationary rate of unemployment tends to increase. This is because the structure of employment has changed and the industry and the economy need to adjust to accommodate this change. Whereas, the non-inflationary rate of unemployment for all workers over the past ten years may have been around 5.0%, this rate, looking forward, may be at 6.0% or more depending upon the restructuring that needs to take place.
What is the problem created by this shift?
The models used by the federal government in determining what monetary and fiscal policies are appropriate for achieving “full employment” contain the lower estimate for the non-inflationary rate of unemployment. These models are based upon historical data and the “historical data” don’t include the adjustments that are now taking place in the actual economy.
The consequence of using an unemployment figure that is too low?
Deficits will be greater than expected because government tax revenues will be lower than initially projected and the choices for monetary policy will be too expansionary for the new structure of the economy. That is, the employment situation will be worse than expected and the pressure on prices will be greater than expected.
What does this mean for the results that we will be seeing? Well, it means that unemployment will remain higher than what is desired and inflation will also remain higher than desired, even though the pressure on wages will be downward. That is, there will be a greater fall in real wages than expected and this will further dampen consumer spending and cause additional foreclosures and personal bankruptcies.
This can have further repercussions in financial markets as increasing federal deficits and rising unemployment puts additional pressures on the Federal Reserve to monetize the debt. Long term interest rates will not fall under these circumstances even though real resources are seemingly under-utilized.
What is happening here?
To me, what is happening is confirmation of what I was writing about last summer and through the fall and winter. First, the shift in economic activity is coming from the supply side of the economy—and not from the demand side! Most economists (and this is especially so with the reincarnation of the Keynesian school of thought) interpret a slowdown in economic activity as a deficiency of demand. Hence the monetary and fiscal policies that are created aim at restoring sufficient demand to return the economy to full or near-full employment levels.
If the slowdown in economic activity is coming from the supply side, different monetary and fiscal policies are needed to confront the state of the economy. A slowdown in economic activity coming from the supply side needs policies that deal with the structural changes in the economy and these require efforts much different from demand side policies.
Demand side stimulus, in cases like this, often exacerbates the problems because all the demand side stimulus seems to do is try and force the unemployed people back into their old jobs which are no longer available. If the structure of production and employment has actually changed, then these old jobs have disappeared and there is no way that demand stimulus will bring them back into existence. Hence, too much money is chasing too few goods—even though unemployment has increased.
The second factor I have discussed before is that there is too much debt outstanding and that this problem must also be dealt with before economic expansion can begin again. But, if there has been a structural shift in the economy, this situation becomes more problematic because a higher rate of non-inflationary unemployment means that previous debt loads are even more out-of-line with what people can handle than at the rate that was being used before. That is, the debt problem is worse than previously anticipated.
The Federal Reserve and the Obama administration still seem to believe that the problem in the financial markets is one of liquidity. However, the problem is one of solvency and this is a structural problem and not one that is temporary and handled by buying more and more different kinds of securities. The focus on the liquidity available in different segments of the financial markets and on the balance sheets of banks is misplaced. Individuals, businesses, and governments have too much debt outstanding relative to the state of the economy. The auto industry is “painfully” shedding some of its debt. The Treasury Department is attempting to help the banking industry shed some of its debt. Still, there too much debt outstanding and the federal government is adding more and more to this total.
The bottom line is that the changes that have taken place in the United States economy are structural in nature and must be dealt with as such. Unfortunately, the policy makers in Washington, D.C. don’t seem to see it that way. As a consequence, the policies that have been forthcoming may only add to the dislocations that exist in the economy and result in a rate of inflation that only adds to these problems.
Even with the substantial decline in real GDP in the first quarter of 2009, the GDP deflator rose at a 2.9% year-over-year rate of increase. This is worrisome. But, when output falls and inflation rises or stays relatively constant, this is an indication that the supply side of the economy has shifted and not the demand side.