The Bernank Comes To Town

by: Acting Man

The Fed and Unemployment

Fed chief Ben Bernanke decided to mingle with the people in keeping with the Fed's new, more open communications strategy. This was done by holding a 'town hall' style meeting at Fort Bliss, an army base in Texas. A transcript of the speech can be seen here.

As we have noted previously upon the introduction of ECB style press conferences after Fed meetings, this is a policy that harbors the danger of backfiring during a secular contraction.

While asset prices are rising and it's party time, there is no need for the central bank to explain itself – it is enough if it drops the occasional hint that it is to be held responsible for the good times (such as Bernanke's back-patting 'Great Moderation' speech back in 2004). When prices go up, 'people will believe the most preposterous stories' to paraphrase Bob Hoye. They will even read and write books hailing the central bank chief as 'The Maestro', which happened to Alan Greenspan shortly before he was pushed off his pedestal.

When prices fall, it is a sign that selling these preposterous stories becomes more difficult. After all, if monetary central planning efforts were responsible for the good times, how come they shouldn't be held responsible for the bad times? If central economic planning 'works' as its proponents assure us, then why was there a crash in the first place and why is there an ongoing crisis?

Well, say the planners, this is akin to an earthquake or a hurricane that suddenly befell us. The good times were undoubtedly our doing, the bad times by contrast are a natural disaster, an act of God. In fact, they say, the bad times are altogether due to the 'defects of the market economy' that we are here to fix.

In keeping with this narrative, Bernanke has lately been busy beating a hasty retreat from assuring us that the Fed can deliver everything short of leading us to Cockaigne. In particular, he has ever more frequently sounded a new note regarding the Fed's ability to deliver on the second part of its dual mandate, namely the 'creation of jobs.' Of course, anyone with even a smattering of good economic sense should be aware that this is an impossibility anyway. Just ask yourself, what is it that actually creates jobs in the real world? The answer is, economic growth. What creates economic growth? Savings, investment and production. The central bank certainly has great influence on these by tinkering with interest rates, but none of it is good. In fact, it is especially during the so-called good times of the boom – the time when people generally do not stop to question its policies – when the most harm is done.

Bernanke has lately begun to adopt the position first enunciated among his colleagues by Minneapolis Fed president Narayana Kocherlakota. This essentially states there's little the Fed can do about unemployment, given that the problem consists mainly of a mismatch between the types of labor demanded and the types of labor offered: in other words, quite a few people need to either acquire new skills or be prepared to lower their wage demands and accept the wage rates paid for unskilled work. The latter possibility is of course hampered by the existence of minimum wages – many types of unskilled labor have simply been 'priced out' of the market by law.

As an aside, Kocherlakota also frequently stresses the role of 'regime uncertainty' in his speeches, such as this one. This of course is normally the hobby horse of Richard Fisher in Dallas.

We actually agree with these deliberations. The malinvestments of the boom are as a rule concentrated in specific sectors of the economy – a mismatch between production and the actual future demand of consumers is created. The 'bubble sectors' are bidding away labor from other sectors of the economy during the boom, and labor skills that were useful for the booming sector will no longer be in demand once the boom falters. Just as capital goods are heterogeneous, so is the labor market. As Ludwig von Mises notes in Human Action, there is no such thing as the 'labor market in general':

What is sold and bought on the labor market is not "labor in general", but definite specific labor suitable to render definite services. Each entrepreneur is in search of workers who are fitted to accomplish those specific tasks which he needs for the execution of his plans. He must withdraw these specialists from the employments in which they happen to work at the moment.

The housing bubble is actually an excellent example for this – the types of labor demanded by builders, such as roofers, electricians, plumbers, bricklayers and so forth are all highly specific. After the boom ends, there will be a certain amount of what Mises referred to as 'catallactic unemployment' for a while. What is meant by this can be illustrated by an example: a plumber in the former building boom town of Las Vegas, who no longer finds work in his line may well be able to get a job as a waiter in, say, Los Angeles. Alas, he would have to be prepared to move as well as accept a lower wage. In the early phase of the bust, he may well decide to 'hold out' and live from his savings for a while, in the hope that the housing sector recovers.

Clearly the housing bust has lowered the demand for all sorts of labor to do with the housing sector, in all the parts of the production structure that were involved in producing goods and services that are in some way related to building and real estate development.

Since one can not expect a plumber to become a computer programmer overnight, it will take a while for the shift of labor from the sector that has faltered to the sectors where labor is demanded to occur. The surfeit of real estate agents may be quicker to dissipate, since the skill set of salesmen can be more easily transplanted to a different sector of the economy. In other words, the less specific the type of labor concerned, the easier it will be to transfer it to new employments.

In this sense the problem is very similar to that entrepreneurs face with regards to the disposition of investments in capital goods that have turned out to be unsustainable – the less specific the capital goods concerned, the easier it is to transfer them to new uses. Highly specific capital on the other hand may just have to be liquidated (the corollary to this in the labor market would be the abandonment of a skill set no longer in demand and retraining to replace it with a new one – obviously this takes time).

Anyway, by law the Federal Reserve is expected to 'ensure maximum employment' and as a result of the persistence of high unemployment in the wake of the 2008 crisis, Bernanke is now beginning to distance the Fed from this particular responsibility.

In his speech to the veterans in El Paso he said on this point:

In the longer term, monetary policy is the main determinant of inflation, and so Federal Reserve policymakers have considerable latitude to choose our longer-term inflation goal. In contrast, "maximum employment" depends on many factors outside of the Federal Reserve's control, such as the skills of the workforce and the pace of technological innovation.

In other words, there's nothing they can do. The main reason for adopting this stance now is of course to ensure that no-one gets ideas about pointing a finger at the Fed and accusing it of not fulfilling its duties. This is why we hear these admissions now and haven't heard them during the boom.

Alas, Bernanke also assures us that the planners have ascertained that the Fed has now great latitude in terms of monetary pumping. It has apparently just rediscovered the long discredited 'Phillips curve'. Says Bernanke:

Right now, my colleagues on the Fed's policymaking committee estimate that the U.S. economy could sustain an unemployment rate of somewhere between 5 and 6 percent without generating a buildup of inflation pressures. But, regardless of whether the sustainable rate is 5 or 6 percent, with unemployment currently at 9 percent, our economy is certainly falling far short of maximum employment. That high unemployment rate is why the Federal Reserve is focusing its monetary policy at strengthening the recovery and job creation, including keeping short-term interest rates near zero and longer-term rates, such as mortgage rates, at the lowest levels in decades. Keeping borrowing costs very low supports consumer purchases of houses, cars, and other goods and services, as well as business investment in new equipment, software, and facilities. Over time, greater demand on the part of households and businesses leads to increased economic activity and employment.”

(emphasis added)

When Bernanke speaks of 'inflationary pressures' he is referring to the rate of change in prices in the economy. He is unconcerned about the distortion of relative prices that monetary pumping brings about – instead he worries solely about 'aggregate price indexes' such as the CPI. The above mentioned 'Phillips curve' holds that there is a trade-off between unemployment and 'inflation' (this is to say, the rate of change of CPI). It is a typical example of an alleged 'economic law' supposedly 'discovered' by empirical observations.

We have previously discussed the impossibility of empiricism to establish anything about economic theory. Theory in economics is antecedent to empirical observations. We will discuss this point in greater detail in an upcoming post, but let us just note here: economic history, i.e. the economic data and statistics describing the past, does not represent the equivalent of a controlled and repeatable experiment. The number of factors influencing a certain constellation of the market data at any given point in time is so complex that it is not possible to determine what economic laws are operative by means of such observations of the past. It is also not possible to make any quantitative forecasts whatsoever - economic theory can only ever provide us with qualitative forecasts. To illustrate this with a simple example: we all know that if the money supply is increased, prices will rise. Alas, it is not possible to make a forecast that states precisely by how much prices will rise, or which prices will rise, based on a certain amount of money supply expansion. The market data such as they were and are result from the decisions and value scales of all individual actors taking part in the economy. These can not be quantified.

The Phillips curve specifically asserts that there are two sets of data – unemployment and rising prices - that are 'statistically correlated.' Well, so are death by drowning and the consumption of ice cream (hat tip to the Irish Liberty Forum):

There is a clearly discernible correlation between death by drowning and the consumption of ice cream – can it be a coincidence?

However, there is of course more to the Phillips curve than just a 'post hoc, ergo propter hoc' fallacy. It is indeed possible to lower unemployment by means of monetary pumping as long as the economy's pool of real funding is still growing. This is to say, it is possible as long as the generation of real wealth still exceeds the capital consumption engendered by credit expansion, as this makes it possible for monetary pumping to divert resources into new wealth-consuming bubble activities.

Just as the capital malinvestment of the boom creates plenty of illusory accounting profits in the early stages of the boom, so does it create an artificial demand for labor. As a rule this demand will appear in the higher order stages of the production structure, as the structure tends to be lengthened beyond what the pool of real savings can actually support when interest rates are kept artificially low and more and more fiduciary media are thrown on the loan market.

However, this means that what Bernanke is effectively proposing is to create additional unsustainable capital malinvestment in order to temporarily lower the rate of unemployment. One would think that the idea that there will never be a price to be paid for pursuing this course should be subject to re-examination even among empiricists.

After all, the Fed did precisely the same thing after the fairly recent faltering of the technology bubble. The result was a boom period that consumed capital on a rarely seen scale, sustaining the illusion of growing accounting profits and a solid labor market for a few years, until the malinvestments were unmasked in the subsequent bust (all it took for that to happen was for the growth in broad US money supply TMS-2 to slow down to just above 2% year-on-year in 2006-2007).

So even if one does not possess the necessary theoretical background to properly interpret what has happened, one should be aware that something has gone wrong. This in turn should provide grounds for re-examining the policy that has led us to this juncture.

Demand As the Be-All and End-All and the Wonders of 'Financial Education'

Consider what else Bernanke states above: “Over time, greater demand on the part of households and businesses leads to increased economic activity and employment.”

This indicates that he believes that if only people were to increase their consumption, the economy would spring back to life. It implies a belief that there is a 'problem with demand'. However, as anyone can ascertain simply by means of inner reflection, demand as such can never be an 'economic problem' – not until all our wants and needs are fully satisfied. As long as it is still possible to imagine a state of greater satisfaction than the present one, we will all be founts of sheer endless demand.

The question is not one of there not being enough demand for goods and services, but how the goal of satisfying this demand can in fact be attained. In Bernanke's view, consumption apparently precedes production. In the real world, the cart won't move if it is put before the horse. In short, one must first produce before one can consume. This sounds like a simple enough truism, but it evidently eludes many a leading light in today's economic mainstream orthodoxy.

It is also not the case, as Bernanke seems to assume, that 'increased economic activity' as such is a worthwhile goal. Naturally we all want the economy to grow, but there is still a vast gulf between economic activity that actually generates wealth and activity that squanders scarce resources. The Fed's monetary pumping is unfortunately liable to mostly create the latter.

So even if it succeeds in temporarily lowering unemployment by setting in motion exchanges of nothing (money created ex nihilo) for something (the real resources this money is used to bid for), these activities will once again prove unsustainable – and once this has been discovered, we will turn out to be poorer than we would otherwise have been.

Bernanke's recent comments on the plight of savers caused by the Fed's policies follow a similar line of thinking as his comments regarding the egging on of consumption. Savers, so he recently averred, are being punished by the Fed for the 'greater good of improving the economy's health.'

However, the economy's health crucially depends on savings. Without saving, there can not be investment, in other words, no capital accumulation can take place unless people first save. Wealth can not be increased by increasing one's consumption – it can only be increased by setting aside some consumption in favor of saving and investment. One can of course heat one's home for a while by burning the furniture. Alas, at some point one ends up in a situation where one will have neither furniture nor heating.

Bernanke wants to force savers to abandon savings in favor of consumption and speculative activities – he for instance specifically held an increase in stock prices to represent a 'mark of the success of QE2' earlier this year.

Alas, when stock prices rise due to money supply inflation, this only entraps investors by leading them to buy overvalued securities. Those who bought stocks in April when he made his remarks on the stock market are still nursing losses today.

In this context he gave astonishing advice to the veterans: they should 'educate themselves about financial matters'. It is of course not a bad thing when people educate themselves about financial matters – but it is quite odd to receive such advice from the man whose main job it evidently is to debase the currency as quickly as possible and who bears a major responsibility for having participated in the creation of a huge wealth-destroying bubble.

Finally, educate yourself about your own personal finances. Research by the Federal Reserve right here at Fort Bliss shows that financial education can pay off.4 Beginning in 2003, the Federal Reserve collaborated with Army Emergency Relief, the U.S. Army's own financial assistance organization, to provide a two-day financial education course, taught by the staff of San Diego City College, to younger enlisted soldiers–mostly men in their early 20s. We surveyed them about their financial history and activities at the time of the course, and we did follow-up surveys in 2008 and 2009 of both service members who had participated in the course and soldiers who had not. We found that soldiers who had taken the course were more likely to make smart financial choices, such as comparison shopping for major purchases, saving for retirement, and educating themselves about money management. They were less likely to make questionable financial decisions, like paying overdraft fees, taking out car title loans, and continually running credit card balances. Making good, well-thought-out financial decisions can make all the difference to your financial future.

He forgot to add: 'or avoiding foolish choices such as taking out 'innovative' mortgage loans way beyond their capacity to repay at the height of a major bubble the Fed has been instrumental in creating.'

He also left out that the present 'ZIRP' policy represents a major impediment to 'smart financial choices', as it makes the return on savings unattractive and moreover once again seduces people into taking out more credit than they can actually afford (at least that is the plan – it hasn't worked lately, with the rather scary exception of an explosion in student loans).

We still recall Alan Greenspan advising people to make use of adjustable rate mortgages right at a point in time when interest rates were sitting at a multi-year low. Later, when rates had risen, the cost of these adjustable rate mortgages rose well beyond the ability of many people to pay.

In short, the Fed pursues a policy that has created numerous obstacles for people to actually act in a 'financially responsible manner' – in fact, the policy's main aim appears to be to seduce them into acting irresponsibly – which in turn will now supposedly be alleviated by 'financial education programs' financed by the same institution.

Bernanke curiously failed to address this dichotomy. If he really wants an 'increase in demand' in the near term, he must bank on people abandoning responsible behavior in favor of returning to the mindless consumption on credit that was a hallmark of the bubble.

Since real incomes are lately declining thanks to the imposition of the Fed's 'inflation tax,' only credit remains as a means to increase consumption. However, as we have mentioned before, if the economy's pool of real funding is in trouble – as it indeed appears to be – then there may in reality simply be nothing left to lend.

The idea that one can forever avoid the pain associated with the necessary corrective activities following a major boom is fundamentally mistaken. The delaying tactics employed by the Fed are especially harmful, as they are apt not only to arrest the liquidation of existing malinvestments, but further the creation of additional ones. The short-term illusion of prosperity that monetary pumping creates is invariably followed by a bust and all the despair and despondency associated with it.

Bernanke insists his institution is meting out punishment to savers in the here and now in exchange for the better future this policy will allegedly bring about. He is as wrong about this today as he was back in 2002.