The world has changed since the Federal Reserve was established in 1914. Most Americans lacked the basic accoutrement of consumer life: movies, mobile media devices (well, radios), cars, washing machines, refrigerators, vacuums, pop music, and fashion (hair styling and fitted clothing). At that time, art and music had not been taken over by the cabal of avant garde and consumerism. In public life, there was no income tax, and senators were still selected by their state legislatures. Women could not vote; racial divisions were engraved in the laws. Abroad, Germany had an emperor; the Japanese one was still divine. Britain's emperor ruled over India, among other places. China had just deposed hers in a desperate struggle to modernize; Russia had yet to do so. There was an Austro-Hungarian Empire.
Of course, one can pick any arbitrary date in even the not-so-distant past, say "the world has changed a lot since then," and come up with countless examples to prove it. It goes without saying, needless to say. The reason I feel that those years in the 1910s mark a watershed is that I cannot remember what came before them. Since I was not to be born until many decades later, that is probably not especially surprising, but what I mean is that I believe I share in a collective memory of the decades that followed those years, while the decades that precede them are at best indistinct to me.
Each decade since the 1910s evokes a definite image. If I say "the 1920s" or "1960s" or "1980s," each evokes a unique set of impressions, good, bad, or ugly. We have, or think we have, a pretty good idea of the difference between the 1950s and the 1960s, the 1920s and the 1930s, or the 1980s and 1990s. But, if I say "1890s," I cannot say my image of that decade varies much from that of the 1880s or 1870s or 1900s. I can certainly think of events and personalities from those times, but they are loosely assembled under much larger headings: Victorian, Darwinist, Reconstruction, Industrial, Socialist, Imperialist, the Frontier.
It is not surprising that the epochs from over a century ago should leave such a light impression and dissolve into the Past of textbooks, but what is odd, I think, is that there is such an abrupt break between the Past and the Modern World that runs, I wager, through nearly every American's consciousness.
Now, why am I talking about this? Some readers are probably thinking, either your correspondent is unaware that he is writing for an investment publication or that he is going to make some sort of unholy connection between the Fed and Lady Gaga. And, as always, the reader would be correct.
On the one hand, there is an obvious connection between the Fed and Lady Gaga (or Kanye West or Justin Bieber or whomever: pick your poison). Apart from Lady Gaga's name itself probably being a nod to Dadaism, which sprang up almost overnight in 1916, I think it is fairly safe to say that both pop music and our central bank emerged from the same soil of progressivism that would lead to both Prohibition and cabarets, the Tuskegee Syphilis Experiment and the Civil Rights Act. But, is the only connection between the Fed and pop culture one of a common genealogy?
(Sources: Composition with Large Red Plane, Yellow, Black, Gray and Blue - Piet Mondrian, Yves St Laurent's Mondrian collection, Katy Perry promo via artnet.com)
In this article, I am going to make an extreme argument, that both central banking and modern society (modern in the popular sense of the word, rather than the less myopic sense of post-Medieval) have been mutually dependent entities but that they also generate tendencies that disrupt one another. I am not sure if the extreme version of this position is the correct one, but it will be easier to argue that position than to qualify every statement as I go along. In short, the precise nature and degree of the interconnectedness can be fleshed out later.
Here is one example of a qualification that will slow things down a lot: there are central banks in states that are not particularly progressive or modern. That is true enough, but those banks are largely derivative. States that have no reliable socioeconomic statistics still have central banks. They are symbols of modernity, sophistication, and progressiveness. Just imagine if a state were to declare the disestablishment of its central bank; they would be written off as cranks at best. We all know which side of history central banking lies on.
What I am primarily concerned about is not central banks, but The Central Bank, the Federal Reserve, because it is central bank to the world, not just the United States. So, to help things along here, take a moment or two to imagine what the world would be like if the Federal Reserve were disestablished. I am not referring to the kind of post-Brexit shock that this would surely provoke, but to the long term. Is there anyone who believes that the likeliest outcome is that the world would be more progressive?
What would the world have been like if the Fed had never been established to begin with? Less prosperous? More? More liberal? Less? Different, surely, but how? Is the only difference that we would have had less inflation than we have had? Or, have we had less volatility over the short term, but no other concrete benefits over the long term? I am not sure what the stock answer is; usually, these sorts of discussions seem to revolve around the gold standard and not central banking as such. Generally, we are sort of aware that the time before the Fed, apart from being more prone to intermittent credit crises, was just generally dark, depressing, and dour, and perhaps romantic where dark, depressing, and dour provide a nice backdrop for some historical fantasy. So, the argument is reduced to a pretty simple question: Would you rather live in the 1880s or the 2020s? Most people like having running water and electricity.
So, I would argue that there is a vague but persistent consensus that things would be considerably worse without a central bank. Not only less wealthy but retrograde.
The point I am making here is that even if it seems odd for me to link Fed and Gaga, the reader probably has similar, vague impressions of a connection between the two. (By the way, I have no particular animus towards Lady Gaga). I have never seen the connection between central banking and progress (however you define it) spelled out, although this is perhaps a failure on my part. Having a bank helps us avoid another Panic of 1907, I get, but is that all? If there was a knockdown, drag-out fight over the creation and role of the Fed, it has faded from memory. Which economic theorist established the justification for creating such a bank? Which school hammered away at this idea until it became a reality?
When economics textbooks speak of the relationship between the Fed and the economy, the verbs they tend to use are "influences," "affects," and "controls." They display nice flow charts that outline the transmission mechanism that begins with "Fed" and ends with "real output," "jobs," and "inflation." The Fed's role is defined as expanding the money supply so as to lower interest rates and thereby boost growth, making sure all the while not to overdo things. Within the Fed, the variables used are quite short-term: Where are GDP, inflation, and unemployment right now?
Things get wobblier when the discussion turns to the relationship between the Fed and the political process. For one, it is noted that the Fed could impact the outcome of elections. And, because politicians are notoriously obsessed with the short term, Fed independence must be preserved in order to serve the "long-term economic welfare" of the country. While some provide evidence that more independent central banks have greater success than less independent ones, how the Fed, or central banks generally, contribute to the long-term economic welfare is not clearly explained.
The Great Depression is probably the greatest justification for having a vigorous central bank. If the Fed had been more proactive, it is suggested, the Depression could have been avoided or abbreviated, and presumably having a more vigorous Fed since then has allowed us to avert the many Depressions we would have otherwise had. I do not know what the proper historical consensus is on the relationship between the Depression and the Second World War, but I assume that most recognize a connection between the two. The Depression fed the flames of fascism and anti-globalization.
I doubt that anyone would go so far as to say that had the Fed reacted more strongly that a World War would have been avoided, but that connection always seems to be implied. So, I wonder, how great of an impact could the Fed's actions in the Thirties have had on what followed in the Forties? Would the West have been in a stronger position to stand against Hitler in the Ruhr or Czechoslovakia or against Mussolini in Ethiopia? And might that have made all the difference? I wish these connections were made more explicit.
Again, the point I wish to make is that the Fed is commonly regarded to have rather incredible powers to impact not only the economy but politics and perhaps even the global order. When one considers the degree to which these conditions then fed into our impressions of society at the time, it is not so preposterous to at least argue the possibility that the Fed has impacted our social life and culture quite considerably. What are the Thirties without the Depression, the Forties without the War, and the Fifties and Sixties without the post-War boom? And what would America be, who would Americans be, without their suburbs and technological might?
This brings me at long last to my thesis:
1. The survival of the Fed depends on a progressive consensus, and progressivism depends on the viability of the Fed.
2. These are both under attack now.
3. These attacks will become more severe in the coming decade.
4. These attacks may succeed.
There is no need, I think, to elaborate too much on the current frustrations with the establishment around the world. This was captured best, I think, by Michael Gove's statement, "I think people in this country have had enough of experts." He was widely ridiculed for this statement and forced to apologize, but I think his critics might have missed, perhaps willfully, his point: the establishment can produce, at will, the expertise required to justify its existence. The British electorate, as old and out of touch as they are reported to be, evidently did not miss that point when they threw their sophisticated metropolitan Londoner offspring under the proverbial double-decker bus or nearest available Uber on June 23 rd.
Forget the Depression; I think it is fairly clear that political developments in many parts of the world would have been far less disruptive if the global economy were not in the midst of its weakest recovery since World War II. As I have argued for the last two years, this recovery will likely end in 2017 and it will be followed by an even weaker recovery than the present one, one that will likely see outright, extended deflation, and the first depression in earnings since the 1930s. And, that may signal that the Fed is permanently losing the capacity to generate inflation and growth.
If the Fed is losing its mojo in a way that produces Depression-style effects, that could challenge the consensus in the progressive trajectory of modern civilization in a way we have not seen since the Interwar years. If political instability were to rise to a certain threshold, it is possible that the Fed would simply lose the capacity to function. But, I want to be clear, that is not a prediction; it is a possibility.
Since the last century is the only time the global economy has operated on a central banking system, we have no experience of how such a system would fail were it to be rejected, like a transplanted organ, by the global economy. But, I believe that the crises we will likely experience beginning next year and over the next decades will force us to reconsider the purpose and function of central banks. My fear is that as long as we refuse to recognize the extraordinary impact central banking has had on markets and the global economy, as well as the international order and the course of global civilization itself, when the next crisis comes, our attempts to arrest the progression of system failures - whether it be by expanding the role of the state, reducing the role of the state, increasing or undoing globalization - will be, at best, futile.
So, this article attempts to address the following questions in a more comprehensive way than I have attempted before: where are we, how did we get here, and where are we going?
The revolution in prices and yields
Once the Americans created the Federal Reserve system in 1914, a number of new market phenomena began to occur. Not only did the baseline rate of inflation permanently rise, but inflation rose roughly to the level of the earnings yield. Government bond yields, which had shadowed the earnings yield before World War I, now gravitated towards it, as well. And earnings growth also clung to the movements of the earnings yield, except for a few key instances in the 1920s, 1960s, 1990s, and now again in the 2010s.
(Sources: University of Michigan Historical Consumer Price Index)
(Sources: University of Michigan Historical Consumer Price Index and Robert Shiller data)
The behavior of the earnings yield also changed. Instead of peaking every 60 years, like Kondratieff Supercycles, it now peaks every 30 years. So, looking forward, one might expect another 15 years of disinflation at the least. If the Kondratieff Supercycles were to lengthen again, we could have as many as 25 years of disinflation. And with inflation already very low, we could expect even outright deflation at certain points along the way.
This is problematic. The Fed system has been able to produce positive inflation fairly consistently since the 1930s. In 2008-09, we saw what a panic a brief, general deflation could bring to society, especially among the establishment, who, on our behalf, have sought to avert deflation by any means necessary. And we have also seen the degree to which this socioeconomic establishment has suffered in the aftermath - at least in terms of its credibility.
They may be correct to fear deflation the way they do, because those classes, whatever their partisan affiliations, have a symbiotic relationship with America's system of rigged inflation.
I say this because this rigged inflation has been generated through the service sector, that portion of the economy, alongside the technology sector, that has come to dominate global civilization since World War I. It is only because commodity prices are more volatile than services and manufactured goods prices that it appears that inflation is caused by commodity shocks. Oil went from $30 to $10 between 1980 and 2000, yet consumer inflation always remained positive. Oil fell nearly 75% after its peak in 2008, yet consumer prices rose 10%.
(Sources: University of Michigan Historical Consumer Price Index; own calculations from US Historical Statistics from Colonial Times to 1970, US Census, Grilli-Yang Commodity Price Index, World Bank)
The persistent rise of services inflation, especially relative to that of manufactured goods and primary commodities, has spawned a name - "Baumol's cost disease." Costs for medical care, education, government, entertainment, finance, law, and public security rise even though prices for manufactured goods and commodities fall. If this trend continues, at some point in the not-so-distant future, 99% of our incomes will be going to services. Baumol predicted that nearly two-thirds of GDP would be going to education and healthcare alone by 2040, and by 2105, 60% of GDP will go solely to healthcare. His predictions over the last half century have proved to be rather prescient thus far.
(Sources: Bureau of Economic Analysis)
The question is, why are we not at 99% already? If this is an inexorable force, why did we not reach that level in 2000 or 1950 or 1900 or 1800? The answer is that it is a decidedly recent phenomenon. The lack of historical price data makes it difficult to be sure, but the commanding position of services prices seems to have occurred no later than the 1940s or '50s and then accelerated from there.
So, we have a situation in which the Fed-engineered rise in the long-term rate of inflation overlaps with the emergence of a quite radical form of the "cost disease." I would be skeptical about claims that this is coincidental.
According to Baumol, the cost disease is caused by the difference between productivity growth in 'dynamic,' capital-intensive sectors like manufacturing and 'stagnant,' labor-intensive sectors like hospital care. Because goods-production can be reduced to routinization and mechanization, labor productivity in those types of sectors tends to be strong, thus reducing the prices of goods and raising the compensation of laborers. Think back to Henry Ford's mass production a century ago. But, the service sector must be 'stocked' with labor to continue operating; people get sick, kids need to be educated, crime has to be fought, and investors need insight into the markets. Because many tasks and skills in the service sector are not easily duplicable or mechanized or even measurable, productivity growth tends to be much slower. In order for the service sector to preserve its stock of labor, however, wages must remain competitive with wages in the dynamic sectors. Therefore, service (or, tertiary) sector inflation tends to be higher than rates experienced in the primary (natural resource) or secondary (manufacturing and construction) sectors.
To be clear, Baumol's hypothesis is only an explanation for relative price movements, not for the phenomenon of rising inflation itself. It only explains why inflation is higher in stagnant sectors than in dynamic sectors. Nevertheless, if he is correct, then we might not only expect to see higher inflation in services, but a displacement of the dynamic sector by the stagnant sector in the economy. Let's call this the "cost disease illusion." According to this notion, it only looks as if the service sector is hollowing out the manufacturing base, because prices are rising faster in the former than in the latter.
How illusory is cost disease?
To take a simple example, if you were stuck on an island Robinson Crusoe-like and you spent a lot of your time acquiring fresh water, a good portion of your one-man or one-woman 'GDP' would be 'spent' on water. If you managed to find a way to supply yourself with fresh water regularly, however, by rigging bamboo in such a way as to pipe it into your cave, you would now have more time to go hunt for coconuts or diversify your calorie intake. All of a sudden, water is no longer as big a portion of your 'GDP' while rat meat is (or whatever your particular preference is). That is not because your productivity in water acquisition has fallen; quite the opposite. The leap in productivity in water acquisition (or production, if you like) made room for other pursuits. It would be laughable for you to lament the hollowing out of your water-production base because it no longer takes up as much of your time, although you do have to concern yourself now with preserving your newly created infrastructure. That is a somewhat different story, however.
The point is, just because a greater portion of GDP goes to one sector does not mean the other sectors are collapsing. On the other hand, broader questions about the long-term viability of such shifts can be raised. What happens if you outsource the maintenance of your water production system to Man Friday? As long as you and Friday remain friendly, that can be a mutually beneficial arrangement. Instead of hunting rats, you cultivate a garden with the surplus water and provide Friday with a regular supply of vegetables.
But, what now of the status of your water-manufacturing base? Has it been "hollowed out"? That is, I think, a timeless conundrum of human cooperation that does not perfectly align with the issue of deindustrialization in the US. In the relationship with Friday, the question of whether the industrial water base has been hollowed out or not depends on the stability of the relationship. When it comes to international trade, however, the issues are more complex. Because production is more mobile than labor, the problem is not just one of hollowing out the industrial base (as a strategic concern) but the social costs incurred, and those are difficult to measure or weigh.
We will come back to globalization in a moment. For now, I want to stick with the question of cost disease illusion. Cost disease illusion is a long-term economic phenomenon. It is inherent in the nature of economic progress. As an economic organism becomes more efficient in producing essential goods, and the costs of essential production fall, the creation of more expensive, less imperative goods could result in the illusion that the economic base is hollowing out.
But, do cost disease and cost disease illusion explain why medical and educational service inflation has been consistently high for so long, why real wages have stagnated for nearly half a century, and why the electorate is turning against globalization? My answer is a qualified Yes, and what I mean by that is, I believe the Fed has taken a natural, progressive phenomenon and put it on steroids, and now we are enduring the side effects. In fact, the entire global economy may be feeling them now.
Again, it is a strange coincidence that relentlessly high services inflation should become a chronic problem not long after the institution responsible for the structural rise in inflation was established. Baumol's insistence that the service sector will consume ever larger portions of GDP is rooted in the assumption that this is an inevitable phenomenon. As he wrote in "The Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis," "There are some economic forces so powerful that they constantly break through all barriers erected for their suppression….[E]fforts to offset these cost increases…can have no significant effect on the underlying trend." But, again, we have to ask, why now?
Has the Fed aggravated the cost disease?
In addition to the structural changes in the market that began a hundred years ago, there were changes in the real economy that began at the same time but that would not become thematic until after World War II. Specifically, my suspicion is that the Fed simultaneously facilitated an expansion of the dynamic, goods-producing sectors and consumer demand. On the one hand, this resulted in bursts of economic development in high-tech goods and consumer empowerment. On the other hand, this aggravated the cost disease, hollowed out less dynamic industries, and created a boom in credit (or, if you are a cup-is-half-empty sort, "debt").
Let me try to unpack that a little bit more. These bursts of economic development created entirely new industries that generated wealth and jobs and helped defeat totalitarians and authoritarians from Nazi Germany to Soviet Russia to Imperial Japan from 1941 to 1989. Paradoxically, this also marked the beginning of deindustrialization, for example, in New England textile factories in the 1920s and up until the decline in manufacturing employment we are familiar with now. This initial phase of deindustrialization was masked not only by the booms in other sectors (radios, cars, phonographs, refrigerators, etc.) but by the industrialization of the South. In other words, what has been happening in recent years - booms in Silicon Valley and Asia while the Rust Belt rots - is not all that different from what happened in the 1920s. The difference is that a century ago, jobs were shipped to peripheral, underdeveloped economies within the US; after that, Europe; then Mexico and Asia. Because the US constituted a unified market for labor and goods, not only did jobs move but people did, too. The 1910s-30s marked one of the beginning of black migration out of the South, for example.
Perhaps a more emblematic example of the process I am talking about is the manner in which the sudden mechanization of farms in the 1920s contributed to the Dust Bowl of the '30s. The combined effects of a commodity boom and the simultaneous surge in underlying inflation seems to have made the Great Plains a perfect candidate for farm industrialization from the 1910s, and as prices fell after 1919, "a futile race with the creditor" only added pressure to keep production moving until the land was worn out and the Depression forced farmers to abandon their land. There is some irony here, because one of the reasons for the establishment of the Fed was to create greater stability in the agriculture sector.
This also seems to have marked the beginning of the deindustrialization of American cities. Industrial growth occurred not only in peripheral regions of the country (i.e., outside the North) but on the peripheries of cities. Factory jobs went to the suburbs, exurbs, and towns as service industries moved downtown: hospitals, media and telecommunications, government, universities, corporate headquarters, department stores, etc. And the mass production of the automobile and the emergence of new communication technologies all encouraged this. The skyscraping boom of New York in the 1920s occurred while factory jobs began moving out. Urban cores are now blocks of gleaming towers, sports and entertainment facilities, museums, "meds and eds," and residential decay - with gentrification trying to square the circle.
(Sources: Sukkoo Kim)
In other words, we have experienced an exaggerated form of rolling industrialization over the last century, and it is fun while the boom lasts, but when the boom ends, the result is Detroit and an immigration crisis, as now mature industries become desperate to find ever-cheaper labor. This also accounts for the tremendous booms in Europe after the War (the "German Economic Miracle") and then the Japanese-led boom in Asia in the 1980s and the Chinese one in the 2000s. Unlike Western Europe and Japan, China lacks as robust an indigenous modernizing tradition and may have already peaked, despite having failed to attain the wealth levels of its East Asian neighbors. Other than that, the story seems to be the same: a spectacular boom, excess capacity, and a debt/capacity hangover.
In short, what began as a cost disease illusion has been turned into a cost disease nightmare.
But, is there any data to support the idea that the Fed has caused this nightmare? Let's begin with employment data.
When did we catch the cost disease?
There are various sources of employment data for the late 19th to early 20th Centuries and there are a number of differences amongst them, but they all show that there was a surge in services employment against both agricultural and industrial employment that began in the 1920s.
(Sources: US Census, Series D127-141)
(Sources: Solomon Fabricant, Table 2)
Sources: Daniel Carson, Table 1; Stanley Lebergott, Table 1; George Stigler, Table 3)
There also appear to have been massive changes in the patterns of female employment. My suspicion is that women were pushed out of agriculture due to a surge in farm mechanization in the 1910s and absorbed by manufacturing and services (as both consumers and producers). In other words, mechanization pushed women out of one sector and pulled them into the others, whether due to increases in mechanized manufacturing or due to demographic changes brought about by accelerated growth in suburbs and a service-sector boom.
(Sources: US Census, Series D11-25)
In any case, women and girls (old employment data often encompasses those 10 years of age and older) began abandoning farm labor in the 1910s and, except for the commodity boom in the 1940s, never looked back. It is possible that this is an early instance of the process I am trying to outline. The farms were industrializing but the labor force was not. In any case, as with so many other indicators, something changed at the same time the Fed was created. When we think about the transition of women into the workforce, we often think of the "Rosie the Riveter" posters of World War II, but the fundamental pattern of female employment was laid down decades earlier.
If we dig a little deeper into the employment data, we can see that in the 1920s, there were jumps in the proportion of every tertiary industry except for "domestic service." And, there was a surge in the 'professionalization' of a number of service industries, e.g. law, medicine, education, and the military. (The data in this and the following three paragraphs comes from George Stigler's Trends in Employment in the Service Industries from 1956).
In 1910 and 1915, roughly 75% of students graduated from AMA-accredited schools. By 1920, the number was nearly 90%. By 1930, 100% had graduated from such medical schools, but there was no increase in the total number of graduating physicians between 1905 and 1950. By the mid-1950s, if not sooner, this was creating a number of tensions that sound familiar: "Medical education costs four to eight times as much per student as the other branches of university instruction, but tuition rates are usually the same or only slightly higher. Unless tuition rates are radically increased, or increased government financial assistance is given to medical schools-and both policies are opposed by the American Medical Association-the number of medical students will not increase rapidly." There was also increasing specialization within the medical field during this time. In 1929, 26% of physicians were "full specialists," but this number rose to 46% by 1949.
In the military, we see a similar process. In the 1910s, there was a spike in the size of the military, which needs no comment. What is interesting is that the military remained substantially larger during the interwar years relative to the pre-war years; I had always been under the impression that the military had atrophied during that time. In 1900, about 1% of the population was under arms; in the interwar years, it was closer to 2%. The real big difference, however, was that after World War I, the ratio of enlisted men to officers went from 20:1 to 10:1 and remained there in subsequent decades.
We see comparable patterns in law and education. For specialized fields like law and medicine, accreditation requirements increased and total numbers remained stable, while in professions such as education and the military, although there was increased professionalization, total numbers also rose significantly. Between 1900 and 1920, there were a total of 26,000 new college teachers. In the 1920s alone, there were 33,000, and in the 1940s, 72,000. In 1900-1930, roughly a third of these teachers had PhDs. In the 1930s-1940s, 60% had PhDs. And, there appears to have been a surge in enrollment in colleges and universities beginning in the 1910s, going from about 4.4% of college-aged youth in 1900-1910 to 8.1% in 1920, 12.2% in 1930, and 29.6% in 1950. This dwarfed enrollment rates in other Western European countries.
Incidentally, I should point out that the 1920s also saw the emergence of consumer culture, not only the debt incurred to purchase the vacuums, refrigerators, and cars that would first boost the economy, then force consumers to retrench in the 1930s, but also the systematic exploitation of consumer data. The transformation of citizen into consumer bled into how individuals saw themselves, beginning perhaps with things like the newfound obsession with fashion. When you mix sudden technological change across many sectors, macro- and micro-migrations, price volatility, consumerism, and debt, you can be sure that there will be momentous changes to mores, habits, aesthetics, and psychology.
I want to emphasize a few things here. First, I am not arguing that nobody ever went to college before the Fed was established, nor that there was not already an increasing focus on professionalization beforehand, nor that these are in and of themselves bad things. But, there are clear breaks in rates of growth, magnitudes, and ratios from this time that dovetail perfectly with the dramatic transition towards post-industrialism that we have a love/hate relationship with today. Strange that this should have occurred just as the multiple breaks in the behavior of consumer and commodity prices and profits were happening too.
(Sources: University of Michigan Historical Consumer Price Index and Shiller)
GDP data for the late 19th and early 20th Centuries is even more difficult to work with than employment data, because of the complexities involved in the calculations. Different measures appear to show somewhat different trends prior to the 1910s, but it is clear that there was a shift due to a relative jump in service sector output and/or a fall in agricultural output after that point. By any measure, the industrial sector rose relative to the agricultural sector.
(Sources: US Census, Series F216-225)
(Sources: US Census, Series F250-261)
In yet another compilation of long-term historical employment and output data, the pattern is slightly different. There is a constant decline in real agricultural output relative to the service and industrial sectors, but from the 1920s, the service sector outstrips industry. A link to the data that Johnston used for that article can be found on Brad DeLong's blog.
(Sources: Louis D. Johnston, Minnesota Post)
Any way you slice it, there was a break in the sectoral relationships of the macroeconomy that began in the 1920s that set the pattern for the next century: a service-sector boom. This brings us to globalization.
Patterns of globalization: The Catch-Up Effect
As with the cost disease illusion, globalization can be said to be a process as old as human history itself. Technological growth in transportation and communication have made it virtually inevitable. But, there have been different sorts of globalization. Since Magellan circumnavigated the world, much of that process was dominated by the West, and it was not until the Meiji Restoration in 19th-Century Japan that a non-Western country had demonstrated that the gap could be decisively closed.
In theory - setting aside how poor countries become poor relative to richer countries to begin with - poor countries should grow faster than rich countries, because the former should have lower costs in adopting new technology. They do not need to reinvent the wheel. Even so, this process of convergence led by Japan does not appear to have become such a dominant theme until quite recently. Convergence was largely dominated by the liberal democracies (G7-style countries) until the 1980s and was then taken over by Asia after that. The following charts show that in the major economies, the real rates of growth negatively correlate with the level of real per capita GDP: the poorer a country is, the more likely its growth will be higher (unfortunately, as I have discussed before, that fact alone does not produce a very useful long-term investment strategy). The countries used in the charts below include the OECD, the BRICS, and Thailand and Indonesia.
(Sources: Maddison Project, St Louis Federal Reserve)
This process generally involves a poorer country providing labor for things like cheap manufacturing, and then graduating to successively higher modes of production. Oddly, no major economies have achieved American levels of wealth; the closer they get to American levels, the slower their economies go. Japanese frustrations about decades of low growth and low inflation are almost certainly rooted in the structure of the global economy rather than in specifically Japanese shortcomings.
Patterns of globalization: The Penn Effect
The Catch-Up Effect of the last half century cannot be fully understood without taking into account its twin, the Penn Effect. The Penn Effect is the correlation between an economy's real per capita GDP and its price level. That is, the more developed a country is, the higher its price level is likely to be. Prices in Switzerland are significantly higher than those in China.
(Sources: Maddison Project and St Louis Fed)
China and Switzerland illustrate what has happened rather well. In the 1960s, in real terms, the average Swiss person was 95% as wealthy as the average American yet paid only 50% as much for a similar basket of goods. The average Chinese citizen was only 5% as wealthy, yet paid 70-160% as much as Americans for a comparable basket of goods. How times have changed! As of 2010, the Swiss were only 75% as wealthy as Americans in real terms yet paid more than 160% the American rate, while Chinese were now a quarter as wealthy as Americans but paid only half as much for their purchases.
Have the Swiss been lost in the mountains while the Chinese have been boldly driving forward to world domination? Not exactly. Nominal per capita Swiss growth has been strong, and this has driven prices up relative to countries like China, and thus cut into Swiss real GDP, making it seem as if the Swiss are poorer. Meanwhile, Chinese prices have fallen on a relative basis, thereby bolstering 'real' GDP growth. In other words, the Penn Effect is just the Baumol cost disease written on a global scale. The only difference is that the adjustments in the price levels have been through long-term currency moves rather than relative inflation rates. The Baumol cost disease has relentlessly driven up the Swiss franc relative to the RMB, which is why the Swiss and the Japanese central banks find undermining the strength of their currencies as impossible as Americans find controlling medical inflation and tuition costs.
(Sources: Maddison Project and St Louis Fed)
To state this in yet another way, if the Penn Effect were perfectly true (that is, if the correlation between relative wealth levels and relative price levels were exactly 1.0), that would imply that changes in real growth have been the square of changes in the price level (so that a 10% rise in inflation would coincide with a 21% rise in real GDP, for example; 1.10^2 = 1.21). But, that has not been the case. Even though headline inflation in rich countries is more likely to be lower than in poor countries, that is more than offset by currency appreciations and depreciations, respectively, and that in turn, further lowers real growth figures in countries like Switzerland relative to countries like China.
The Penn Effect and the Catch-Up Effect are spillover effects from America's cost disease. They overlap so much as to be almost identical, and they are most likely caused by America's rolling, Fed-financed hyperindustrialization. Manufacturing started moving away from New England in the 1920s and on to the South and Midwest, spurring urbanization in rural areas, decay in urban areas, and suburbanization in the hinterlands. As the manufacturing frontier in America closed because production became too expensive, cheaper foreign markets beckoned. Detroit was replaced by Western Europe and Japan, then by Korea, and then China and other developing countries.
The question may now be, is China effectively the final frontier of this process of hyperindustrialization? Or will South Asia finally live up to the hopes of those who have looked for an alternative to China? I certainly cannot answer that definitively, but I am skeptical. Even if the frontier of growth is not yet closed (and there is no reason to be more than skeptical, as far as I can tell), is this a process which can continue indefinitely? Can America really thrive while undergoing further deindustrialization in the coming decades?
Before continuing, I want to go back to the aside I made above of how the Catch-Up Effect has been a poor guide to outperforming the market. I have shown before that the Catch-Up and Penn effects can be used in conjunction to time emerging markets over medium-term intervals. Specifically, the best time to risk buying into emerging markets is when the dollar is strong against other rich-world currencies. That is because emerging market booms tend to coincide with the dollar falling against the pound, euro, yen, and franc. But over the long-term, markets in developed countries have outperformed emerging markets, plus they are less volatile.
(Sources: Maddison Project and St Louis Fed)
Why is that the case? For one, because of Baumol's cost disease, rich country real exchange rates tend to appreciate more quickly than those in poor countries, and because rich country real exchange rates tend to appreciate due to movements in nominal exchange rates, they tend to experience greater rates of currency appreciation.
That, in turn, suggests a link between Baumol's cost disease and the stock market.
Therefore, during surges in productivity, we see higher rates of service inflation relative to primary commodity inflation, which coincides with surges in consumer durables production, which in turn correlate with market P/E ratios. It appears that every durables boom has coincided with stock market booms. This seems to be the case in US markets, at any rate, and I suspect that is what is going on elsewhere.
And, it is this hyperindustrialization or hyperproductivity that is resulting in shorter Kondratieff Supercycles over the medium-term as well as a host of other chronic macroeconomic imbalances like the cost disease.
(Sources: Shiller; own calculations from St Louis Fed and John W. Kendrick Table D-II)
(Sources: Own calculations from US Census, GYCPI, and World Bank; own calculations from St Louis Fed and Kendrick)
The social impact of the Fed bubble
In order for this global process of exploding social costs to continue, the state will have to take on more and more of the burden involved with education, health, and social order. In Baumol's 1967 article on the urban crisis, he urged the federal government to bail out American cities from the cost disease without asking what would become of the federal government's fiscal position in the process, even though his entire argument rests on the notion that the disease is unstoppable. As long as the state creates inflation through its central bank, it can only manage this process through increasingly draconian constraints on markets and societies and constitutional guarantees. Ultimately, it may at once create inflation (via the central banks) and try to dictate prices by taking over virtually the entire service sector, which would be tantamount to the state becoming indistinguishable from the economy itself. Needless to say that this entails a fundamental rewrite of the social contract, but conducted under the aegis of technical discussions about controlling costs.
But will we really get to that point, where 99% of GDP goes to services while the service economy is gradually nationalized? Not necessarily. There are a lot of moving parts here, but the question, I think, comes down to how the sociopolitical and economic spheres respond to these trends. If I am correct about the state of present imbalances, one likely consequence of the next crash is an even greater contraction in the manufacturing sector. And in a general deflation, where is demand going to come from then? In the short-term that could mean the service sector assumes an even greater share of economic production, but in the long-term, extended, exacerbated industrial overcapacity in a highly indebted economy makes it difficult for the booms in the service sector, corporate profits, and stocks to continue. This would also entail extreme degrees of economic, social, and political dislocation at home and abroad. That is already the evident short-term direction. It is not hard to imagine a negative feedback loop.
As we have seen, the Fed has historically exacerbated volatility, and the system is vulnerable to, and terrified of, deflation. Anti-Fed polemicists have argued over whether the system would die from inflation or deflation, and the answer may be both simultaneously. Deflation in stocks, profits, manufactured goods, and commodities, but relentless relative inflation in services. But because the Federalization of our markets and economy has shaped them and our societies so profoundly, a genuine systemic breakdown (that is, not just a crisis) could be drawn-out and messy.
If, for example, this provoked outright de-urbanization and de-globalization, the process would not be linear or quick, to put it mildly. Urbanization and consumerism have completely transformed global civilization in the last century. I would argue that the clear before-and-after moment of modern history is not World War II, but the establishment of the Federal Reserve. World War II simply removed much of the doubt about where global civilization was going. From Dadaism to the flapper to rank commercialism to pop culture to progressivism, it was the 1910s and '20s that set the tone for the next century not only in America but around the world, and these forces may have been unleashed more slowly if the Fed was not generating economic imbalances and demographic turbulence.
(Sources: World Bank - PPP ratio, urbanization, service employment)
In his book, The Great Wave, the historian David Hackett Fischer attempted to draw strong parallels between episodes of rising prices and/or rising inflation to periods of social upheaval, for lack of a better word. Kondratieff, I believe, drew this connection first at the international level, noting that every peak in inflationary waves (for example, the early 1800s, the 1860s, and the 1910s) coincided with war. The "Neo-Kondratieff" peaks in the 1940s, 1970s, and 2000s were also marked by wars, although the last two episodes were less severe. In Fischer's book, he tried to draw the parallels between consumer prices and domestic disorder measured in rates of births-out-of-wedlock, substance abuse, and crime. Covering nearly a thousand years of history, it was ambitious, to say the least, and the precise nature of the relationships were, as he said, unclear. I am not sure how convinced I am that those connections exist, but I would nonetheless like to suggest the possibility that, if they do, they may not always be strictly price-related, but rather - at least in the period of unprecedented inflation of the last century rather - that the combined effects of hyperindustrialization, deindustrialization, rising service costs, consumerism, and the persistent rise of a technocratic overclass have caused dislocation, indebtedness, a rapid change of mores, tribalization, and social atomization. Worst of all, hopelessness and deepening frustration. Fear.
Those kinds of forces create vicious cycles of social costs and disorder, and I would suggest that our cities may be the canaries in the coalmine.
The worry is that as the Fed, by virtue of its existence rather than any given policy, continues abetting global hyperindustrialization alongside local deindustrialization, this not only hollows out the manufacturing base and raises prices for medicine, education, and security, but simultaneously hollows out the base of civil society, which relies on interlacing intermediate associations to cushion the blows of history.
The future of the bubble
So what signs might there be were the system created by the central bank to begin to unravel? Because this process has been so expansive, and because we have never experienced anything like this in global history, it is hard to say. My guess is it does not involve citizens storming the Fed Bastille-like. On the objective level, I would suspect that evidence that the system was failing would be an end to the Convergences. That is, a rise in "real" yields to pre-Fed levels, especially the gap between the earnings yield and inflation, primarily as a result of extended deflation, and a re-differentiation of global economies. Perpetually rising profits and global development would no longer be guaranteed.
The persistence and impact of the cost disease is an important element, as well, because this is an indicator of the ability of the Fed system to promote seemingly hypercapitalist hyperindustrialization on the one hand and an increasingly socialized expansion of the service sector on the other. If things continue on their century-long course, then nationalization of the bulk of the economy is virtually inevitable, and it will be managed by an increasingly small, if meritocratic, technocracy. If we were to break from this course, however, one would have to suspect a reversal in the cost disease, which I am simply unable to contemplate in a modern context. Presumably, we would have to spend more of our income on basic necessities. It would likely be a painful, violent readjustment that was part of and interacted with a global readjustment. Things could end up materially worse afterwards.
Can the economic system handle another depression? Can the political system? More importantly, can the social democratic consensus survive?
My sense is that a massive change, more momentous than the effects of the Depression, is on the horizon, but whether it will result in more freedom, security, and happiness or less is impossible for me to say. Much depends on the quality of the socioeconomic dialogue that follows. Right now, the tendency towards a confrontation between right and left (or more worryingly, re-tribalized societies) seems to be growing, with the technocratic mandarinate, out of ideas, stuck in the middle.
There is no way I can argue, based on historical precedent, that this spells the permanent end to a century-long boom where you could buy stocks for the long-run or invest under the fundamental principles of Benjamin Graham and Warren Buffett and everything would turn out all right. The modern system of inflation engineered by the Fed withstood the crises of the 1930s and 1940s and many others since. But, were I to try to plot out the conditions that would be required for a system such as the one we have to implode, they would look much like the ones that are forming right now. The bull market on Wall Street is going to come to an end next year, but it might also be the beginning of the end of the bull from Washington.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.