The Bear’s Lair: Curing the 21st Century malaise

The Cato Institute Annual Monetary Conference last week clarified my thought processes, and has solidified my conviction that the 21st Century economic malaise that has affected the United States and most rich countries has two causes: monetary policy and regulation. Questions that have puzzled me, notably why we have no inflation, have found potential answers, and the connection between the two causes has been identified. Essentially, the malaise is one of productivity. Knowing that, and having identified the mechanisms by which the malaise is imposed, we can also identify solutions. All we have to do then is to get the idiots who run our lives to implement them.

The central problem for critics of the “funny money” policies that have been running since 2008 is that inflation has not surged. Friedmanite monetary theory would look at the growth of U.S. M2 money supply, which has run far above the growth of nominal GDP at more than 6% per annum, and expect inflation to have reappeared at a swift trot – “Inflation is always and everywhere a monetary phenomenon” after all. Alternatively, looking at the octupling of the U.S. monetary base since 2008 and the budget deficits between 2009 and 2012 one is reminded of nothing so much as the policies of Rudolf von Havenstein, luckless Reichsbank President who produced the 1923 trillion percent hyperinflation of the Weimar Republic – in which case, why hasn’t the same spectacular result occurred here? Inflation robs savers, but has a useful economic function in disciplining central bankers and politicians generally.

It hasn’t happened, hasn’t even been close to happening. James Bullard, St Louis Fed President, produced an explanation at the Cato conference of why not. Apparently the Fisher Effect, discovered by economist Irving Fisher (1867-1947), pushes the inflation rate close to the short-term risk-free interest rate (i.e. the federal funds rate, today effectively zero) minus the natural rate of interest set by the real economy. In other words, the whole system works backwards from the way we thought it did. (No I don’t know how the Fisher Effect squares with Friedman’s monetary theories, or indeed with Austrian analysis; it seems to me that if we had fewer economists the economy would be more comprehensible!)

In 2009-12, with a lot of slack in the economy, the natural rate of interest was negative, so the inflation rate was positive. Now there is much less slack, so the natural rate of interest is positive (as it must be, in an economy near equilibrium, otherwise you would soon have no capital) so by the Fisher Effect an interest rate near zero pushes the economy into 1-2% deflation. If you look at inflation rates (as Bullard did) you see a Friedmanish push towards higher inflation from 2009 until the spring of 2012, then a Fisherite downward force takes over and inflation declines towards zero. If Fisher is right for the time being, inflation will shortly go negative, and the Fed, by seven years of zero interest rate policies, will have produced precisely the deflation of which it is so terrified. Certainly in Japan that seems to be what has occurred.

That will make the Fed’s first rate rise, perhaps in December as the market currently assumes, really exciting. Possibly the Fisher Effect will still dominate, and inflation will still go negative, just a bit less so unless the Fed pushes up rates rapidly. Alternatively, the sign that the Fed is not actually dead after all may cause the Friedman effect to awake from its magic sleep, pushing inflation at least to around 5% if M2 growth governs it, or perhaps towards infinity if M0 growth governs it instead. Gosh, isn’t it suspenseful!

You may detect a certain tongue-in-cheek quality in my discussion of the various monetary theories propounded at Cato, but another paper presented there, by Claudio Borio, chief economist of the Bank for International Settlements, was much more convincing. (The BIS is a central bankers’ central bank in Basel, set up by the great Montagu Norman in 1931; it is responsible for the Basel Accords on bank supervision, but is otherwise far more sensible than any current central bank, having preserved the spirit of Norman himself.)

Borio confirmed my view, based on historical data, that deflations are essentially benign; indeed he found some evidence that in general they increase the rate of economic growth. Financial booms, produced by prolonged periods of sub-normal interest rates, are however a different matter; Borio found from analysis of historical data in 22 advanced economies over the past 30 years a 0.3% annual productivity lag during a financial boom, most of it due to misallocation of resources, and a 0.7% annual productivity lag in the five years following the financial crisis that inevitably succeeds the boom, for a total loss over a 10-year period of boom and bust of about 6%. This is not just a deficit that can be made up, it is a permanent loss; as a result of “funny money” policies pursued over a decade we are permanently 6% less productive and therefore, ceteris paribus, 6% poorer.

Borio’s analysis is borne out by the Bureau of Labor Statistics analysis of multifactor productivity. After a burst in 2009-10 after a downturn during the recession itself, this has grown since 2011 by an annual average of only 0.6% per annum, far below the 2.0% per annum average over the period 1987-2014. In manufacturing, multifactor productivity shrank for three successive years in 2011-13, something it had never previously done in the history of the series (2014 figures for manufacturing multifactor productivity are not yet out, for some reason, even though the overall statistics are.) What’s more, these figures overstate the true position, because capital productivity, growing quite rapidly at present, shrinks sharply in recessions as investments previously thought to be viable turn out to be rubbish. This suggests that when the bubble bursts, productivity figures will deteriorate further as the mal-investment is washed out of the system – as predicted by Borio’s own analysis.

Funny money is not alone however in having produced a decline in productivity; indeed the observed decline in multifactor productivity in 2011-14 is much larger than suggested by Borio’s analysis. The other major drag on productivity and output is regulation, which has grown considerably more enthusiastic and damaging under President Obama. Here I was introduced at Cato to an excellent 2013 paper “Federal Regulation and Aggregate Economic Growth” published in the Journal of Economic Growth by John W. Dawson and John J. Seater, which estimates that regulations over the 57 year period from 1949 reduced 2005 economic output to 28% of the level it would otherwise have reached. I had previously estimated by back-of-an-envelope means the effect of post-1973 regulation at about a 35% reduction in output from its potential, so this 72% reduction in 2005 output from its potential, albeit over a longer period, is at least somewhat compatible with my own much less sophisticated analysis although the final number is even more startling.

Using an equation derived from endogenous growth theory, Dawson and Seater examined the effects of the entire body of Federal regulation, and determined that regulation reduced the economic growth rate by about 2% per annum compared to its level in regulation’s absence – thus the 72% reduction in growth from 1949 to 2005. They also found the effect of regulation on total factor productivity to be especially important, with regulation explaining the whole of the productivity slowdown in the 1970s. They were able to examine effects of changes in the rate of regulation by examining the Code of Federal Regulation, which expanded from 19,335 pages in 1949 to 134,261 in 2005, with a mean growth rate of 3.5% per annum and a standard deviation of 3.9% per annum.

As you would expect, economic growth was faster in periods of restrained regulatory growth such as the early to mid-1980s and the “reinventing government” period of the mid 1990s and slowest in periods of exuberant regulatory growth, such as the early 1950s (the Korean War) and the 1970s. Previous studies had looked only at subsets of regulation, such as that of transportation, and at more restricted periods. Using the correlations derived from the CFR, Dawson and Seater were able to extrapolate to the effect of the entire body of Federal regulation.

There are thus two effects slowing multifactor productivity growth since 2008; the distorting effect of funny money and the inexorable growth in Federal regulation (albeit by only 11.1% between 2008 and 2013, although that represented an extra 17,500 pages of regulations, an historically high number for a 5-year period.) Changing these policies is easy, at least in principle. The problem is that changing monetary policy is likely to result in a 3-4% loss in real output, as all the mal-investment is liquidated, while huge reductions in the page volume of regulations would be needed to restore productivity growth rates to their unregulated level, even starting from the lower level of output from which we are currently suffering.

Thus a reformist President would find the economy suffering a major recession in 2017-20, followed by a recovery which might still be unimpressive in 2020 as insufficient progress had been made in torching the regulatory weeds which impeded all economic activity. Only after 2020, as the effects of the financial crash wore off and the deregulatory progress accelerated, would the economy respond by delivering truly superior performance. But of course, that might well be too late, as the reformist President failed to be re-elected.

In the Republican primary process therefore, those wishing to choose a President who will truly revive the economy must select one who is not only committed to good policy (which rules out Carly Fiorina, Jeb Bush and Chris Christie), but who has the personal characteristics to remain popular, as did Dwight Eisenhower and Ronald Reagan, thereby achieving re-election in 2020, which is absolutely vital to long-term success. In other words, they must choose a Ben Carson or a Marco Rubio, not a more abrasive Donald Trump or Ted Cruz.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)