The 1930s is remembered in the United States as a period of economic despair, with unemployment well into double digits throughout the decade and a generation’s lives ruined. In Britain it is remembered as a “Gathering Storm” with satisfactory economic performance after 1932 marred by an increasing fear about the inevitability of future conflict with Germany and the other totalitarian dictatorships. The current global situation is taking on unpleasant similarities to both those versions of that unhappy decade.
Economically, first, the GDP drop in 2008-09 was nothing like as severe as in 1929-32 – about 4% in real GDP, top to bottom, compared with 25% in the Great Depression. However the Great Depression also saw a remarkable recovery, with 1933 and 1934 seeing GDP growth at almost double digit rates. That has not happened this time; instead we have had a recovery from recession that is anemic by any standards, with long term unemployment still at higher rates than at any time since the 1930s.
Geopolitically, there is no threat similar to that of the Third Reich. However there are a number of fairly major powers, at the level of Mussolini’s Italy or Hirohito’s Japan, that are aggressive with their neighbors and generally ill-disposed towards the democratic axis of the United States, the Anglosphere, the EU and Japan. Furthermore there is a risk that did not exist in the 1930s, of rogue states or terrorist groups arming themselves with nuclear weapons, that has in no way been alleviated by a decade’s ill-considered activity in the Middle East.
Both economically and geopolitically, therefore, we are not in the extreme situation of the United States in 1932-33 nor in that of Britain in 1938-39. Unemployment is not 25%, nor is a major war imminent. However there are enough middle level economic unpleasantnesses around, and enough uncontrollable security risks, that for the first time we can see the strong possibility of a decade not dissimilar to the 1930s, in which the life of a generation is blighted either by long-term economic depression or by war or both.
My capability as a geopolitical strategist is not particularly great, so on that front I will content myself with observing that the Western alliance badly needs a period of quiescence in the commodity markets. While successful emerging markets like India that rely for their prosperity on manufacturing tend to be friends of international economic order, those which rely on commodities are much less reliable, especially when commodity prices are high and inexorably rising, as at present. Even where such countries are democracies, their electorates tend not to see the connection between sound economic policies and prosperity. Thus Venezuela, Russia and most of the Middle East are basically hostile to the international economic order, funneling resources to rogue states and opposing sanctions on regimes that engage in nuclear proliferation. Even where a free election is held, as in Peru recently, the electorate in a commodity-producing state at a time of high prices is likely to choose the spendthrift anti-Western leftist over the moderate pro-business candidate.
It therefore follows that if Western countries want to reduce the likelihood of nuclear conflict in the next decade, although probably not to eliminate it altogether, they should adopt economic policies that will prick the bubble in commodity prices. The objective should not be to return to the ultra-low and declining prices of the 1990s, which are probably in any case unattainable given the continued growth of emerging markets with large populations. Instead we should aim at something like $80 per barrel oil, $3 per pound copper and $1,000 per ounce gold, levels at which extraction operations remain profitable and revenues flow into producing countries, but producing country governments are discouraged from spending bonanzas or foreign policy adventurism. At those prices, Russia would have enough revenue to develop its economy, but would require a substantial non-oil manufacturing sector in order to increase its wealth, while a Soviet-era military would become unaffordable. Venezuela and Iran would be unable to develop aggressive anti-Western military capabilities, and North Korea would run out of friendly sources of funding for its mad ambitions.
Economically, in order to avoid a lost decade of high unemployment, the West needs to increase its growth rate, while reducing the drain of manufacturing jobs to emerging markets. Some of the latter is at last happening naturally. The invention of the Internet and modern communications in the 1990s had hugely reduced the cost and increased the efficiency of global supply chains. That had made the available premium for Western over emerging market (especially Chinese and Indian) labor considerably smaller, thus ushering a decade in which Western wages tended to decline but the cost of imported goods also declined, more or less preserving living standards.
This effect may now be drawing to a close. The dollar has declined while emerging markets inflation has risen. In China and India especially, wage inflation is running around the 20% level. This is reducing the cost advantage of emerging markets labor, without entirely eliminating it. In order to get the full emerging markets labor advantage, investors are having to venture further afield, to “frontier” markets where labor costs remain well below Chinese levels and overall costs remain well below Indian levels (when you include the costs of dealing with India’s appalling bureaucracy).
Nevertheless, even if the cost advantages of outsourcing are lessening, outsourcing itself will remain a continuing trend because it is becoming easier. As systems are adapted to global production, further operations can be outsourced. All that is required is some capital investment in the outsourcee country, to provide the production facilities that can replace the domestic factory.
To preserve their people’s living standards and prevent the 2010s turning into a high unemployment decade like the 1930s, Western economic policymakers must thus slow this process, ensuring that the rise in emerging markets’ standards of living is not achieved at the expense of Western citizens’ jobs and livelihoods.
This cannot be done by protectionism, as was done in the 1930s. The loss to global productivity from erecting trade barriers, thereby disrupting already existing supply chains, would be immense and would impoverish Western and emerging market citizens. That was the gravest mistake made in the 1930s; it must not be repeated.
However when you look at factor costs, it becomes clear that one policy move would revolutionize the global economic picture. Outsourcing almost always requires capital investment (and emerging market risk) that is paid for by labor cost savings. However with interest rates artificially low for over a decade, and exceptionally low for three years, capital is extremely cheap. That encourages the substitution of capital inputs for labor inputs, which has three effects. It encourages outsourcing. It makes labor productivity figures artificially favorable, as labor usage is trimmed to the minimum. And it increases unemployment in wealthy countries, as capital is substituted for labor and jobs are moved offshore.
Thus a sharp rise in interest rates, to perhaps 3-4% in real terms or about an 8% Federal Funds rate, since U.S. inflation is running at close to 5%, would reverse this effect, reducing the attractiveness of outsourcing, reducing the artificial boost to labor productivity (but making capital usage more efficient, so probably boosting multi-factor productivity) and reducing unemployment, by making it more attractive when expansion was needed to hire new workers rather than outsource production.
The same policy change would also alleviate the geopolitical problem. Even though emerging markets would continue growing, their consumption would grow more slowly, reducing the strain on energy and commodities usage. On the other hand, with high real interest rates it would no longer be attractive to hoard commodities hoping for a price upturn, so supplies would be released onto the market. The result would be a sharp decline in commodities prices, probably initially overshooting the target range of $80 oil/$3 copper/$1,000 gold, but eventually swinging back towards that equilibrium as speculator commodity holdings were absorbed. As discussed above, this would almost certainly reduce the funding and support available for the world’s bad guys, and reduce the chances of medium level conflict.
One must be fair. Not all the world’s problems can be laid at the door of Ben Bernanke’s misguided monetary policies. Not quite all. But it’s truly remarkable just how widespread their pernicious influence has been.
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(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.)