Yesterday I raised the issue of the dysfunctional political situation in the US which is preventing the US President from introducing a public works program aimed at boosting the degenerating public infrastructure. The fact that such a policy could generate millions of jobs and improve the long-term productive capacity of the nation is unquestioned. It was suggested that the US President might offer the conservatives widespread deregulation which would cut wages as a compromise. This would be pandering to their erroneous claims that that supply-side factors are restraining the capacity of American businesses to create work. Today we examine some recent research evidence that demonstrates how far amiss the current policy debate is. The evidence shows that firms are constrained by lack of spending at present and that the private sector is in a vicious cycle of spending paralysis. It suggests that the only way ahead is for the government to increase aggregate demand (via fiscal policy) but that the ideological obsession of the elected politicians is blocking the only growth option currently available. We are in a state where our politicians are deliberately stopping the economy from growing.
There was an interesting research paper published recently (July 21, 2011) by the US Federal Reserve Bank of New York – Why Small Businesses Were Hit Harder by the Recent Recession – which is part of its Current Issues in Economics and Finance series. I was initially interested in it because I have done a lot of work in the past on the role of firm size in job creation and job destruction rates. Specifically, I have been interested in the popular view that small business is the dynamo of advanced economies – which feeds into the debate about the impact of regulation and employment protections on employment.
My work which resonates with other international studies suggests that small businesses do not generate the most jobs and that the impact of legislation pertaining to job security and redundancy protections etc do not impede employment growth. But that is another blog.
The NY Federal Reserve paper mentioned above is less about those issues and more about the cyclical impacts on firms by size. So that is another interest of mine – how do economies adjust during a cyclical downturn?
The Paper begins by noting that:
The recent economic downturn saw an unprecedented deterioration in labor market conditions. From the December 2007 start of the recession to December 2009,1 nonfarm payroll employment—the traditional measure of U.S. jobs – declined by 8.4 million, a drop in levels unmatched in the entire postwar period. A closer look at the employment figures reveals that the recession’s effect has not been uniform across firms of different sizes: small businesses have in fact been more adversely affected than large ones. Jobs declined 10.4 percent in establishments with fewer than fifty employees, compared with 7.5 percent in businesses with fifty-plus, while overall employment decreased 8.4 percent. This pattern is noticeably different from the trend of the 2001 recession.
Given that finding the Paper aims to “shed light on some of the factors that caused small businesses to be hit harder than large firms during the last downturn.”
So that is an interesting research exercise and they conduct a large national survey of businesses and combine the results with several other publicly-available datasets. The details of the data and the survey sample are outlined in the Paper and I won’t go into them here.
The NY Federal Reserve Paper considers two supply-side explanations for the “recession’s disproportionate effect on small firms: sectoral composition and credit availability”.
The sectoral composition hypothesis says that “if employment declines relatively more in sectors populated with small firms” then “in the aggregate these firms could account for a higher percentage of job losses”. The evidence fails to support his hypothesis – small firms in all sectors were “hit harder than large ones”.
They also find that “limited credit availability” was of secondary importance in explaining the difficulties faced by small firms.
Overall they say that:
… demand side factors – notably, economic uncertainty and poor sales stemming from reduced consumer demand—appear to be the most important reasons for the relatively weak performance and sluggish recovery of small firms.
The following graph reproduces the NY Federal Reserve Paper’s Chart 4 and it shows the various assessment of the factors that small businesses considered impacted on their performance. The authors say that “owners of small businesses are regularly asked to identify the most important problem associated with weak economic conditions”.
The result is stark and shows the increasing impact of aggregate demand as the economy contracted and unemployment rose.
The deficient aggregate demand creates a vicious cycle. The NY Federal Reserve paper concludes that the evidence shows that:
… the chief reason for their sluggish performance appears to be a lack of current and expected future demand for their goods and services, as reflected in the firms’ concerns about poor sales. This reduced consumer interest in the products of small firms likely lowered the firms’ demand for credit. In these scenarios, firms do not have the ability to invest and thus have little need to borrow.
From which we understand that the constraints are not emerging from the financial system (liquidity constraints etc) but from the lack of aggregate demand – which in turns reduces the need to invest which reduces the demand for credit.
The final question of interest (that you might like to know about) is why did small business suffer more this time than big business?
The answer is not straight forward but the NY Federal Reserve paper suggests that sales growth recovered earlier for the larger manufacturing firms “while sales of small firms have lagged and their recovery has been sluggish”. Further, the inventory cycle has been more severe for smaller firms such that “small businesses managed the fluctuation in sales through greater inventory adjustment”. In other words, the larger firms seemed to start producing inventory replacement earlier than the smaller firms.
But overall, the reason the “downturn has had a deeper employment impact on small businesses than on large ones” is because the “poor sales and economic uncertainty” have impacted more severely on the smaller firms.
The Paper however, doesn’t provide a detailed explanation for why that would be the case and so I suggest a PhD student could write a very good thesis exploring that topic.
The facts are there – small businesses suffered disproportionately. The link between aggregate demand and employment growth is also clear. The research question is why did aggregate demand fall more sharply for smaller businesses.
The results call into question those who have been arguing that monetary policy is the only show in town.
This research also resonates with a recent New York Times article (August 16, 2011) – It’s the Aggregate Demand, Stupid – which was written by a former senior policy adviser to Ronald Reagan and George Bush (senior) – one Bruce Bartlett.
Given he has also served on the staff of Ron Paul I was wondering what the article was to be about – apropos of the title.
Well it couldn’t be more clearly expressed:
With the debt limit debate temporarily set aside, the Obama administration is talking about finding some way to create jobs and stimulate growth. But the truth is that there really isn’t much it can do and it knows it. There may be some small-bore things it can do without Congressional action that may help a little, but the operative word is “little.” The only policy that will really help is an increase in aggregate demand.
Aggregate demand simply means spending — spending by households, businesses and governments for consumption goods and services or investments in structures, machinery and equipment. At the moment, businesses don’t need to invest because their biggest problem is a lack of consumer demand …
The federal government could increase aggregate spending by directly employing workers or undertaking public works projects. But there is no possibility of that given the political gridlock in Congress and President’s Obama’s desire to appear moderate and fiscally responsible going into next year’s election.
That really leaves just consumers as a potential avenue for increasing spending. But that will be difficult as long as unemployment remains high, thus reducing aggregate income, and households are still saving heavily to rebuild wealth, which was decimated by the collapse in housing prices. Saving is, in a sense, negative spending.
So three points are clear:
1. There is not enough spending in the US at present and that is why there is high unemployment and stagnating growth.
2. The components of aggregate spending are obvious – and an examination of them reveals that non-government spending is not going to grow fast enough to stimulate the economy largely because firms are constrained by lack of consumer demand which is being driven by entrenched unemployment.
3. The only way out is for public spending to increase – “by directly employing workers or undertaking public works projects” – but that won’t happen because the “political” situation will not allow it.
The evidence is very clear – the politicians are deliberately undermining the growth of the US economy.
This insight is obvious to anyone who understands the economics of the situation – and that doesn’t include the majority of my profession which prefers to promote their ideological dislike of public activity ahead of an appreciation of the research evidence.
The challenge is to get that message out into the public domain so that the political debate changes and the artificial restrictions on fsical policy that are undermining growth and prosperity are lifted and national governments get back to doing what they were meant to do – pursue public purpose and sustain full employment.
There was a related New York Times (August 24, 2011) – How Much More Can the Fed Help the Economy? – where we read that there is little that the US central bank can do with monetary policy to provide the necessary stimulus to US growth.
The author (Catherine Rampell) concludes that the Federal Reserve is the only policy arm of government that has room to move because:
After all, Congress seems wholly unwilling to engage in fiscal stimulus, and instead is planning further fiscal tightening.
Once again you understand that it is not a problem of fiscal effectiveness but the politicians who have to act to use the fiscal tools.
Rampell however believes that “the Fed’s remaining tools may be losing their potency” to which I would say when did they ever have any potency.
She understands that monetary policy works via interest rate movements and that cutting interest rates provides a “good opportunity to extend more loans. If more loans go out to people and companies, those people and companies can buy more goods and services, creating more demand and eventually more jobs”.
Quite apart from whether monetary policy works, what you understand here is an emphatic statement that aggregate demand (however originated) stimulates production and jobs.
But the proposition is that with interest rates “already at zero” and quantitative easing not appearing to have stimulated borrowing (despite holding down long-term interest rates), there is little the Federal Reserve can do.
She suggests there is political pressure on the central bank not to expand its balance sheet further although there “would probably be less political resistance to reconfiguring, rather than expanding, the central bank’s debt holdings” – that is, purchase debt further out on the yield curve (longer maturity assets) which might lower long-term interest rates.
It is clear from the NY Federal Reserve paper that there is little demand for credit at the moment for the reasons discussed. So it is not about price but poor expectations of future revenue streams that is driving the flat demand for loans.
She says the central bank “could also lower the interest rate it pays banks on their reserves” and “(m)aybe this would encourage them to hold less cash and increase their lending” but in saying that she falls into the trap of thinking banks lend out reserves. They do not need the reserves to lend. Their capacity to lend is not enhanced by the reserves they are currently holding.
Her concluding suggestion is that the central bank should announce “that it is raising its medium-term target for inflation” which might bring forward consumption and investment decisions (because people would be worried that prices would rise) and also deflate current debt burdens. These real balance effects are likely to be very small indeed and are not a credible way to promote higher economic activity.
The fact that people are still harking after the central bank to cure this impasse is a reflection of the ideological bias against fiscal policy which is promoted by mainstream economists.
The crisis has emphatically taught us that monetary policy is a largely ineffective policy tool to counter-stabilise negative demand shocks. It has also taught us that while economists eschew the use of fiscal policy and dismiss it as being ineffective and inflationary, the fiscal stimulus interventions of governments all around the world helped consolidate aggregate demand and restore growth. In the same way, the fiscal contractions are pushing economies back into the red.
The message is simple – aggregate demand has to rise for there to be serious job creation.
That requires spending and at present the private sector is stuck with low confidence and high debts. There is only one solution and the politicians that have been elected are failing in their duties to increase the welfare of their nations.
That is the message that should be getting out – get rid of politicians that deny the obvious – just because they hate public activity. At present, whether you hate it or like it, increased public spending is the only way out of this crisis in the coming months. Putting political constraints on fiscal policy is tantamount to admitting that you want more citizens to be unemployed and more firms (particularly small businesses) to go to the wall.
Why don’t the Texans etc tell that to their Tea Party supporters – as they put their hands on their hearts and feign a devotion to matters spiritual including integrity and honesty.
That is enough for today!