"The Labor Department reported that prices received by producers of finished goods rose 0.3 percent last month, further blunting the prospect that the economy was veering into a vicious cycle of lower prices and lower wages known as deflation.” (See http://www.nytimes.com/2009/05/15/business/economy/15econ.html?hp.) Analysts continue to be amazed that we have not yet moved into a deflationary spiral, given the weakness in the economy.
The amazement is due to the fact that most analysts still perceive the decline in the United States economy as one of a collapse in aggregate demand.
The amazement would disappear if these analysts considered that maybe the decline in economic activity was, at least, partially caused by a reduction in aggregate supply. However, most economists are still locked in their retreat to a fundamental Keynesian interpretation.
The banking industry has shrunk. The automobile industry has shrunk. Many retail chains have fallen by the wayside. The housing industry has suffered a massive decline in activity. And, there are many other structural shifts taking place in output and production. These are supply side shifts that are resulting in a major reconstruction of American commerce.
Yes, demand has fallen as the collapse in these industries has resulted in layoffs, firings, and reductions in force. However, the reductions in demand coming from the consumer have been the result of the structural shift in how the United States produces goods and services. Aggregate demand has fallen, but it has followed the decline in aggregate supply and not led it.
The consequence of this? A double whammy! Employment and output have declined due to the shift in both aggregate supply and aggregate demand, yet price increases have not declined as might have been predicted if the reduced output were just a result of a fall in aggregate demand as in the Keynesian case.
What evidence do we have to support this shift? First, there is the massive drop in capacity utilization. Since the start of the recession in December 2007, capacity utilization in the United States has dropped from about 80% to about 65%, a huge decline. Of course, capacity is defined in terms of the current industrial structure and does not take into account that a goodly portion of this capacity is redundant given the changes that are going on in the economy. This is why the auto industry is closing plants.
Furthermore, capacity utilization always lags the recovery of the economy, but in this case the response will be just that much slower because of the structural shift that needs to take place in how we produce and deliver goods and services.
Second, industrial production has nose-dived since the recession began. This is another indication of the structural shift that has taken place in the economy, a shift that will not be recovered just because aggregate demand increases. There has not been a decrease like this in Post World War II history, even in the 1981-1982 period. The year-over-year rate of change in industrial production has dropped from about a 2% rate of increase in December 2007 to a 13% rate of decrease in March 2009 with no let up expected.
Third, civilian unemployed has increased tremendously and the rate of increase of those unemployed has not yet slowed down on a year-over-year basis. This too is a reflection of the structural shifts that have taken place in employment patterns. Furthermore, these numbers include those that are discouraged from the work force and those that are partially employed but would like to be fully employed. Year-over-year, the civilian population that is unemployed has increased from around 10% in December 2007 to about 80% in March 2009. We have not seen such an increase in the Post World War II period!
So, the United States economy has been seeing a tremendous shift in its productive base. Yet, inflationary pressures seem to have remained relatively steady. This is captured in the year-over-year rate of increase in the consumer price index, when energy costs are excluded, which is increasing at a 2.2% rate in March 2009 which is down only slightly from a 2.8% rate of increase in December 2007. In terms of a broader measure of inflation, that recorded by the year-over-year rate of increase in the deflator of real GDP, inflation was at 2.1% in the first quarter of 2009, down modestly from 2.5% in the fourth quarter of 2007.
The use of resources, that is the use of capital and the use of labor, has declined in a major way since December 2007 reflecting not only the weakening economy but also the structural shifts taking place in the production of goods and services. Inflation has decreased only modestly. The combination of these two facts cannot indicate that the changes in the economy have only resulted from a shift in aggregate demand.
There are several reasons why we need to get a consistent interpretation of what is happening to the United States economy. The first is to understand that any stimulus that increases aggregate demand will have a minimal impact on the growth of economic output. The reason for this is that the restructuring of the economy is underway and jobs will just not be forced back into the previous employment patterns. Ironic as it sounds, demand stimulus will have more effect in keeping inflation where it is rather than increasing output. That is what happens when there has been a shift in aggregate supply.
This is, of course, difficult on the consumer because employment and incomes are falling, yet prices are staying constant or increasing, which reduces real incomes.
In addition, this interpretation can also help us to explain why the long term Treasury yields remain high. Everyone agrees that Treasury rates dropped dramatically last fall due to the international rush to quality. As the desire for low risk investments resides, the fact that inflation is not dropping off is being transmitted back into the bond market and Treasury yields are rising once again. In addition, with the massive federal deficits that are now on the horizon, the fear that this new debt will be monetized becomes more and more real to participants in the bond markets.
Furthermore, as Treasury rates rise, upward pressure is also asserted on mortgage rates, which is not helpful to a sagging housing market, and on corporate rates, which will not help stimulate business activity or support corporations in their attempt to restructure their balance sheets.
Finally, as the concern over quality declines, the value of the United States dollar will decline. It seems as if the structural shift in United States economic activity is more supply side than in other parts of the world. Thus, the behavior in prices appears to be different than that in other countries. That is, the price in goods outside the United States will fall relative to the price of goods in the United States. This will put downward pressure on the value of the United States dollar over time, even though interest rates in the United States may stay high relative to those in the rest of the world. This paradox exists because of the change in the relationship between price levels in the various countries.