Is the Engine of the Economy Flooded?
When one hears talk about the Wicksellian natural rate of interest, one hears that a real rate below the natural rate will cause inflation and economic heating. Then a a real rate above the natural rate will lead to disinflation and economic cooling.
“Wicksellian analysis is an older tradition; it argues that there is at any given time a “natural” rate of interest in the sense that keeping rates below that level leads to inflation, keeping them above it leads to deflation.” Paul Krugman, July 7, 2014
So the logic looks simple, if we lower rates to below their natural level, the economy will heat up. That is like pushing down on the accelerator to speed up a car. OK… But does pushing down on the accelerator always speed up a car’s engine?… No
Case in point, Flooding a Car’s Engine.
“A flooded engine is an internal combustion engine that has been fed an excessively rich air-fuel mixture that cannot be ignited. This is caused by the mixture exceeding the upper explosive limit for the particular fuel. An engine in this condition will not start until the excessively rich mixture has been cleared. It is also possible for an engine to stall from a running state due to this condition.” (Link)
When an engine is flooded, pushing more and more on the accelerator does no good.
Low interest rates are an excessively rich air-fuel mixture. The Federal Reserve and most central banks around the world are trying their hardest to fuel their economies with ever lower interest rates. But the economies are not heating up. So real rates must obviously be above the Wicksellian natural rate, right?
But what if economies are “flooded” with a multitude of subsidies, while wages stagnate? Businesses receive benefits from sources other than consumption by labor income, namely low interest rate costs, lower taxes and direct subsidies. I am implying that real rates can be below the Wicksellian natural real rate, and the economic environment will not ignite while labor income is so weak. So even with the rich fuel of extremely low interest rates, the economy does not respond.
What would be the solution? Clear the excessively rich mixture by withholding the fuel for a sufficient period of time. Basically, take your foot off of the accelerator and wait for the engine to drain off the excess fuel. The Fed rate would have to rise a bit for some time. Then firms that can afford higher interest rate costs and higher wages will get stronger. The weaker firms will weed out. Then the Fed rate could be lowered but this time the economy would respond. The process is similar to waiting 20 minutes when your engine is flooded. Make the market work out its weaknesses.
It would help to also raise the “effective” taxes on high incomes and corporations. And to give more power to labor for getting higher wages.
Sensing Social Benefits
Most of us can sense that something is not right. Social benefits are not being maximized. We know that lower wages are dragging down the economy, even though lower wages should be good for business. We sense that higher wages would increase overall social benefits to society. But can we sense that higher interest rates would increase social benefits, even though low interest rates are supposed to be good for business expansion?
Low interest rates in the face of falling labor share of income is pointless. You end up flooding the production side expecting the demand side to rise. But when you flood the production side too much, while the demand side, labor income and fiscal policy, is obviously getting weaker, you end up with reduced social benefits for society overall.
The economy may be like a flooded engine.
Edward,
If it is flooded that the Fed did it. I believe there is a better explanation of our current ordeal.
Suppose that you buy a new car. Everyday when you leave for work you drive down a hill that is relatively steep for about 1 mile, then travel mostly level roads to your workplace. At the end of the day you drive back toward home and up that relatively steep hill. Your new car has plenty of power to climb that hill and good fuel economy.
After 4 or 5 years, the engine does not seem have as much power as it did, so you notice that you have to depress the gas pedal down further to get the accustomed speed when going up that hill. And your gas milage is not as good as it was. But the speed on the level roads is perfectly normal, so you don’t have it checked. A year or two later you find that you can not go up that hill except at an unusually slow speed.
Now you do get it checked and the problem is diagnosed as a catalytic converter which has become clogged. That problem lowered engine efficiency and available power. Your mechanic replaces the catalytic converter and your efficiency and power problems are gone.
If your car did not have an operator controlled gas pedal you would have been forced to deal with the problem much earlier.
You and your gas pedal were part of a feedback loop used to control the car’s speed. But the feedback was masking a problem with the catalytic converter. And it was only when the feedback control could not compensate that you were forced to recognize the problem and have it repaired.
The Federal Reserve with the Effective Fed Funds Rate are part of a feedback loop. When the economy slows excessively the Fed lowers interest rates which makes it cheaper to borrow money and spend. When the economy returns to normal growth the Fed raises interests rates and makes it more expensive to borrow and spend.
The overall effect is to stimulate spending in a slow growing economy so as to avoid deflation, and as the economy recovers to slow spending so as to avoid inflation. But the overall effect can mask external problems which are affecting economy.
From 1985 on, the Fed was moving interest rates lower and lower during each recession. And never quite returning interest rates to the high peak which existed before each recession. They were masking an external problem which was building just as that catalytic converter was becoming more and more clogged.
See: https://research.stlouisfed.org/fred2/graph/?g=26XZ
The growing external problem was from the effects of free trade treaties. As more and more production was moved to other countries, workers were layed off, retrained, and shunted into lower paying jobs. Those workers borrowed money to sustain their standard of living, but that has its limits.
Eventually the effect on workers/consumers were so large that we got the Great Recession which began in December 2007. That recession was so bad that even the Fed taking interest rates to almost 0% was not enough to get a generally recognizable recovery of the economy.
Now the ‘powers that be’ are trying to get by without fixing the real problem in the economy. They want to continue to drive this jalopy of an economy without doing the necessary repairs.
Japan used the same techniques to drive their jalopy of an economy without doing the necessary repairs. Their problems were different from ours, but their problems were just as serious. They have been going down this road for about 25 years.
Denial is not helpful.
JimH,
I am inclined to say that we are saying the same thing. We push harder on the accelerator, but we go slower. So maybe I think the engine is flooded, but you think the global environment is making the hill seem steeper for the US.
When you talk about repairs, I say “Make the market work out its weaknesses.” As long as rates are low, the market will have a hard time working out its weaknesses. Then the rates stay low anyway.
You talk about the powers that be fixing the real problem in the economy. But the market eventually has to fix itself being helped along by policy. It may be that the policy itself is so out of touch that the market falls out of balance and social benefits collapse.
Edward,
In your comment you write: “It may be that the policy itself is so out of touch that the market falls out of balance and social benefits collapse.”
I believe that we are already seeing some of that.
Continuing my comment above.
If the catalytic converter is not replaced it will become more and more clogged. In other words the damage is continuing and fuel economy is getting worse and worse. AND it raises the possibility that at some point the engine itself will be permanently damaged. (By overheating.)
And if the ‘powers that be’ do not reverse course on free trade treaties then the damage to the economy will get worse and worse as more and more production is moved to foreign countries. AND at some point it raises the possibility that the economy will be permanently damaged. (Loss of manpower skills, withered supply chains, etc)
And in the meantime, the Fed’s zero interest rate policy encourages rampant speculation and the associated misallocation of capital.
I think that this process of moving production to other countries might be self limiting but will that limit come too late? Or is the limit already showing itself? China’s exports are dropping, presumably because they can not sell as much to the developed world. Presumably that is because American and European workers can not buy as much with their stagnant incomes.
JimH, your mumbling again. China’s exports are dropping? Well, not really. China’s exports to America are increasing. Your view is on nominal chain dollars which is misleading.
I think if you want to use a broken engine part as the problem then we just replace the broken part and its fixed does not go deep enough in the analogy. To me it is more like the wrong program being used for the engine management system. Kind of more like the current VW engine controller issue. But in the interest rate situation it appears that we may be using the wrong economic approach all together to control the money supply rate and velocity to spur the economy. Perhaps we should be looking at some of the “other factors” Jeremy Corbyn is telling us in his economic vision for Brittan found at Global Research.com on 9-27-15 by Steven Lendman .The moving of the interest rate up and down ain’t workin for ya no more…It’s not just the catalytic converted but maybe we need a whole new engine or even a new car is where we are now.
Yes.
We could also say the economy has a vapor lock. https://en.m.wikipedia.org/wiki/Vapor_lock
Economies require a circulation of capital through the system. It’s often referred to as a liquid: A startup needs capital to “prime the pump.” Easily salable stock is “liquid.” Pay begets purchases, purchases beget profit, profits beget hiring, and hiring begets increased payrolls — or ought to.
But capital’s not a liquid, it can behave as a gas. It is compressible. My pocket with $100 in it is just as heavy as my pocket with $1,000,000 in it.
So, if the pay-purchase-profit-hiring cycle has new profit stopping at the “profit” stage, compressed and bled off into inert storage, then expecting the engine to pick up power is nonsense. Pumping harder at the labour segment isn’t getting anything through to the pay segment.
Noni Mausa,
I like your analogy of vapor lock. It is like capital dissipates and disappears into thin air and becomes useless to drive the engine of the economy.
Still, as I see it, stocks are way up, labor share is way down. Where do firms get their capital to survive because people have to spend less? They get relief mostly from low interest rates, low effective tax rates and foreign markets. So if you tighten up interest rates and raise taxes, you eventually force businesses to seek money from consumers. Consumers at some point get more power. And at some point translate that power into demanding better share of national income.
Labor share fell since 2000 partly in response to labor share falling so much in China. The consumer began to be weak. To make up the difference, interest costs fell and effective tax rates fell. And some other perks along the way. So businesses have been supported while labor has not.
So I see the engine of the economy is being flooded because labor income is weak. Once labor starts to get more money, you will see inflation pressures, then you will see the fed rate moving upward.
Until labor gets more money, low interest rates are part of the flooding to businesses…
Thanks Ed.
“It is like capital dissipates and disappears into thin air and becomes useless to drive the engine of the economy.”
It’s actually worse than that. The offshore or other storage of capital, the skimming off of it, has created two economies: one flat, the other inflated. But they share a single currency (very bad!) So a slight effort exerted by the inflated side, a thousand here, a million there, has a huge effect on the other side.
It’s like someone of modest means moving to a third world country, and suddenly becoming a person of wealth and influence. A nickel here, a dollar there, and you can manipulate a whole community. But with the sequestering of fungible wealth,* a wealthy person can now do the same thing without having to go anywhere. Nice work if you can get it.
Noni
* economics, a force for good! Teaches lots of new big words!
Edward,
I believe that If the US leaves all these trade treaties in place then labor share is not going to improve. And it will probably go lower.
What market force do you see improving labor share in the US?
JimH,
When China slows down, labor share should start to go back up in the US.
But that depends on jobs being onshored. And from what I read, that is not happening yet.
Harry Mosser has the re shore calculator that shows that the cost benefit analysis of staying in the US or re shoring is now most often beneficial to stay here. As China labor prices continue to rise the most now appears to be Mexico…More significantly is that China does not want to become part of the TPP. The reason is because they can game the system by not being a member. With the current trade defect running near $700B /year with China who want to play only by their set of rules one should expect them to manipulate-devalue their currency any day now to keep their unfair trade alive. We need a separate trade deal with China that implements Balanced Trade through the variable rate tariff with them exclusively. At the same time we must cut off the free labor flow of illegal labor from Mexico if we are to make any real wage gains in our economy…”The price that good men pay for indifference to public affairs is to be rules by evil men”. Plato. Go see http://www.reshornow.ogr for more on the re shoring initiative.
That “catastrophic converter” is a great analogy. Because it is only there because the government mandates it, and it saps the efficiency of the car as it builds up gunk — remarkably like government regulations. 😀
Absolutely! Much better to have all that gunk in the air!
Much better to have a vibrant unregulated financial sector. And those car safety standards — if the companies want repeat customers, they will be very careful to make cars that don’t catch on fire or accelerate on a whim. And the CEO that doesn’t want to end up in jail — surely he would never dream of running a Ponzi scheme or defrauding billions from the state of California.
It would be so sad if the mean old government tried to regulate these guys.