Sunday, July 1, 2012

A flexible economy

Alan Greenspan in his book Age of Turbulence refers to economic flexibility as a reason for the US economy’s ability to withstand the shocks of the collapse of the stock market in 1987, the savings and loan crisis of 1990, the Mexican crisis of 1994, the East Asian crisis of 1997, the Russian default of 1998, the failure of LTCM, the dot-com bubble, and 9/11. (The housing bubble was probably the last bubble to break the back of this economy.)

He has referred to it in his past speeches, for instance,
Flexibility implies a faster response to shocks and a correspondingly greater ability to absorb their downside consequences and to recover from their aftermath. No specific program encompassed and coordinated initiatives to enhance flexibility, but there was a growing recognition, both in the United States and among many of our trading partners, that a market economy could best withstand and recover from shocks when provided maximum flexibility.

This was during the period of the Great Moderation which Greenspan was wise enough to acknowledge that the resilience and moderation could not be fully attributed to central bank policies alone. While the reference is presumably to the ability of the economy’s GDP to absorb these shocks it isn’t clear what caused this increased flexibility. The hand waving economist points to deregulation and competitive market forces but surprisingly the data devourer that he is known to be did not delve deep enough into the statistics to find out whether this moderation at the aggregate level was real, deep and wide.

Economic flexibility can also refer to the the range of options available to a policy maker. For instance, being up against the zero nominal interest rate as we are today is not flexibility. The ballooning deficits in the early 2000s during the tenure of Bush II limited the ability of the government to try to pass a larger fiscal stimulus. But since most of the shocks occurred during the Clinton administration when deficits were falling and surpluses were projected this might have added some flexibility in the economy.

We also know that during the past 20 years, the rich got richer, the financial sector got bigger and riskier, and the low and middle class earnings either stagnated or fell. In the 1980s, Bud Crystal published In Search of Excess, a criticism of CEO compensation. It drew outrage from both CEOs and the public - the former believing that their pay was not excessive. Over time, the furor faded and excess compensation became the norm rather than the exception. As is clear in hindsight, the economy really wasn’t that flexible and never was. This is one of the times that the aggregate statistics fooled the economists and perhaps this is because the Greenspan aura had yet to wear off and inflation targeting was the rage and economists were too eager to confirm their biases either of competitive market forces or effective policymaking.

There is no doubt that there is some truth to the Greenspan idea that deregulation has contributed somewhat to economic flexibility. The European labor market provides that contrast - where employment is more rigid and firing and layoffs more costly. Production is considered flexible if it is able to adjust quickly to demand and supply shocks or if it can switch from producing widget A to widget B in less time. Again there may be some truth in this kind of flexibility with the introduction of just-in-time inventories - although JIT can also be a curse when the supply chain does not function as expected. If this is all there is to flexibility then again the economy really can’t be so flexible that it could have absorbed all those shocks. Something else must have been at work and that something else is still elusive.

For workers, flexibility really isn’t an option, it’s a necessity. If creative destruction could be measured then it is one measure of flexibility. How much creation comes out of the destruction - a flexible economy is one where there is more creation than destruction. As capital is reallocated toward new industries and new jobs are generated how well the destroyed workforce responds will be one yardstick to measure creative destruction. Do the old workers start new companies, acquire new skills and move to other industries quicky? While entrepreneurship does provide one component of creation, the other component - that of retraining workers is less successful. Acquiring new skills and adapting has always been hard and it is difficult to believe that during the Greenspan era this was really happening.

One possibility is that the asset price bubble in particular the dot-com bubble that began in 1995 masked the weakness in the labor (and perhaps the product markets). This was a time when hiring was in such a frenzy - programmers were flipping jobs like homeowners would flip houses a decade later. Even those who weren’t trained as programmers thought they could be programmers and signing bonuses flourished just for finding workers who were willing to be trained.

This is one experience:

  • Skyrocketing salaries resulted in a rash of neophytes entering the software development field with giant dollar signs in their eyes.
  • Internet companies with irrational, unsustainable business strategies built to cash in and hiring at a frenetic pace.
  • You were never more than two degrees of separation away from a tale of some programmer who became an overnight millionaire.  

But the demand for programmers does not only affect their salaries. Without doubt, it would also affect the salaries of production, sales, support and administrative staff and not just those in the IT industry. Just as many of the companies of this era really had no hope of existing beyond their initial venture funding, many of these workers really had no skills to fall back on once the bubble burst.

Those who really could program moved were able to move into other sectors. But the hiring frenzy also tapped into the lower rungs of the ability scale of workers whose existing salaries set an expectation that they were better in their minds than they were in reality. They really didn’t have the flexibility required to move into other jobs. Overall, sticky expectations might have been set.

The history of employment training is one that is littered with more failures than successes. In Big Blues: The Unmaking of IBM by Paul Carroll, in the post-Watson era:

Lucente had few options as he went about expanding the U.S. sales force, because IBM’s tradition of lifetime employment mean that he couldn’t simply hire from the outside. He had to take the people whose programming and manufacturing jobs were being eliminated and retrain them as salesmen. That meant months of schooling and many months more for these people to get comfortable in their new jobs. Even them, senior ex-IBM marketing executives now acknowledge, the quality of the sales force suffered. The say salesmen are born, not retrained. Even if someone was the best plant foreman ever, it didn’t mean he’d ever learn to close a sale. While IBM says it doesn’t keep statistics on how many of those put into the sales force are still with the company, the senior ex-IBMers say that the vast majority of those retrained at such expense have left as the sales force has imploded in recent years. (pg. 163, 1994).

The inflexibility of workers is a constant - retraining is hard. But harder if the job itself is changing or has changed - it may require the use of more specialized tools, the nature of the tasks might have changed and have also become more complex. Consider the administrative assistant or in the early days the secretary. He or she (more likely the latter) was required to know shorthand, take dictation, and type on a typewriter. Today, he or she is more likely not to know shorthand, some dictation but must learn not just how to type in a word processor but also perhaps use PowerPoint, Excel and manage a contact database. Moreover, it is more likely that several people are using the services of one assistant whereas in the past it was almost a one-to-one ratio. The nature of the job has changed and has become more complex.

Throughout the history of economic turmoils, the rallying cry has also been more education (as well as more retraining). The belief was that a college education was necessary for flexibility and in that a liberal arts education that taught someone how to think was more important than teaching specific job-related skills and knowledge. A college student could possibly be all things to anyone because he or she had the general skills to learn new task and job specific skills. This may have been true once but increasingly the question asked is - is it still true?

Consider this article (originally in Time) on the Washington bubble (HT: MR)
Most of the people who have moved to Washington since 2006 have been under 35; the region has the highest ­percentage of 25-to-34-year-olds in the U.S. “We’re a mecca for young people,” Fuller says. One recent arrival says word has gotten out to new graduates that Washington is where the work is. “It’s a place where a ­liberal-arts major can still get a job,” she says, “because you don’t need a particular skill.”

Where education was once the bastion of flexibility, it is increasingly true that the inflexibility of the entire education sector from high costs to irrelevant courses has become a curse for college graduates.

Flexibility of an economy has three components: government (via monetary and fiscal policy), production (the ability to adjust to demand) and labor (the ability to adjust to demand). (Not quite related to the US is also exchange rate flexibility.) Historically, labor has been and still is the most inflexible. While the late 1990s might have provided some government flexibility when interest rates were not at a zero bound and deficits were small this component is period is too short to justify the period of Great Moderation which dates from the early 1980s to the 2000s. Moreover, the production sector was suffering from the onslaught of Japanese competition and had not had time to implement the lessons learned from this competition and the investment in information technology had yet to really pay off in terms of productivity.

While the sources of the moderation will probably not be known it is clear that policy makers and economists were fooled by the aggregate statistics - fooled because after being a dismal science for such a long time, they were looking for something to cheer about. Fooled because they wanted to pat themselves on the back that their theories of market forces and deregulation really could lead to desirable outcomes without knowing fully the paths through which these forces interacted.

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