Creative Destruction vs. Interest Rates

On the back of yesterday's post and spirited comments on the change of the recession cycle, some more ideas along the same lines.
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We are all familiar with Joseph Schumpeter's creative destruction principle, about the ups and downs of the economic cycle forcing businesses to adapt and evolve. I think of it as Darwinism for business (see book on the right).

Here's a question, then, that ties monetary policy with creative destruction: Did the massive interest rate cuts of the Greenspan Fed - and those in the works by Bernanke - prevent the creative transformation of the US economy?

During the last recession rates went to near zero, a level not seen since the 1960's. The response should have been a strong flow of investment in new industries (creation) to replace those damaged by the downturn (destruction). This clearly did not happen and low rates produced instead a capital misallocation of historic proportions. Massive debt pumped up a housing bubble, maintained consumer spending and financed portfolio transactions such as LBOs and share buy-backs.

Observing employment patterns, i.e. the number and type of jobs lost and created during the business cycle, provides excellent insight. Manufacturing jobs, in particular, are key because they add high value at many levels. Modern manufacturing is capital, knowledge and skills intensive.

In the chart below (click to enlarge) we observe that every time the Fed dropped rates in response to a recession (blue line), employment in manufacturing rebounded (red line) - except now. During the last cycle the economy shed 3.3 million manufacturing jobs - one in five - but did not get them back when the economy rebounded, despite record-low interest rates. Losing 20% of manufacturing jobs so fast certainly qualifies as "destruction". But what sort of "creation" occurred as the economy came back?

Fed Funds and Manufacturing Jobs Chart: St. Louis Fed

The rebound did create new jobs to replace industrial workers, but of a very different sort than before. Since the end of 2000, the US private sector created a net 4.5 million new jobs but nearly all (4.4 million) are in leisure, hospitality, health care and social services, i.e. low-skill, low value-added jobs located in the periphery of the service economy. And what replaced the 3.3 million factory jobs lost? Mostly construction, financial services and business services. The table below sets out the numbers.

Data: BLS

Even if we assume that these replacement jobs add as much value as manufacturing (a very big if), we see that on a net basis the latest expansion generated nothing but low-pay employment. This point is further corroborated by a study from the Ecomic Policy Institute which shows that despite the recovery real family median incomes are lower now than in 2000. As the NY Times puts it:

A new study by the Economic Policy Institute uses Census data to trace the dismal trajectory. Economic growth during the Clinton administration peaked in 2000, followed by a brief recession. Growth resumed at the end of 2001, the beginning of the Bush-era expansion, but real family income continued to fall through 2004. It has turned up since then, but as of the end of 2006, it was still about $1,000 below its peak in 2000. Even if that difference is made up this year (and it’s still too early to tell if that will happen) Americans would be merely breaking even. That would be a pathetic outcome after six years of strong labor productivity.

For the United States, therefore, the creative destruction process ran in reverse: it destroyed high-value manufacturing and replaced it with specifically low-value services. The loss of earned income implied by this shift should have been unacceptable to society, but as we know living standards were artificially maintained by increasing debt and by the illusory rise of purchasing power from cheap imports. Instead of going through the painful, but ultimately beneficial process of creative destruction, America took the easiest way out.

Data: FRB St. Louis

Simply put, Greenspan threw a monkey wrench into Schumpeter's creative destruction process and now Bernanke is repeating the mistake. What's worse, we have been led to believe that the Fed can keep the economy going indefinitely by mere adjustments of interest rates and injections of liquidity. However, wealth is not created by monetary policy but by constant innovation and judicious investment. We are clearly not investing as we should and innovation will soon depart, following industry abroad. No one has a lock on knowledge, after all.

We can make one more observation linking the cost of money with the creative destruction process. When capital costs are unusually low, businesses can be less choosy about their investments. For example, if a businessman can borrow at 4% he may be happy with starting a hair salon returning 8%. But if rates are at 10% he has to invest in something that adds more value and is potentially more profitable.

The conclusion is that for a developed economy, at least, unusually low cost of capital - debt and equity - ultimately works against the creative destruction process and leads to a loss of competitiveness. Let me put it another way: artificially low interest rates and high share prices over a prolonged period make America complacent and "dumb", particularly if it has to compete with a dynamic bloc like Asia.