In the Nation's Interest

What is “The Great Reset?” Falling Oil Prices, Stagnant Wages, and Reduced Expectations

If anyone had told you 40 years ago (assuming that you were at least near adulthood 40 years ago) that the United States would develop technology that would make us the world’s leading oil producer and that oil prices would plummet, you very likely would have pronounced that an unmitigated Good Thing.

So here we are, with crude oil production way up and prices down by roughly half over their apparent trend one year ago, an economy that is stumbling, and a reasonable case being made that the former is contributing to the latter.

It doesn’t make sense, except that it has to.  And in fact it is quite pertinent to the current work of CED’s Sustainable Capitalism Subcommittee.

It also is related to a Tyler Cowen New York Times column of couple of weeks ago.  (Thanks to Howard Fluhr for suggesting this column as the basis for a blog post.)  Cowen references an argument, itself coming from Richard Florida of the University of Toronto, that the economy is making its way through a deep-seated, slow-moving “reset” which is dampening incomes, spending and expectations, and thereby holding back growth.

To illustrate the “reset,” Cowen uses the example of manufacturing employee pay.  U.S. automakers and some other manufacturers in effect cut a deal with labor unions in the early days of the financial crisis to protect the jobs and wages of then-current workers while allowing the hiring of new workers at significantly lower pay.  Over time and with turnover, the total wage bill of those firms declines.  With this reduction in total pay, household incomes and consumption decline, and with them, consumer sentiment declines as well.  Cowen points out that the young workers hired at the lower entry-wage tier might be set on a trajectory of lower incomes for much of their lifetimes, given that individual workers’ wages tend to follow fairly predictable paths based on their starting point.

What to think of this story (noting that Cowen cites these as examples of a larger phenomenon)?  It does sound a bit superficial to me, although not in a fashion that necessarily would alter Cowen’s conclusion.  The story as told does not explain why the manufacturers can hire at these new, lower wages – which would seem to be an important prior question.  The straight-forward answer most likely is the globalization that allows workers in far-off economies, previously barely linked to ours, to compete directly with those tenured unionized and new entry-level workers.  In effect, the relevant supply of labor has increased because of exogenous forces, driving down U.S. wages – which would be to the benefit of U.S. producers, if they didn’t have to compete with foreign producers paying those same low far-off wages.  That being the operative cause, it seems premature to say that young workers’ wages will be determined for decades by what they make today; there will be other factors that will help to determine the course of their careers going forward.

We could say in a socially idealistic tone that U.S. producers should be responsible citizens and continue to pay those higher wages of tenured workers even for young entrants, because that would maintain our strong consumer market and therefore pay for itself in higher U.S. demand.  The problem, of course, is that foreign producers would eat our producers’ lunch, not just in foreign markets but in our own as well.  Look at the autos within sight on your street and ask yourself whether U.S. consumers have chosen to buy U.S. nameplates to support U.S. workers.  There is no such thing as an uncompetitive world leader.

Which takes us to the implications for our economy at large.  Lower wages for newly hired manufacturing workers reduce the cost of the labor needed to produce one unit of output (the “unit labor cost” in economists’ lingo), and so make our manufacturers more competitive.  The more-competitive part is a good thing; consider the alternative.  But there is another way to reduce unit labor cost:  We could have increases in productivity, which would increase output rather than reducing cost.  An equal percentage increase in productivity would be just as good for competitiveness as a reduction in wages, but it would not entail the drop in employee incomes and in consumer sentiment.  Now, granted, productivity is increasing, too – but not enough to lead to significant increases in wages.

In other words, the problem with increasing competitiveness through a gradual reduction of the manufacturing wage bill – rather than from an increase in productivity – is that it is a transfer from one part of America to another (rather than an increase in America’s production).  Producers have more income – which is to say, they still have viable companies – but consumers have less.

Which in turn was what raised the opening thought about the irony of a struggling U.S. economy that also is swimming in oil.  We started that revolution by becoming the world’s largest oil producer, and then had our knees capped by OPEC determining to maintain its market share and therefore not cutting its production, driving prices way down.  The falling prices landed hardest on the world’s largest oil producer, of course.  Thus, with apologies to the late Walt Kelly of the old Pogo cartoon strip, we have vanquished the world’s oil barons, and they is us.  The drop in incomes in some of our nation’s leading oil producing regions so far has hit the economy harder than the falling gasoline prices have collectively boosted it.  These developments, on top of the financial crisis and its fallout, have depleted the economy’s “animal spirits.”  Economic forecasters assumed that a substantial fraction of consumer savings on gasoline would be spent, but those dollars haven’t yet escaped from underneath the mattress.

The linkage to our Sustainable Capitalism work comes through our project on inequality.  Some argue that greater inequality reduces economic growth, because people with low incomes must spend every dime to keep body and soul together, whereas people with higher incomes save more.  In the long run that argument doesn’t make much sense, because once the income distribution settles down, consumption grows at the same rate as incomes.  But in a dynamic setting, changes like Cowen’s “reset” can matter.  If income moves from wage earners to firm owners, the wage earners likely will reduce their spending very quickly, but it may take the smaller number of firm owners more time to put their added dollars to use.  (This ignores the likely counterfactual that in the absence of such a switch, some firms would fail entirely.  Here, we are looking at the change in trend as the “reset” pulls down the total wage bill.)

Some might ask why, if the economy is being held back by a shortage of animal spirits in the form of consumer demand, we don’t just apply fiscal stimulus to get spending going.  After all, we have no inflation, and plenty of technological improvement to boost output without pushing prices higher.  But that gets into our current fiscal troubles, with an accumulated debt that already is too high.  One of the downsides of fiscal irresponsibility, experts always say, is that you don’t have borrowing capacity when it is needed.  That, unfortunately, is a real danger today.

Anyone who can see the future would be out buying and selling instead of reading (or writing) this blog post.  But our economic future is not just about random events.  It is driven by some enormous and unprecedented forces.  When we gather our Sustainable Capitalism Subcommittee for its quarterly meeting 85 years from now, fortunately all of us will have the wisdom of hindsight to explain what our economy is going through right now.  (But then, come to think of it, ask a monetary economist, a fiscal economist, and a trade economist today what caused the Great Depression…)

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