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Guest Post: On Commodity Inflation And Long Term Underemployment

Tyler Durden's picture


Submitted by reader Grant Dossetto

Thanks to the invaluable work of modern financial writers and economists, conservatives have found it easier to defend capitalism against the salacious charge that markets were responsible for the enduring unemployment seen during the Great Depression.  Amity Shlaes’ The Forgotten Man and the work of Lee Ohanian and Harold Cole, of UCLA and the University of Rochester respectively, have made a compelling case that the Great Depression resulted from the failure of wages, in real terms, to adjust to macroeconomic deflation.  This failure could have a benign cause, a result of imperfect information and the inability of business to properly assess the productivity shock that resulted from the crash of 1929.  This theory would certainly explain why a severe recession could turn into a prolonged recession.  It remains suspect that poor economic decision making could last for over a decade. 
    In fact, if the labor force was not reduced dramatically by our first ever peace time draft and the ramp up in preparation for World War II we do not know when the Depression would have ended.  The true culprit was policy from Washington as pointed out by the Secretary of the Treasury Henry Morganthau who wrote in May of 1939, “We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!”  Policies aimed at wage stabilization were begun under President Hoover and accelerated under FDR.  As a result of the National Recovery Act, industries were forced to submit Codes of Fair Competition.  In essence, each industry’s Code was a legalized cartel with output, productivity and wages all strictly regulated and backed by the authority of the Federal Government.  The tragic story of the Schechters is a haunting embodiment of this control.  The Schechters owned a small poultry business and allowed customers to choose which chickens they wish to purchase.  This small example of independence earned the Schechters jail terms.  Farm controls resulted in slaughtered livestock left to rot in the sunshine and dairy products dumped at the side of the road as millions went hungry.
    The NRA, along with much of the original New Deal, was tossed by the Supreme Court.  Government power needed to be consolidated though, and Congress remained undeterred by judicial rebuke.  In 1935, the Wagner Act was passed allowing for collective bargaining by employees through unions.  Previously, this had been prosecuted under antitrust legislation.  The National Labor Relations Board was created to mediate negotiations between business and unions.  Although it has become popular through photos of sit-ins by the UAW against GM in Flint, among many other examples, to cloak early unions as knights crusading for “fair” wages it was, in essence, a continuation of the NRA administration of wage protection.  People were paid more to do less.  The result was massive underemployment among the economy at large.  Rates touched as high as 30% despite numerous government work programs.  The swelled ranks of the unemployed ensured that demand for final products could never recover.  Without pricing power and rising costs businesses retrenched and curried favor with politicians rather than creating the conditions for economic recovery.
    This recession has seen wages decline, both real and nominally, the average work week reach record lows, and productivity rise sharply.  Companies cut workers quickly as the unemployment rate is now at 17% according to recent U6 statistics.  It would stand to reason that our current troubles could never morph into a prolonged depression.  Unfortunately that is not the case and, logically, government is the reason why the macroeconomic performance will continue below trend for years to come.  The United States government has not just guaranteed losses in money market funds in the past year, it has, through the Federal Reserve, propped up failing financial institutions, doubled the money supply by dumping cash out of its discount window in exchange for evermore questionable collateral, and has bought nearly $300 billion of its own Treasury debt and nearly $1 trillion of agency debt.  The government has done everything it can short of ad hoc devaluation of our currency to increase the amount of money in the system and create a resultant increase in asset prices. 
    The government has rationalized that its unprecedented steps have staved off deflation.  This is only partly true.  It has staved off asset deflation, it has not ended the threat of demand pull deflation.  Since the lows of last winter, commodities and financial assets have rallied seemingly without interruption.  Oil has doubled from the low thirties to nearly seventy dollars a barrel, copper has doubled in price, silver has recently exploded as high as seventeen dollars, and gold now stands north of one thousand dollars per ounce.  The stock market has increased nearly sixty percent with the S&P now around 1,020, a far cry from the ominous intraday low of 666.  The Nasdaq has proven even more resistant to sluggish fundamentals and the Dow Jones Average has also yielded healthy six month returns.  Equity strength should portend bond weakness but that has not been the case.  Bonds also remain highly priced pushing the 30 year yield to below four percent.
    This remarkable equity and commodity performance has come even though the economy at large has shed over 2.5 million new jobs without one month of employment growth.  Initial claims remain in the mid-500,000s, continuing claims remain near record highs, and emergency claims continue to set monthly records.  Employment is not the only indicator of continued economic weakness.  Car sales remain poor except when government finances short term programs such as cash for clunkers.  Realtors are already asking for an expansion of the first time home buyer tax credit to keep housing sales from retreating further, pulling prices with them.  Popular industries such as video games are even feeling the pinch.  Game sales are down several months running and console prices have been slashed.  The Sony PlayStation 3 is now less than half of its initial retail price, less than three years after its initial launch.  The Nintendo Wii, the best selling of the latest generation consoles, will see a price reduction of 20% for the holiday season.  Gasoline prices have decoupled from oil with per gallon prices in the Michigan area now standing at $2.30 and falling.  Refiners are one of the worst performing industries as they cannot add margins sufficient to cover costs.  Our refinery capacity continues to shrink, down to just 84%.  It is expected that natural gas supplies will reach storage capacity by the end of November while the excess is dumped onto the market forcing down spot rates.  Because of operation flow orders mandating only 80% capacity as of Labor Day, we saw this phenomenon a month ago driving spot prices below $2 per million cubic feet.  Even with expansionary prints, regional surveys, from Dallas to Chicago, Richmond to Kansas City, have shown contractionary readings for prices received.  Much like Depression era work programs failed to create permanent employment, short sighted fiscal programs cannot create permanent product demand.
    By now, the problem should be obvious.  As pricing power declines, raw materials costs are rising (highlighted by the 65 prices paid number in the August ISM and 63 in September).  This should erode margins which were the source of the earnings beats of the 2nd quarter.  As prices fall, total revenue will continue to miss expectations.  Credit is contracting at historical rates with commercial real estate and option ARM resets looming.  Record foreclosures portend future losses and the shutdown of banks at an escalating rate.  Credit will not expand soon increasing the likelihood of further price decreases as consumers increase personal savings rates. 
    The government reflation experiment has ensured that company costs cannot reach equilibrium with weak final goods markets.  This is similar to the Great Depression except that artificial wage inflation has been replaced by artificial commodity inflation to create the disequlibrium.  To cut rising costs, the only option is to reduce salaried employees, or shut down completely due to losses in core operations.  Rising unemployment will create further weakness in final goods.  This portends continued macroeconomic performance below trend for a length of time not seen since the Depression.  Asset prices will eventually fall to the market solution, government intervention aimed at avoiding this harsh reality will only delay the inevitable and probably assure a more painful destination in the process.


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Sat, 10/03/2009 - 16:37 | Link to Comment Anonymous
Sun, 10/04/2009 - 05:05 | Link to Comment Anonymous
Sun, 10/04/2009 - 21:00 | Link to Comment Anonymous
Sun, 10/04/2009 - 23:35 | Link to Comment Anonymous
Sat, 10/03/2009 - 16:53 | Link to Comment mikeyv1970
mikeyv1970's picture

Excellent analysis.  Especially the historical comparisons as ole Ben Bernanke seems to have forgotten some of the larger historical lessons to have been learned!


Sat, 10/03/2009 - 17:16 | Link to Comment Lionhead
Lionhead's picture

Bravo; you sir have summed up the problems in a nutshell. There is nothing new under the sun in our age vs the Great Depression. When will "leaders" finally come to their senses?

Sun, 10/04/2009 - 09:46 | Link to Comment mikeyv1970
mikeyv1970's picture

Lionhead, I was referring to larger lessons such as throwing money at a problem may not be the best thing to do. Or the idea of artificially maintaining wages (ALA Unions or legislatively)...etc.  This crisis is new in so far we have a massive credit contraction, production surplus, and massive unemployment that is growing due to the death spiral of no money to buy, means less stuff can be bought, which means companies have to lay off to meet "expectations"...which fuels more of the same.  My view being expressed is somewhat simplistic of the massive problems...especially the ones concerning real estate, banks...etc.  However, that is the point I was making about historical lessons.  Many of the larger issues are very similar BUT this one is different as the populace can communicate nearly instantaneously via twitter, and other social mechanisms.  When the populace decides it has had will be very fast and violent...


Sat, 10/03/2009 - 17:51 | Link to Comment ZerOhead
ZerOhead's picture

Pretty much dead on.

However the shocker this time around could be 'stubbornly' high global oil prices. That will in effect put a floor under many commodity prices from falling... especially argicultural products. And the precarious way farm credit is structured... big price swings are possible. Just can't imagine the dollar strengthening to a point (with a known QEer at the helm) that people will get more for less post-crash.

Course I've been wrong before...

Sat, 10/03/2009 - 18:35 | Link to Comment Anonymous
Sat, 10/03/2009 - 19:12 | Link to Comment Miles Kendig
Miles Kendig's picture

It remains suspect that poor economic decision making could last for over a decade.

LTCM, its aftermath and the fed put have been around for longer than one decade.  Does Grant Dossetto support the idea that the economic decisions of this past decade are a case study in sound economic decision making?  His article would argue otherwise.

Sat, 10/03/2009 - 19:38 | Link to Comment Michael
Michael's picture

Hopefully, long term unemployment will cause a 75% off sale in the price of health care. We already know what the unemployment rate is doing for the real estate market.

Sun, 10/04/2009 - 00:21 | Link to Comment Hephasteus
Hephasteus's picture

The health industry has been swimming in deep pocket tax cash for so long they don't even know how to face limitations of growth and wealth any more.

Sat, 10/03/2009 - 20:22 | Link to Comment Great Depressio...
Great Depression Trader's picture

Great analysis. He is calling for stagflation with rising prices but falling output. Its the middle ground between pure deflation and 80's style inflation.

Sat, 10/03/2009 - 21:24 | Link to Comment glenlloyd
glenlloyd's picture

Now that's what I call honest straightforward writing!

And he's right too, in the depression there was a policy initiative to keep wages high and to raise wages as well. Super bad idea, this contributed to unemployment. I've always found it very difficult to get people to understand this fact. When I explain that if someone receives a higher wage because of union mandate, someone somewhere else must receive a lower wage and they just don't seem to get it.

Lots of bad policies in the Depression (first one), lets see what kind of bad policies they come up with for this time around...we have some showing up already!

The Great Depression was the point at which interventionism really got rolling, before that time we hear about recessions but no one really remembers them much because they were short lived. The Great Depression was the first time Govt. took an interventionist roll and look at how badly it went. When Bernanke says the Fed didn't do enough he's lying.

Rothbard's "Americas Great Depression" is a good read on this.

Sun, 10/04/2009 - 10:50 | Link to Comment torabora
torabora's picture


"someone somewhere else must get a lower one (wage)?

An economy is NOT a zero-sum gain. Each participant adds value in excess of what they take out because of the multiplier effects. The game gets bad when debt fails to be people failing have a multiplier far exceeding the average working man and scams like Madoff are more than a ripple in the economic fabric.

If this was true then a CEO who receives 400X the average floor workers wage means 399 people didn't get a job.

The level of nonsense...especially union bashing, gets worse with every passing day. Yet the corporate execs are scurrying off with mega-million$$$$ in options cash outs. Besides, union memberships have been running at all time lows for decades. Also, Minimum wages have NEVER even caught up with inflation.


It isn't hourly wage folks that are responsible for ANY of this. This is caused by the top raking off all the cream leaving the no-fat milk behind that has no protein in it either.


Sun, 10/04/2009 - 11:28 | Link to Comment Anonymous
Mon, 10/05/2009 - 02:42 | Link to Comment Anonymous
Sat, 10/03/2009 - 23:03 | Link to Comment OrganicGeorge
OrganicGeorge's picture

I've had the honor to know some men who worked in the WPA.  These make work jobs you write about were a lifeline to these, out of work homeless people or US citizens depending on your point of view when doing a cost benefit analysis.  If you dial back the "wealth effect" of your CBA you will discover that giving a citizen a job, when there are no jobs to be had, is not make work, but life affirming.

Maybe I'm the only gray beard here but I read this kinda of stuff back in the 60's how everything from the New Deal was really a raw deal for the country.

Sun, 10/04/2009 - 03:33 | Link to Comment MsCreant
MsCreant's picture

Greybeards are cool. I kinda doubt you are the only one.

If they did high speed rail, or hell, even improved the current rail we have now, that would be a new deal project that would get us something that was not simply make work, and something life affirming.

I have been to national parks made possible by WPA funds. The facilities were built to last forever. I fear the work they will come up with will be shoddy crap made with, oh I don't know, Chinese steel. I feel very conflicted about it.

Sun, 10/04/2009 - 10:12 | Link to Comment Anonymous
Sun, 10/04/2009 - 00:56 | Link to Comment Anonymous
Sun, 10/04/2009 - 05:02 | Link to Comment chindit13
chindit13's picture

Quite the battle of the academics. Almost eighty years after the fact we still argue about both the cause and the solutions implemented at the time.

The problem is that only one of the academics has control today over the monetary policy, and he has decided that since he spent his early career studying Great Depression I, he is certain he has the answer for Great Depression II. His ego is so large, or so fragile, that he cannot see that maybe he got it wrong and maybe he didn't really earn his PhD. Now he is playing it with the same style as a Nick Leeson or the guy at Amarinth...doubling down and tripling down on what may well turn out to be a losing position.

Sun, 10/04/2009 - 08:33 | Link to Comment perpetual-runner-up
perpetual-runner-up's picture

I mentioned this a few weeks ago on the boards...since no two crisis are the same...what I am seeing shape up is a collapse in asset prices as we have to much stuff and no one is buying crap they dont need anymore (less the darwins who should go away anyway) but at the same time, we are on the verge of a currency collapse which should manifest next year when tax recipts come in at a horrible level and debt maintanence req are much larger than anyone pictured....

simultaneous global deflation with a localized currencey collapse and silver to the moon (beyond all expectations)




Sun, 10/04/2009 - 08:40 | Link to Comment DrPsycho
DrPsycho's picture

thanks for this great post, I'll send it to friends as must read for its clarity and knowledge.

Sun, 10/04/2009 - 12:41 | Link to Comment perfectlyGoodWh...
perfectlyGoodWhiteBoy's picture

I just want to make sure that you used console prices to prove deflation without a single mention of Moore's law and no one has yet to point this out. How is everyone enjoying their confirmation bias this weekend?

Sun, 10/04/2009 - 18:24 | Link to Comment Anonymous
Sun, 10/04/2009 - 18:15 | Link to Comment Anonymous
Sun, 10/04/2009 - 20:11 | Link to Comment Anonymous
Sun, 10/04/2009 - 20:20 | Link to Comment boooyaaaah
boooyaaaah's picture

We handle price inflation by increasing salaries and (union) wages -- strikes, career moves -- some get more others less

When will we learn to handle deflation by salary & wage decreases -- some get more others less

The devaluation of the dollar through money inflation doesn't seem to do the trick

Even when the Fed gets serious about reigning in money inflation by raising interest rates, al la Volcker, the wages never go down --- only the number of employees

Unfortunately the safest employer to protect against both job loss and wage loss is the Government -- which is the prime culprit at the begining of the cycle

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