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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Anonymous's picture

What is the logic that says government intervention will "assure a more painful destination in the process"?

Market force is just that, and disregards all attempts to artificially control it. Mass mind, which is the market, shouldn't be all that duly influenced by meager government attempts to oppose it.

Anonymous's picture

The answer is in the article.. if you still don't understand, I suggest reading up on some introductory managerial accounting..

Anonymous's picture

I would like to suggest a review of Adam Smith's "Wealth of Nations". Adam does consider it a zero sum game where, on a macro level, the taking of one deprives another.

To Adam, all economic cycles revolve around nothing more than the speed of money -the time it takes for a capital investment to be repaid. The longer it takes, the less employment can be supported and all the rest that flows from that.

In his time the focus was on America and the effect on trade it had on the UK and Europe. We can compare that in some sense now to the US and China. So undeveloped and so thriving, the capital thrown at it is lost in ever expanding development.

As Adam points out, capital, returned in whole in a year , employs 4 times more than it could if 4 years were required but only 1/4 of that returned "in whole" in just 3 months.

Capital, it should be noted, consists of far more than just pecuniary rewards and "in whole" means just that, it cannot be supplemented from an external source which then acts as a the whole.

Britain benefited from America & the West Indies but not nearly as much as it could have, and most of that benefit , or what was perceived as a benefit, was derived from the negative effects Britain's handling of trade with America had on Europe.

If you read "Wealth of Nations" and replace England with America and China with America, do you not see history repeating itself?

Anonymous's picture

The creation of asset bubbles causes misallocation of resources (think housing for most of this decade). The Fed turned on the spigot of easy money to avoid falling prices. We got falling prices, five years later after many new houses were built. This increased supply, caused only by distorted economic incentives related to the housing bubble, caused the price of homes to fall by a greater value than would have happened if the Fed did not use such accommodative monetary policy. Therefore, the final destination for the housing market will end up more painful than what we would have originally had.

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!


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?

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...


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...

Anonymous's picture

'2012' movie has it wrong. The looming disaster will be a financial collapse. This post makes a good case for S&P <666.

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.

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.

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.

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.

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.

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.


Anonymous's picture

There is little doubt that government and its bedmates propping up the system so that taxpayers and the ignorant investors are left with the bag. The problem with artificial union and CEO pay is the same. It seems awfully difficult to reign in CEO pay as a shareholder. Although much of the problem is that each shareholder is hurt too little to make it worth his while to fight, I bet if you go digging through the legal jungle there is regulation that encourages this entrenching. Inflated CEO and Union pay are both taken from the shareholder. Bring back the corporate raiders!

Anonymous's picture

I've seen the argument being made here before, and found it somewhat wanting then. I believe your counterpoint is and should be well taken.

Most unionism in the 1930s did not start out giving moderate waged people high wage jobs. It basically made it possible for people who, in almost every case, were making below living wages to make wages that were sufficient for them to get a basic foothold again. This in turn made it possible for them to save (which was only heightened with the deferred pay to soldiers during World War II), and most of the businesses that were started during the 1950s could be traced to this savings pool, not to the investments by the ultra-wealthy.

I'd contend that one of the bigger factors during the Depression was the continued payment of dividends by companies, which sucked out a significant amount of potential working capital that could have been used to hire more employees (or could have been used to pay them more, this increasing the potential market). The wealthy then (just as the wealthy now), tend to keep the wealth in a very limited community - trickle down economics did not work then any more than it does now.

There has been two forms of stimulus proposed in the last year. The first has been an attempt to make the banks "whole" and for the most part has been wasted by the banks themselves as high bonuses, excessive speculation and money used for hostile M&As. The second has been spent on infrastructure investment, is just now moving into the economy, and is slowly beginning to manifest itself in at least an overall decrease in the second derivate of unemployment loss, if not yet the first.

One other point to consider - unlike with the New Deal, most of the jobs being promoted are not, in general bureaucratic ones - instead, they are jobs that are being put out on bid contracts to private companies, in order to spur growth in the private sector.

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.

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.

Anonymous's picture

OrganicGeorge, I think you are right on target. What many fail to realize is that in an economy with massive unemployment, we are essentially squandering lost opportunity. The people that worked for the WPA would like have not worked at all. The value of the product they created was tremendous and long lasting (university buildings, roads, bridges, dams, etc). I think the key to the success of the WPA was putting people to work building valuable product.

The problem I see with our stimulus of today is that we are focused on building projects that were valuable yesterday and will not create the kind value that benefit society in future years. Instead of building roads and bridges where we already have them, we should be building the roads and bridges of the future: extremely efficient electric grids and public very high speed internet to every home and business in the country. These two could put a lot of people to work and result in a long term reduction in cost across a multitude of industries.

Anonymous's picture

There are still many WPA bridges and buildings in use where I live. All much prettier and much more practical than the cr*p we built in the last 20 go-go years. Take the money back from the banksters and put it into a new WPA.

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.

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)




DrPsycho's picture

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

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?

Anonymous's picture

Moore's Law would explain why the IPhone is dropping in price during sales growth. Cutting prices when sales are dropping is an indication of lack of pricing power, hence final goods market deflation.

Anonymous's picture

About your unprecedented steps; they did everything NOT to do ANYthing. Plus; not every asset is/was pumped up by goberment. Now,

go try & make your homework. Again.

Anonymous's picture

We Can Handle inflation by inceasing wages
Salaries & (union) wages go up
Some get more than others

So why can't we learn how to handle deflation
by decreasing wages -- Some more than others

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