US Fed and Interest Rate Liftoff

Is the US Fed making accurate assessments of its interest rate policies?


Barry Eichengreen writes: For much of the year, investors have been fixated on when the Fed will achieve “liftoff” – that is, when it will raise interest rates by 25 basis points, or 0.25%, as a first step toward normalizing monetary conditions. Markets have soared and plummeted in response to small changes in Fed statements perceived as affecting the likelihood that liftoff is imminent.

But, in seeking to gauge changes in US monetary conditions, investors have been looking in the wrong place. Since mid-August, when Chinese policymakers startled the markets by devaluing the renminbi by 2%, China’s official intervention in foreign-exchange markets has continued, in order to prevent the currency from falling further. The Chinese authorities have been selling foreign securities, mainly United States Treasury bonds, and buying up renminbi.

This is the opposite of what China did when the renminbi was strong. Back then, China bought US Treasury bonds to keep the currency from rising and eroding the competitiveness of Chinese exporters. As a result, it accumulated an astounding $4 trillion of foreign reserves.

And what was true of China was also true of other emerging-market countries receiving capital inflows. These countries’ foreign reserves, mainly held in US securities, topped $8 trillion at their peak last year.

The effects of these purchases attracted considerable attention.  Although no one outside official Chinese circles knows the exact magnitude of China’s foreign-exchange intervention, informed guesses suggest that it has been running at roughly $100 billion a month since mid-August. Observers believe that roughly 60% of China’s liquid reserves are in US Treasury bills. Given that reserve managers prefer to avoid unbalancing their carefully composed portfolios, they probably have been selling Treasuries at a rate of roughly $60 billion a month.

The effects are analogous – but opposite – to those of quantitative easing. Menzie Chinn of the University of Wisconsin has examined the impact of foreign purchases and sales of US government securities on ten-year Treasury yields. His estimates imply that foreign sales at a rate of $60 billion per month raise yields by ten basis points. Given that China has been at it for 2.5 months, this implies that the equivalent of a 25-basis-point increase in interest rates has already been injected into the market.

Some would object that the renminbi is weak because China is experiencing capital outflows by private investors, and that some of this private money also flows into US financial markets. This is technically correct, but it is already factored into the changes in interest rates described above.

Another objection is that QE operates not just through the so-called portfolio channel – by changing the mix of securities in the market – but also through the expectations channel. It signals that the authorities are seriously committed to making the future different from the past. But if Chinese intervention is just a one-off event, and there are no expectations of it continuing, then this second channel shouldn’t be operative, and the impact will be smaller than that of QE.

The problem is that no one knows how long capital outflows from China will persist or how long the Chinese authorities will continue to intervene.

Interest rates?

What Pressures Are Suppressing Inflation?

Stephen S. Roach writes:  Fixated on inflation targeting in a world without inflation, central banks have lost their way. With benchmark interest rates stuck at the dreaded zero bound, monetary policy has been transformed from an agent of price stability into an engine of financial instability. A new approach is desperately needed.

The US Federal Reserve exemplifies this policy dilemma. After the Federal Open Market Committee decided in September to defer yet again the start of its long-awaited normalization of monetary policy, its inflation doves are openly campaigning for another delay.

For the inflation-targeting purists, the argument seems impeccable. The headline consumer-price index (CPI) is near zero, and “core” or underlying inflation – the Fed’s favorite indicator – remains significantly below the seemingly sacrosanct 2% target. With a long-anemic recovery looking shaky again, the doves contend that there is no reason to rush ahead with interest-rate hikes.

The Fed’s presumption that the US will soon approach full employment has caused the so-called dual mandate to collapse into one target: getting inflation back to 2%.

Here, the Fed is making a fatal mistake, as it relies heavily on a timeworn inflation-forecasting methodology that filters out the “special factors” driving the often volatile prices of goods like food and energy.

This approach failed spectacularly when it was adopted in the 1970s, causing the Fed to underestimate virulent inflation. And it is failing today, leading the Fed consistently to overestimate underlying inflation. Indeed, with oil prices having plunged by 50% over the past year, the Fed stubbornly maintains that faster price growth – and the precious inflation rate of 2% – is just around the corner.

Missing from this logic is an appreciation of the new and powerful global forces that are bearing down on inflation.  Rather than recognize a seemingly chronic shortfall of global aggregate demand amid a supply glut and a deflationary profusion of technological innovations and new supply chains – the Fed  would rather attribute low inflation to successful inflation targeting, and the Great Moderation that it presumably spawned.

Unable to disentangle the global and domestic pressures suppressing inflation, a price-targeting Fed has erred consistently on the side of easy money.

This is apparent in the fact that, over the last 15 years, the real federal funds rate – the Fed’s benchmark policy rate, adjusted for inflation – has been in negative territory more than 60% of the time, averaging -0.6% since May 2001. From 1990 to 2000, by contrast, the real federal funds rate averaged 2.2%. In short, over the last decade and a half, the Fed has gone well beyond a powerful disinflation in setting its policy interest rate.

Over the same 15-year period, financial markets have become unhinged, with a profusion of asset and credit bubbles leading to a series of crises that almost pushed the world economy into the abyss in 2008-2009. But rather than recognize, let alone respond to, pre-crisis excesses, the Fed has remained agnostic about them, pointing out that bubble-spotting is, at best, an imperfect science.

That is hardly a convincing reason for central banks to remain fixated on inflation targeting.

Today’s enemy is financial instability. On that basis alone, the case for monetary-policy normalization has never been more compelling.

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Financial Regulation for Crowdfunding?

Robert Shiller writes:  If one were seeking a perfect example of why it’s so hard to make financial markets work well, one would not have to look further than the difficulties and controversies surrounding crowdfunding in the United States. After deliberating for more than three years, the US Securities and Exchange Commission (SEC) last month issued a final rule that will allow true crowdfunding; and yet the new regulatory framework still falls far short of what’s needed to boost crowdfunding worldwide.

True crowdfunding, or equity crowdfunding, refers to the activities of online platforms that sell shares of startup companies directly to large numbers of small investors, bypassing traditional venture capital or investment banking.

Regulators outside the US have often been more accommodating, and some crowdfunding platforms are already operating. For example, Symbid in the Netherlands and Crowdcube in the United Kingdom were both founded in 2011. But crowdfunding is still not a major factor in world markets. And that will not change without adequate – and innovative – financial regulation.

There is a conceptual barrier to understanding the problems that officials might face in regulating crowdfunding, owing to the failure of prevailing economic models to account for the manipulative and devious aspects of human behavior. Economists typically describe people’s rational, honest side, but ignore their duplicity. As a result, they underestimate the downside risks of crowdsourcing.

The risks consist not so much in outright fraud – big lies that would be jailable offenses – as in more subtle forms of deception. It may well be open deception, with promoters steering gullible amateurs around a business plan’s fatal flaw, or disclosing it only grudgingly or in the fine print.

It is not that people are completely dishonest. On the contrary, they typically pride themselves on integrity. It’s just that their integrity suffers little lapses here and there – and not always so little in aggregate.

The SEC’s new rules for crowdfunding are complex, because they address a complicated problem. The concept underlying crowdfunding is the dispersal of information across millions of people. Most people, even the cleverest, cannot grasp the next breakthrough business opportunity. Those who can are dispersed.

The problem is that the promise of genuine “unique information” comes with the reality of vulnerability to deception. That’s why channeling dispersed knowledge into new businesses requires a regulatory framework that favors the genuinely enlightened and honest. Unfortunately, the SEC’s new crowdsourcing rules don’t go as far as they should.

The SEC with rulemaking for crowdfunding platforms specified that no startup can use them to raise more than $1 million a year. This is practically worthless in terms of limiting the scope for deception. In fact, including this provision was a serious mistake, and needs to be corrected with new legislation. A million dollars is not enough, and the cap will tend to limit crowdfunding to small ideas.

Some of the SEC rules do work against deception. Notably, crowdfunding platforms must provide communication channels “through which investors can communicate with one another and with representatives of the issuer about offerings made available.”

That is a good rule, fundamental to the entire idea of crowdfunding. But the SEC could do more than just avow its belief in “uncensored and transparent crowd discussions.” It should require that the intermediary sponsoring a platform install a surveillance system to guard against interference and shills offering phony comments.

The SEC and other regulators could go even further. They could nudge intermediaries to create a platform that summarizes commenters’ record and reputation. Indeed, why not pay commenters who accumulate “likes” or whose comments on issuers turn out to be valuable in light of evidence of those enterprises’ subsequent success?

For the financial system as a whole, success ultimately depends on trust and confidence, both of which, like suspicion and fear, are highly contagious. That’s why, if crowdfunding is to reach its global potential, crowdphishing must be prevented from the outset. Regulators need to get the rules right (and it would help if they hurried up about it).

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ISIS: Horrifying and Baffling

ISIS  An important review of two books by an ‘ananymous’ contributor who has been involved with ISIS.

New York Review of Books: The rise of Ahmad Fadhil—or as he was later known in the jihad, Abu Musab al-Zarqawi—and ISIS, the movement of which he was the founder, remains almost inexplicable. The year 2003, in which he began his operations in Iraq, seemed to many part of a mundane and unheroic age of Internet start-ups and a slowly expanding system of global trade. Despite the US-led invasion of Iraq that year, the borders of Syria and Iraq were stable. Secular Arab nationalism appeared to have triumphed over the older forces of tribe and religion. Different religious communities—Yezidis, Shabaks, Christians, Kaka’is, Shias, and Sunnis—continued to live alongside one another, as they had for a millennium or more. Iraqis and Syrians had better incomes, education, health systems, and infrastructure, and an apparently more positive future, than most citizens of the developing world. Who then could have imagined that a movement founded by a man from a video store in provincial Jordan would tear off a third of the territory of Syria and Iraq, shatter all these historical institutions, and—defeating the combined militaries of a dozen of the wealthiest countries on earth—create a mini empire?  ISIS

Isis

Cutting Off ISIS Funds?

Cutting off the financing for ISIS is critical.  Mark Gilbert writes: Dr. Christina Schori Liang, a senior fellow at the Geneva Centre for Security Policy, notes in a paper for the IEP that IS (also known as ISIL or ISIS) is “the richest terrorist organization in history, with an estimated wealth of $2 billion.” IS earns about $1.5 million a day from selling oil, producing as many as 40,000 barrels per day and selling for as little as $20 a barrel. The oil is smuggled through Iraq and Kurdistan, border guards are bribed, while donkeys and trucks traverse deserts and mountain passes to avoid detection. IS has its own underground pipelines and refineries; while coalition forces had destroyed 16 mobile refineries by the end of last year, they can be rebuilt for as little as $230,000.

Its income is boosted by trafficking people and auctioning slaves, kidnapping for ransom (raising $45 million last year), extortion, taxes on income, business revenues and consumer goods in the lands it controls, as well as looting and selling antiquities. The Financial Action Task Force reckons IS stole about $500 million late last year just by raiding state-owned banks in the territories it controls. As Liang argues, “the West has so far failed to impede ISIL’s financial gains which are marked by a fluidity and wealth never seen before.”

Strangling the flow of cash that allows IS to arm its jihadists and fund the local infrastructure in the regions it occupies could smother the organization in ways that may prove even more effective than bombing its bases. As the journal Studies in Conflict and Terrorism noted as long ago as 2004 in a report on al-Qaeda, though, terrorist groups typically rely on informal money transfer networks and under-regulated Islamic finance channels which are harder to close down.

Thomas Sanderson, co-director of the Transnational Threats Project at the Center for Strategic and International Studies, said:

Our options and appetite for more investment of blood and treasure in the fight against terrorism may be limited, but without addressing all dimensions of the financing threat, our progress over the years may be lost. If groups like ISIS can fill their coffers, run economies and consolidate their hold on power, we may be facing a new, more dangerous brand of global terrorism that will threaten the United States and its allies for years to come.

Driving a wedge between IS and the dollars it needs demands greater cooperation between the various countries that profess to oppose the group, more punishing sanctions against any nation found to have turned a blind eye to stolen oil crossing its borders, a coordinated refusal to pay ransoms, and severe retributions against anyone found to participate in the trading of looted treasure. Waging financial war on IS to undermine its ability to operate as a nation state should clearly be more of a priority than it has been so far.

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State Banks the Answer?


Banking in the Spotlight in New Mexico
There was a recent Symposium in Albuquerque, New Mexico on November 7, 2015 to Promote Public Banking.

First of all, what is a Public Bank? I am not sure there is a good definition but presumably it is not a private bank or even a non-profit bank but in some sense is associated with government and I think we are talking here about something other than the Central Bank of a nation. Thus perhaps the best way to look at a Public Bank is that it is a bank owned by a political jurisdiction and intended to advance the interests of the political jurisdiction which presumably means the residents of that political jurisdiction. But there may be differences of opinion as to the range of services that need to be provided in order for this entity to be considered a bank. It is important to understand that certain banking functions are performed by governmental entities which do not have a bank charter. This could be important.

Here are statements by a state legislator. First, after eleven years in the Legislature, I was astonished to see, in a “weekly report of activity” from the LFC. The LFC is the Legislative Finance Committee which employs fiscal analysts who examine budgets and review the management and operations of state agencies, higher education institutions and public schools and participate in the state’s revenue estimating process. Buried in a paragraph updating us on department activity, the sentence that “the Department of Transportation had awarded a $6 million loan for a wastewater system with Estancia. The funds will be processed through the State Infrastructure Bank.”

I was astonished for two reasons: first, what is the Transportation Department doing lending money for waste water infrastructure? Second, what in the world is the State Infrastructure Bank? I confess in my time as a legislator, this entity had never been mentioned to me…at least I couldn’t recollect ever hearing about it. So I did a bit of internet research, and while the NM State Infrastructure Bank eluded my search, the general concept of state infrastructure banks produced a wealth of information. I now realize that we are among the states which have for years been utilizing this simple method of financing some of our projects for highways and water. I couldn’t determine for sure, but it appears in NM we have housed the “bank” in the department of transportation (bridges and roads would be one of the uses, so this makes sense).

State Infrastructure banks are “a well-regulated method for financing projects selected by the state. A low-interest, below market rate, loan is issued to finance the project. Repayments, including interest, return to the bank and are then available for lending out for additional projects.” What struck me about the existence of this mechanism is that it is precisely the way a public bank would function. We, in effect, already have one–just haven’t named it as such and haven’t made full use of its simple, elegant mechanism…so why not?

The power of the banking lobby. Their program fits with their overall strategy of convincing Americans that banking is far too complex an issue to be attempted by anyone but members of the banking brotherhood. Leave your financial dealings to us…you’ll just screw them up. This ignores the reality that is described in numerous books I’ve been reading on the topic following last fall’s symposium on public banking in Santa Fe. Ellen Brown’s “Web of Debt” is the cornerstone for the discussion. Michael Lewis, among others, has explored just how it was possible for the banking industry to get things so terribly wrong during the housing bubble and the resulting crash of 2008 in “The Big Short” and “Boomerang”. What becomes clear from these works is that bankers are NOT the smartest guys in the room; that in fact the incredible profit they are able to produce out of public financial dealings is in no way a necessity. Instead, there is plenty of room for a state (like North Dakota) or a City (as Santa Fe is attempting) to omit the banking industry from many (if not all) of its finances.

Like you, I think it would make sense to move slowly and carefully in incremental steps, building on those activities in state government that are already very much like public banking, like my new discovery of the State Infrastructure Bank (SIB) or the State Investment Council (SIC). What I would see happening first would be to expand the SIB’s role, increasing the amount and number of self-financed projects, projects in which we pay ourselves a modest return rather than see public money go into bankers’ vaults for no good reason. In time this could include issuing our own bonds. It could involve an initial deposit from the state operating reserves of a percent or two (each percent represents $62 million and we are currently carrying over 10% reserves, far more than actuaries say is necessary). That deposit, used to finance state or municipal projects (a la the SIB) would earn a better return than we now get from the reserves, which are not invested but retained in a private bank “until we need to withdraw it”.

Governance of a public bank is the big concern. It needs to be as independent as possible from the executive and the legislature. Decisions about its operation should be divorced from political considerations. We can do it…if North Dakota can. In time it could develop into a full-blown State Bank, one that buys a piece of commercial loans entered into by community banks, reducing the overall interest rate and fostering economic growth for local business. Banking in the Spotlight in New Mexico

State Banks

Entrepreneur Alert: Doing Business in Mexico

The Mexican economy is growing, slowly but surely.

A Dallas Federal Reserve Reports indicates: Mexico’s economy continued growing in the third quarter. The government’s monthly gross domestic product (GDP) measure increased in July and August. In addition, recent data on exports, employment, retail sales and industrial production are all up. Inflation appears firmly under control despite the peso’s depreciation against the dollar. The consensus 2015 GDP growth forecast held steady in September at 2.3 percent.

Mexico’s Global Economic Activity Index, the monthly proxy for GDP, grew 0.4 percent in August after increasing 0.1 percent in July. The three-month moving average shows steady growth since the end of 2013 (Chart 1). Service-related activities (including trade and transportation) increased 0.5 percent in August, while goods-producing industries (including manufacturing, construction and utilities) grew 0.2 percent. Agricultural output expanded 6.6 percent. Official estimates of third-quarter GDP will be released Nov. 21. Mexico GDP grew 1.9 percent (annualized) in the first half of the year.

Exports grew 1 percent in September after dropping 6.4 percent in August. The three-month moving average of exports stabilized after declining for several months (Chart 2). Oil exports improved in late spring due to a slight recovery in oil prices; however, the trend was quickly reversed. Total exports were down 3 percent and oil exports were off 45 percent in the first nine months of 2015 compared with the same period a year ago. Manufacturing exports were up 2.3 percent year over year in September.

Mexico industrial production (IP) growth is recovering after pausing earlier in the year. Total IP – which includes manufacturing, construction, oil and gas extraction, and utilities – inched up 0.2 percent in August. Three-month moving averages show a turnaround in total IP (Chart 3). In addition, manufacturing IP continues on an upward trend. Meanwhile, U.S. IP fell 0.2 percent in September.

Retail sales rose 0.5 percent in July after growing 1.2 percent in June. The three-month moving average shows strong growth over the first seven months of the year (Chart 4). Year over year, retail sales are up 5 percent. However, consumer confidence worsened in August and September.

Formal-sector employment – jobs with government benefits and pensions – rose at an annualized rate of 3.7 percent in September (Chart 5). Year to date, employment is up an annualized 4.2 percent, which is about the same as the 2014 annual job growth rate.

The peso held steady against the dollar in October, when the exchange rate averaged 16.6 pesos per dollar versus 16.9 in September (Chart 6). The peso has lost 19 percent of its value against the dollar over the past 12 months. The Mexican currency has been unstable, in part due to the expectation of an increase in U.S. interest rates and the impact of falling oil prices on Mexico’s government finances. Oil revenues account for about a third of the federal government budget.

Inflation in September fell to 2.5 percent year over year (Chart 7), logging its fifth straight month at a rate below the central bank’s long-term inflation target of 3 percent. Consumer prices excluding food and energy rose 2.4 percent. Banco de México has kept the policy rate at 3 percent since June 2014 based on the belief that inflation expectations are well-anchored. However, policymakers have noted their intent to raise interest rates as soon as the Federal Reserve tightens U.S. monetary policy. Their objective is to prevent further deterioration of the peso, which could push up inflation.

Mexico Grows Slwly

Are Women Leaving the Workforce in the US?

Maria E. Canon, Helen Fessenden, and Marianna Kudlyak of the Richmond Federal Reserve write:  The female labor force participation (LFP) rate has dropped steadily since 2000, especially among single women. At the same time, the percentage of single women has grown as a share of the female population, a trend that has increased the impact of the single women’s LFP rate on the aggregate women’s LFP rate. An analysis of data from the Current Population Survey shows that a growing percentage of single women who are not in the labor force are going to school. Meanwhile, an increasing share of married women list retirement as the reason for no longer participating in the labor force.

A growing debate among economists concerns the causes and consequences of the drop in labor force participation (LFP) rate in the United States. In contrast to the unemployment rate, which shows the percentage of people in the labor force who are actively looking for work and cannot find it, the LFP rate measures what percentage of people age 16 and above do not participate in the labor force – for example, those who head into retirement or accept disability benefits, those who are too discouraged to search for work, or those who are not a part of the labor force for a variety of other reasons.

In October 2015, the unemployment rate was 5 percent – about where it was before the recession of 2007 – 09. But the LFP rate in the United States has continued to decline to around 62 percent, about 4 percentage points lower than it was before the recession. Citing this drop, some economists argue that there remains significant capacity for the labor market to tighten before wage growth picks up again. Other economists counter that much of the decline has to do with demographic forces and that many of these former workers are unlikely to return to the labor force. The rising number of retired workers in the Baby Boom generation, for example, is often cited as a driver for falling labor force participation.  Women Leaving the Workforce?

Costs of Higher Education in US

Evaluating higher education costs. which have become exorbitant in the US.

Elliott Morss writes:  Tuition and other costs have increased, but not primarily because of higher faculty salaries or more administrators. While these have gone up a small amount, fringe benefits, most notably health benefits, have increased more. And higher faculty costs have been offset by employing more part time faculty and increasing the use of teaching assistants. Student costs have increased substantially because of falling state and local government subsidies. In addition, higher education costs have risen significantly because of the hiring of a large number “non-teaching professionals.”

A major factor impacting school costs is the reduction in governments support and in particular, the reduction in state and local government assistance for public institutions. Table 1. – Costs of Attending Colleges/Universities (in 2011 $s)
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Source: American Institutes for Research, Delta Cost Project, “Trends in College Spending: 2001–2011”

b. Growth in College/University Costs

Table 2 shows what happened to major school expenses per full-time equivalent (FTE) student in 2011 dollars. Several patterns are apparent. The fiscal squeeze resulting from the reduction in government support show up in the numbers for public and community colleges. And with the exception of these colleges, “student service” costs have increased dramatically.

Table 2. – Total Expenditures per FTE Student, 2001- 2011 (in 2011 $s)
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Source: American Institutes for Research, Delta Cost Project, “Trends in College Spending: 2001–2011”

c. Staffing

Table 3 provides summary data on employees. The reduction in both Public University and Community College staffing is a manifestation of the reduction in government assistance. It is also notable how much higher the staffing levels of private institutions are than public.

Table 3. – FTE Employees per 1,000 FTE Students
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Source: American Institutes for Research, Delta Cost Project, Donna Desrochers and Rita Kirshstein, “Issue Brief”, February 2014.

The large increase in “Other faculty” suggests a major substitution of full-time faculty by this group. It includes part-time as well as teaching assistants.

Table 4. – Growth in Staffing by Category, 1990 – 2012
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Source: American Institutes for Research, Delta Cost Project, Donna Desrochers and Rita Kirshstein, op. cit.

d. Salaries

Table 5 provides data on what has happened to college/university wages and salaries. There have been substantial jumps in salaried research, but the funds for many of these payments come from funded research sources. The increase in payments for student services and maintenance are also notable.

Table 5. – Change in Wage/Salary Expenditures per Total FTE StaffFY 2002-FY 2010 (in 2011 $)
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The evidence presented above indicate that for the 2001 – 2012 period, the costs of higher education grew, but not by much and not by the reasons usually cited – increased administrative staff and/or higher faculty salaries. The increases were felt because students are having to pay a significantly larger share of the tuition bill because government support has been declining. College/university costs are rising as the result of the hiring more non-faculty professionals. Faculty cost increases have been mitigated by hiring more part-time faculty and teaching assistants.

Higher Education Costs

Relationship Between Capital and Labor?

Since capital and labor tend to be complementary in the production of goods and services, the same factors that have slowed down capital accumulation since the early 2000s may have weakened businesses’ labor demand and may have decreased the labor share.

The Cleveland Federal Reserve reports:  The labor share of output – the ratio of labor compensation to output – has trended downward for decades, but it has declined at a faster rate since the early 2000s. The labor share in the nonfarm business sector hovered around 64 percent in the 1950s, declined to 61.4 percent in 2002, and dropped more rapidly thereafter. It is currently close to 57 percent.

Figure 1. Labor Share

A declining labor share means that wages grow less than productivity. Since the early 2000s, wages have risen much more slowly than productivity. Since 2002, real compensation per hour in the nonfarm business sector has grown at an average annualized rate of 0.74 percent, while productivity has grown at an average annualized rate of 1.79 percent.

Figure 2. Real Wage and Productivity

The causes of the long-term decline of the labor share are debated but likely include changes in the technology used to produce goods and services, increased globalization and trade openness, and developments in labor market institutions and policies.

According to Karabarbounis and Neiman (2013), the decrease in the relative price of investment goods, partly due to progress in information and communication technologies, has induced firms to replace labor with capital, thereby reducing the labor share. Elsby, Hobijn and Sahin (2013) find that part of the long-term decline in the labor share may be explained by the offshoring of labor-intensive production processes, which has led to a higher capital-labor ratio in U.S. production, and a lower labor share.

Lawrence (2015a and 2015b), however, points out that the labor share decline may be connected with a lower, rather than a higher, capital-labor ratio. Most estimates suggest that capital and labor tend to be complementary in the production of goods and services, which means that production requires the use of both capital and labor together, and it is difficult to substitute capital for labor or labor for capital. When capital and labor are complementary, a decrease in the capital-labor ratio is associated with a contraction in businesses’ demand for labor, which leads to a plunge in the wage rate and to a decline in the labor share. Lawrence then connects the labor share decline with a lower effective capital-labor ratio induced by labor-augmenting technological progress – a type of technological progress that raises the productivity of labor relative to capital and encourages businesses to substitute labor for capital.

Lawrence’s argument suggests that the steeper decline of the labor share since the early 2000s may be connected with the slowdown of capital growth in those years. Capital services, which grew at an average rate of 4.3 percent annually before 2002, have since grown only 2.2 percent annually on average. Capital services per hour, an indicator of the capital-labor ratio, grew at an average rate of 2.89 percent annually before 2002, but have since grown 2.05 percent annually on average.

Figure 3. Capital Services

Depending on the strength of the complementarity between capital and labor, a given decrease in the growth rate of the capital-labor ratio can be associated with a sizeable decline in the labor share. For instance, if we use an empirically plausible value for the strength of complementarity (an elasticity of substitution equal to 0.5), then a decrease in the capital-labor ratio of, say, 10 percent translates into a decrease in the labor share of approximately 2.5 percentage points, all else constant.

This suggests that the same factors that have slowed down capital accumulation since the early 2000s may have also weakened businesses’ labor demand, leading to a faster decline in the labor share and a wider gap between wage growth and productivity growth. One such factor could be the deceleration of multifactor productivity. Since 2005, multifactor productivity has grown 0.58 percent annually on average, more than a percentage point slower than in the previous 1996-2004 period, which was characterized by fast productivity growth.

Figure 4. Multifactor Productivity