Resource Allocation Distortions in the Great Recession: Empirical Evidence

by Mario Rizzo

The recent annual report of the Bank for International Settlements (BIS) has focused attention on the sectoral imbalances in the previous boom that resulted in the Great Recession. This is a refreshing change from the excessively aggregative analyses of the Keynesian-stimulus crowd.  

It is well known that John Maynard Keynes himself was not particularly interested in the basic causes of depressions. His view was that a policy of general stabilization of investment spending could prevent them. In the absence of such a long-run policy (that is, permanently low interest rates and social management of investment), a general stimulus could jump start the depressed economy.

In my previous blog posts I emphasized the microeconomic or relative price aspects of business cycles. The BIS report is useful because it directs us to some empirical evidence that supports this concern. The data also shows that the allocation distortions that comprised the recent boom are more complex than most theoretical frameworks would suggest.

A dramatic increase in credit was made possible by the confluence of several factors: the low interest rate policy of the Fed, the financial innovation that increased the effective credit of the shadow banking sector and housing policies that distorted the relative price of home ownership.

Two sectors that clearly expanded in a non-sustainable way were the financial sector and the construction (housing) sector. What is perhaps not fully understood is that amid the expansion of “aggregate economic activity” the expanding sectors pulled resources away from other sectors, even in absolute terms.

The expansion of the construction sector pulled capital in financial and physical forms from the rest of the economy. The rapid expansion of the financial sector made financing available for many sectors but, because of the rapidity of its expansion, pulled highly-skilled workers away from knowledge-intensive industries.

“The cross-country evidence indicates that, indeed, the boom in construction and financial intermediation coincided with lower productivity growth in the rest of the economy.” (23)

“Rapid increases in credit and asset prices may inflate the profitability of the financial sector to the point that it diverts resources away from other sectors. A conjecture is that the sectors most likely to be disadvantaged are those that, like financial services, depend heavily on highly skilled labour. …We then estimate whether a fast-growing financial sector – and, separately, whether a fast-growing construction sector – would have a disproportionate effect on the growth of the higher-intensity, versus the lower intensity, manufacturing industries. The negative coefficients reported in Table II.A for value added growth and employment growth in the financial intermediation and construction sectors (first and third lines and fifth and seventh lines of data) suggest that they would have such an effect and that it would be stronger in the case of finance than in the case of construction.” (25, Table)

While these results are by no means definitive they do represent the kind of disaggregated cyclical analysis that is missing from the standard Keynesian studies. The policy implications are also important. Part of the process of recovery from a “great recession” is the reallocation of resources away from those areas which expanded because of distortions in price signals.

“Other sectors will have to take over from construction and financial intermediation as the engines of growth. Which sectors will do so is difficult to say, since past performance is not necessarily a good guide to the future. Nonetheless, the likely (relative or absolute) stagnation of construction and finance could liberate resources for use in other sectors – so long as authorities do not prevent such a reallocation through subsidies or other measures that preserve the status quo.” (24)

There is much more in the 81st Annual Report of the BIS that is worthy of study and analysis. I recommend it for summer beach reading.

4 thoughts on “Resource Allocation Distortions in the Great Recession: Empirical Evidence

  1. One of the mysteries that Steven Kates tries to clear up in his important study, _Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost Its Way_, is how the economics profession so quickly, after the publication of Keynes’ _General Theory_, “forgot” what it had known about Say’s Law — that economy-wide supply creates its own demand, as long as significant supply sectors don’t badly err in what downstream buyers will demand. In its classical 19th century formulation, the proponents of Say’s Law regarded monetary and credit disturbances as having the potential to magnify existing disproportionalities between supply and demand but not themselves create the disproportionalities.

    But shouldn’t the “Little Depression” of 2008 et seq. be regarded as an economic disorder in which monetary and credit disturbances didn’t merely aggravate existing disproportionalities but actually provoke them in the first place? And doesn’t this provide a clue as to why Keynes’ revival of Malthus’s discredited idea of aggregate demand and rejection of Say’s Law excited so little comment in the aftermath of the publication of the _General Theory_? Namely, that there was a vulnerability in the classical understanding of trade cycles: monetary and credit disturbances help create disproportionalities as well as merely aggravate them. This would have been easier to recognize in the 20th century as opposed to the 19th. As the power of central banks increased in the 20th century, so did the importance of monetary and credit disturbances.

    Finally, I’m not sure to what extent this new reality has been assimilated in current Austrian theoretical discussions of trade cycles.

  2. BIS has been producing excellent research for a long time. The latest annual report would appear to continue in that tradition.

    Bad monetary and regulatory policy has driven the outsized growth of financial services. As BIS notes, that has come at the expense of other sectors.

    A recent post at Coordination Problem concerned economic stagnation. The current slow growth (especially slow job growth) is surely partly the result of the malinvestment during the housing boom.

    I’ve noted an increasing concern even on the political right with growing income inequality. Compensation practices in financial services are driving the outsized gains at the very top of the income distribution (top 0.1%).

    All this would be dandy if it were because financial services was adding value in a free market. But it just isn’t so. As the folks at BIS know.

  3. Thank you for the analysis. I started reading the report two weekends ago and saw that it would take full-concentration with all the data. So, it is on my list.

    I came across this passage from the report and interpretation from Perry Mehrling:

    BIS:“For the advanced countries that were most affected by the crisis, undue delay in the normalisation of the monetary policy stance entails the risk of creating serious financial market distortions, the postponement of deleveraging and the misallocation of resources. Moreover, the unusually accommodative monetary conditions in advanced economies have probably been an important factor behind the recent large capital flows to emerging market economies.” (p. 62)

    PM:Translated into English, what this quote means is that the advanced countries are using monetary policy to avoid necessary adjustment, and in doing so they are not only delaying their own recovery but also threatening the rest of the world with a repeat bubble. The mechanism of that repeat bubble, so the authors suggest, is the carry trade—borrowing in the low rate advanced countries and lending in the high rate emerging market economies. The mechanism of the potential collapse is the growing risk exposure involved in that trade: mainly interest rate risk, foreign exchange risk, and counterparty risk.

    I believe Dr. O’Driscoll has been very much on top of the capital flows e.g., “carry trade” to emerging markets.

    Well, bernanke wanted more risk-taking…is that the Fed’s role?

  4. Re “could liberate resources for use in other sectors – so long as authorities do not prevent such a reallocation through subsidies or other measures that preserve the status quo.”

    Low mortgage rates, not to mention other interventions to bolster real estate, are already hampering such reallocation.

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