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.