"That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality."

I love these kind of Yves Smith posts:

"Disingenuous New York Times Story on Global Imbalances

Since I am endeavoring to spend some time with my family, forgive me for dispatching this New York Times story, "Dollar Shift: Chinese Pockets Filled as Americans’ Emptied."

The article buys, hook, line and sinker, then- Fed-governor Ben Bernanke's depiction of so-called global imbalances (the US borrowing from abroad to fund overconsumption; Japan, China, Taiwan, and the Gulf States running significant, persistent trade surpluses and oversaving). Bernanke chose to position the problem as a "savings glut" which had the convenient effect of placing responsibility for the problem overseas, particularly on the Chinese, who kept the renminbi cheap via a hard peg to the dollar( THIS ISN'T QUITE THE SAVER COUNTRY VS SPENDER COUNTRY DICHOTOMY. IT'S WHAT I CALL THE GIANT POOL OF MONEY SLOSHING AROUND THEORY, WHICH, IN MY MIND, IS MECHANISTIC, AND SO NOT USEFUL ). Key bits:

In March 2005, a low-key Princeton economist who had become a Federal Reserve governor coined a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending.

The problem, he said, was not that Americans spend too much, but that foreigners save too much. The Chinese have piled up so much excess savings that they lend money to the United States at low rates, underwriting American consumption.

This colossal credit cycle could not last forever, he [Ben Bernanke] said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, “we probably have little choice except to be patient.”....

Yves here. As far as I am concerned, this was rationalization of a clearly unstable and unsustainable pattern. But rather than try to find a way out, or at least keep it from becoming more pronounced, Bernanke recommended doing nothing. And it was NOT a market phenomenon, but the result (on the surface, at least) of China pegging the RMB at an artificially low level. Did we explore the possibility of WTO sanctions for the currency manipulation as an illegal trade subsidy( I AGREE WITH DOING THIS )? Apparently the US was acutely aware of this as a possibility, and took great care not to give private parties any grounds for using the RMB as the basis for a WTO action. This comes late in the article:

At the last minute [in 2006], however, Mr. Bernanke deleted a reference to the exchange rate being an “effective subsidy” for Chinese exports, out of fear that it could be used as a pretext for a trade lawsuit against China( MISTAKE ).

So we knew we had the nuclear option in our hands, and there was no will to use it. One has to wonder if there were any threats made in private. My gut says no, given the history here.

Back to the piece:

China, some economists say, lulled American consumers, and their leaders, into complacency about their spendthrift ways( SILLY ).

The problem with this characterization is it make the US a passive party and a victim in a paradigm that we embraced( FROM MY PERSPECTIVE, IT'S AUTOMATIC, OR MECHANISTIC. NOTHING FORCES HUMANS TO SPEND BUT THEIR DESIRES ). And let us not forget it takes two to tango. If China ran a savings glut, the rest of the world in aggregate had to consume (overspend and borrow enough) to take up the slack. But it most certainly did not fall upon the US to put up its hand and do it virtually solo (the EU runs a slight trade surplus).

Funny, some (many?) Chinese bureaucrats say that the US conned China into taking worthless paper (US Treasuries)( THEY KEEP BUYING THEM ) in return for valuable Chinese products. Two can also play the blame game.

And the New York Times buys hook, line, and sinker into the "gee, we really had no choice" party line( AGAIN, IT'S A SILLY THEORY ):

To be sure, there were few ready remedies. Some critics argue that the United States could have pushed Beijing harder to abandon its policy of keeping the value of its currency weak — a policy that made its exports less expensive and helped turn it into the world’s leading manufacturing power. If China had allowed its currency to float according to market demand in the past decade, its export growth probably would have moderated. And it would not have acquired the same vast hoard of dollars to invest abroad( TRUE, BUT I'M MORE BOTHERED BY THE SUBSIDY ISSUE ).

Others say the Federal Reserve and the Treasury Department should have seen the Chinese lending for what it was: a giant stimulus to the American economy, not unlike interest rate cuts by the Fed( I'VE ALREADY SAID THAT I DON'T HOLD INTEREST RATES TO BLAME. AT MOST, THESE ARE INCENTIVES. NO ONE IS FORCED TO DO ANYTHING, AND CERTAINLY IT DOES NOT JUSTIFY PROFLIGACY ). These critics say the Fed under Alan Greenspan contributed to the creation of the housing bubble by leaving interest rates too low for too long, even as Chinese investment further stoked an easy-money economy. The Fed should have cut interest rates less in the middle of this decade, they say, and started raising them sooner, to help reduce speculation in real estate( THAT WOULD HAVE CAUSED HOWLS ).

The story also conveniently makes the global imbalances problem sound as if it is all about the US and China (and by implication, of relatively recent origin) when in fact it has long been in the making but the vital indicators moved into the danger zone in the post 2002 era (US trade deficits rising to unprecedented levels as a % of GDP, savings plunging to zero) and were ignored.

In fairness, the Times piece later suggests that the Greenspan Fed was far too sanguine, that the Chinese were highly resistant to pressure regarding revaluing their currency, while the Japanese went along with the 1985 Plaza accord which called for a stronger yen (I remember when it was 250 to the dollar).

While we admittedly have more leverage over Japan than China, the flip side is the Chinese wanted badly to win on this issue and we caved. I sincerely doubt we tried very hard, since as the story clearly indicates, the officialdom rationalized global imbalances as a "market phenomenon" when it was anything but( SUBSIDIES DO OFTEN EFFECT THE MARKET, BUT NOT MECHANICALLY ).

The article points out that we used cheap Chinese funding poorly:

But Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads ( WHAT WOULD THAT BE? ). Instead, the government engaged in a costly war in Iraq, and consumers used loose credit to buy sport utility vehicles and larger homes( AS OPPOSED TO WHAT? ). Banks and investors, eagerly seeking higher interest rates in this easy-money environment, created risky new securities like collateralized debt obligations.

Let us turn to economist Thomas Palley for an alternative point of view as to where the problem originated, which in turn suggests other courses of action. Note that the material from Palley comes from 2007 and early in 2008, yet the Times gave no consideration to his or other dissenting-from-orthodox views.

Palley starts with the observation that our recent expansion was unbalanced. He sees the big problems as record trade deficits (the result of an overvalued dollar), and (related but somewhat separate) the erosion of manufacturing.

The emphasis on the role of manufacturing is interesting and credible. When you consider the lead times, inflexibility, and transportation costs of manufacturing in Asia (remember, even goods like furniture, which involve round-trip shipping, are often made in China) one has to wonder how we screwed up, particularly when I hear from clothing designers that the reject rate on Chinese garments is typically 50%. ( SO THEY'RE NOT PROFITABLE? )

One would think there would be a role for at least for highly-flexible, high quality manufacturing that took advantage of geographic proximity, ability to do small runs at competitive prices, and high reliability( HOW WOULD ONE KNOW WITHOUT MARKETING IT? ). It would never be as large as China's output, but it would cream the high end of the market (and with them, presumably high margins) and also keep core skills at home( MAYBE ). And the US is still competitive in highly capital intensive and highly demanding manufacturing, such as coated paper (unlike newsprint, coated paper production is very difficult to keep running at the near-constant output level that its huge capital base requires).

Part of the problem, as we have discussed earlier, is that we have taken a naive stance in trade negotiations. We seem seduced by the idea of open markets, when in fact what we have is a system of managed trade( TRUE ). And our trading partners, who for the most part are keen to preserve employment, protect certain key industries, and have trade surpluses, seem to have achieved better outcomes than we have( TRUE ).

A 2007 Wall Street Journal article, "Is Productivity Growth Back In Grips of Baumol's Disease?" supports Palley's hypothesis about the value of manufacturing:

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet -- there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can't get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise....

Sectors where productivity is high and average labor cost low "are those things that can be automated and mass-produced," Mr. Baumol, now in his mid-80s and still teaching, said in an interview. "And things where labor-saving is below average are things that need personal care -- these are health care, education, police protection, live stage performance... and restaurants."

Uh-oh.

U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government....

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much"

Here's the whole post from the WSJ:

"By BRIAN BLACKSTONE

Is Baumol's disease back?

Named for economist William Baumol, the theory argues that the labor-intensive nature of some services acts as a constraint on productivity growth in an economy that increasingly produces services. It's relevant again years after some economists pronounced it "cured."

Between the mid-1970s and mid-1990s, annual productivity growth in the U.S. nonfarm business sector averaged about 1.5%. In the past decade, it has averaged about 2.6%. For a couple of years in the early 2000s it was near 4%, and Mr. Baumol's idea looked destined to join others in economics that looked good in theory but wrong in practice.

Yet last week's downward revisions of U.S. productivity growth for the past three years( IS THAT AN ERA NOW? ) suggest that the trend is closer to 2%, and shows that productivity growth has slowed for four straight years.

At the same time, employment in traditionally( AS IN THE PAST ) less-productive sectors such as health care and leisure is growing rapidly, while employment in higher-productivity business services is growing more slowly; in manufacturing and retail trade, it is flat or shrinking. Therein may( HERE WE GO AGAIN ) lie clues into whether the recent dip in productivity growth is a major turn or a temporary lull( SO NO ONE KNOWS ).

That's where Baumol's disease comes in( IT'S JUST A DESCRIPTION OF A FACT. NOT AN EXPLANATION ).

In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.

Their famous example was a classical string quartet -- there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can't get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise( AND? ).

But something happened in the last decade.

The information-technology boom( THIS IS WHERE I SEE THE PROBLEM ) led to rapid efficiency gains not just in the production of high-tech equipment, as expected, but also in services such as retailing -- which had long been assumed to have little prospect for much improvement. The quartet can now be heard on iPods and even cellphones, meaning that even if musicians themselves aren't more productive, the methods of distribution are.

In fact, it is in services -- particularly in retail and wholesale trade, in something called the "Wal-Mart effect" -- where economists credit a good part of productivity gains in the late 1990s and early 2000s. That led Brookings Institution economists Barry Bosworth and Jack Triplett to conclude in an influential 2003 paper that Baumol's disease "has been cured."

Along similar lines, a pair of economists from the Federal Reserve -- Carol Corrado and Paul Lengermann -- argued in a recent paper that much of the growth in the U.S. economy since 2000 can be accounted for by strong multifactor productivity growth -- which includes labor as well as inputs such as capital and materials -- in industry, a "remarkable turnaround" in finance and business services, and an "end to the drops" in productivity in personal and cultural services.

Still, the Fed economists and their co-authors estimated that from 2000 to 2004, multifactor productivity growth averaged just 0.2% a year in personal and cultural services (which include health care, social assistance, recreation and food services, among others), compared with almost 2% for finance and business, 2.6% for distribution and 5.4% for high tech.

Sectors where productivity is high and average labor cost low( THAT'S GOOD? ) "are those things that can be automated and mass-produced," Mr. Baumol, now in his mid-80s and still teaching, said in an interview. "And things where labor-saving is below average are things that need personal care -- these are health care, education, police protection, live stage performance... and restaurants."

Uh-oh.

U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government( WHO'S PAYING FOR THESE SERVICES? PAUPERS? ).

Going back to Baumol's disease, it still takes a bartender( WHO'S PAID FOR HIS ABILITY TO SCHMOOZE AND GET BOUGHT DRINKS AND GIVEN TIPS ) the same two minutes it always has to make a gin-and-tonic( THEY CAN WATER IT DOWN ). And an "end to the drops" in productivity referred to in the Fed paper may not be enough to sustain living standards over generations( WHO THE HELL KNOWS THAT? ).

While there's surely a cyclical component to recent job gains and losses -- areas such as health care and personal services tend to lag the business cycle -- there are longer-term forces at work( I DON'T SEE THEM FROM THAT GRAPH ).

Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much.

"If what we're starting to see is an increase in personal services -- nursing homes, care for the elderly -- as they become bigger and bigger, that would create a very important composition story( SO WE DON"T WANT THEM TAKEN CARE OF ? )," says Martin Baily, a productivity scholar at the Peterson Institute for International Economics, a Washington think tank.

If employment and sector-specific productivity trends continue, "I would start heading toward 1.5%" annual productivity growth over the long term, says Mr. Bosworth. Still, he doesn't think that will happen; he stands by his notion that Baumol's disease( SO FAR ALL THIS MEANS IS LESS PRODUCTIVITY. I DON'T SEE THE CAUSALITY. I UNDERSTAND HIS EXPLANATION, BUT THAT'S DIFFERENT ) has been cured, in part because medical care -- the ultimate test of Baumol's theory because it's set to account for so much of the economy -- holds promise for "big productivity gains."

There are other reasons for optimism. The U.S. is very competitive globally in high-paying and high-productivity services, so any expansion of trade could positively affect the job mix domestically.

Asked whether Baumol's disease spells doom for productivity, its namesake replies "yes and no."

"It is true that in money terms our productivity will be slowed down by the shift in labor from agriculture, manufacturing and services like telecommunications into services like health care and education," Mr. Baumol says.

"But if you count the number of students who have graduated or the number of people who have been taken care of after a heart malfunction, that is not going down." And the benefits of education and health care, on future output, can be hard to measure.

As for the disease that bears his name, not only does Mr. Baumol say it hasn't been cured, he adds: "I can brag and apologize that we've made the longest-lasting [correct] prediction that's ever been made in economics."

Back to Yves Smith:

"Palley argues that the Fed, despite having given lip service to global imbalances, is in fact operating from and supporting a flawed paradigm.

From Palley:

The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been persistently fragile and unbalanced. That is now coming home to roost in the form of the sub-prime mortgage crisis and the bursting house price bubble.

As part of the fallout, the Federal Reserve is being criticized for keeping interest rates too low for too long, thereby promoting credit and housing market excess. However, the reality is low rates were needed to sustain the expansion. Instead, the root problem is a distorted expansion caused by record trade deficits and manufacturing’s failure to fully participate in the expansion.

If the Fed deserves criticism it is for endorsing the policy paradigm that has made for this pattern. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.

By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Beginning with an extended period of jobless recovery, private sector job growth has been below par through most of the expansion. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.( HE NOTES MY PROBLEM, WHICH IS RISING PRODUCTIVITY. WE NEED TO ATTACK THE JOBLESS PART OF THE GROWTH. HOWEVER, I'M MORE OF A TECHNOLOGY THAN MANUFACTURING PERSON. )

This gloomy picture justified the Fed keeping interest rates low. However, it begs the question of why the economic weakness despite historically low interest rates, massive tax cuts in 2001 and huge increases in military and security spending triggered by 9/11 and the Iraq war( THIS DEBT IS A MAJOR PROBLEM )?

The answer is the over-valued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion, equaling 6.5 percent of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing’s weak participation in the expansion( DOES HE WANT TARIFFS? ). Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have reduced investment owing to weak demand or have moved their investment to China and elsewhere( HOW ARE THESE COUNTRIES SUPPOSED TO GROW? ). These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened job creation.

The evidence is clear. Manufacturing has lost 1.8 million jobs during the expansion, which is unprecedented. Before 1980 manufacturing employment hit new peaks every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. This business cycle it has fallen during the expansion. The business investment numbers tell a similar dismal story, with spending being much weaker than in previous cycles( WHAT ABOUT TECHNOLOGY? ).

These conditions compelled the Fed to keep interest rates low to maintain the expansion. That policy worked, but by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5 percent of total employment, has provided over twelve percent of job growth. Meanwhile, higher house prices have fuelled a borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.

The overall picture is one of a distorted expansion in which manufacturing continued shriveling while imports and services expanded. This pattern was carried by an unsustainable house price bubble and rising consumer debt burdens, and that contradiction has surfaced with the implosion of the sub-prime mortgage market and deflation of the house price bubble.

The Fed is now trying to assuage markets to keep credit flowing, and it will likely soon lower interest rates. On one level that is the right response and it may even work again – though it does increasingly seem like sticking fingers in the dyke to prevent the flood. However, the deeper problem is the policy paradigm behind the distorted expansion, which is where the Fed is at fault and where it deserves criticism.

The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the White House and Treasury’s unbalanced expansion policies. The Fed’s professional economics staff also seems to have dismissed domestic manufacturing’s significance and endorsed corporate globalization in the name of free trade. Consequently, the Fed has tacitly supported the underlying policy paradigm that has given rise to America’s distorted expansion. Despite talk about reducing global financial imbalances, the Bernanke Fed still seems locked in to this paradigm and that is where constructive criticism should now be directed.( I CAN SEE THE POINT OF THE DISTORTING ASPECT OF MANAGED TRADE, BUT I CAN'T CREDIT ALL OF THE LOSSES IN MANUFACTURING TO THAT )

And Palley gave a broader view of the fundamental problem in an early 2008 post:

The last twenty-five years have witnessed a boom in the reputation of central bankers. This boom is based on an account of recent economic history that reflects the views of the winners....

That said, there are other less celebratory accounts of the Great Moderation [the post 1980 smoothing of business cycles] that view it as a transitional phenomenon( ISN'T EVERYTHING? ), and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment( THIS IS HELLISHLY HARD TO DO ). The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages( WHAT ABOUT INCREASED PRODUCTIVITY? BY THE WAY, JUST GETTING A RAISE IN AN INFLATIONARY ENVIRONMENT DOESN'T AUTOMATICALL GUARANTEE THAT YOU HAVE MORE BUYING POWER THAN BEFORE ). That is what happened in the 1960s and 1970s. However, rather than solving this political problem( HOW WOULD THAT GO ? ), economic policy retreated from full employment and assisted in the evisceration of unions( WHEN I HAD VIEWS BASED ON "THE SHARE ECONOMY", UNION MEMBERS DIDN'T LIKE IT ). That lowered inflation, but it came at the high cost of two decades of wage stagnation( WHAT ABOUT BUYING POWER? ) and a rupturing of the link between wage and productivity growth.( I'M NOT FOLLOWING HIS REASONING )

Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow( WASN'T THAT GOOD? ).

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic( WHAT'S A DYNAMIC? TOO MECHANISTIC ON THE ONE HAND, NOT SPECIFIC ENOUGH ON THE OTHER ) in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic( MECHANISTIC. DYNAMIC HERE SOUNDS LIKE AN ENGINEERING TERM ) is exemplified by the housing bubble of the last eight years.

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Given this, the Great Moderation( THIS WAS OVERDONE ) could easily come to a grinding halt. Though high inflation is unlikely to return( I AGREE ), recessions are likely to deepen and linger( WHY ? ). If that happens the reputations of central bankers will sully, and the real foundation and hidden costs of the Great Moderation may surface. That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality( I'M FOR THESE THINGS, BUT I DON'T FOLLOW HIS REASONING. IT READS MORE LIKE A CAUSALITY MISHMASH. ). How we tell history really does matter."