Not long before his death Kurt Vonnegut famously wrote, “If I should ever die, God forbid, let this be my epitaph: ‘The only proof he needed for the existence of God was music’.”
Mr. Vonnegut loved jazz, a music which to some ears appears chaotic. In fact, my wife has often said the music I fancy sounds like a car crash. As a jazz musician myself, I can verify this music is anything but chaotic or random. Yet I can understand why the uninitiated observer might reach that erroneous conclusion.
Jazz is structured around a set of repeating chord progressions instead of repeating melodies. As a soloist alters his rhythm or melody, the other players respond, but within an established boundary of harmonics. Two renditions of the same tune are never the same.
An economy can be seen through a similar lens. Economies are in constant motion, ever changing, perpetually driven by an array of forces which operate within a set of boundaries. For example, populations rise and fall through migration, birth, death, and wars.
Tastes and preferences of consumers change. Do you remember the Cabbage Patch doll or the pet rock?
Technologies evolve and disrupt former products. Once upon a time the country was dotted with numerous copy centers filled with large Xerox machines. Then came the affordable home printer/fax/scanner/copier.
Investment vehicles change from vogue to vagabond. Bubbles become bloated and burst.
Just as jazz musicians constantly adapt to the meandering movements of the soloist, businesses, consumers, and governments, including monetary authorities, are in a state of perpetual motion to adapt to the ever shifting movements of our economy.
Two signals send the message of change: prices and quantities of goods and services sold. When GM discovers that new car sales are softening, the message motivates managers to change. If car sales are soft everywhere, production is cut. If sales are strong for other car makers but soft for GM, heads roll.
In the investment world, prices convey their communiqué, and traders respond in kind. The recent drop in the prices of German government bonds has caused an enormous sea change in portfolios as well as policy discussions in the eurozone.
The process of adjustment to the host of changes taking place within our economy can at times be trivial, and at other times tumultuous. For example, the adjustment from flip phones to smart phones has been revolutionary to both consumers and businesses, but the overall adjustment has not required excessive pain within our nation. (Although a chat with the Finns might provide a different impression given that Nokia has all but imploded, putting thousands of Finns out of work.)
In contrast, the shift from nothing-down subprime mortgages to a more responsible home lending practice has been accompanied with a catastrophic plunge in home prices, millions of jobs lost for several years, and breathtaking volatility in the financial markets.
At times when adjustments are needed within an economy to accommodate a change in technology, or altered tastes and preferences, or a natural disaster, or war, or whatever it may be, the chief concern of economists is always output and employment.
Economists despise idle resources, especially idle labor. When a worker is involuntarily unemployed, and unable to find suitable work, his productive capability is discarded for a time. This not only lowers output, but also creates stress and tension within one’s family.
Fortunately, the economy has a number of mechanisms which enable adjustment to take place to keep employment high. Some of these are natural, automatic mechanisms, involuntary responses if you will, and others are purposely administered as needed.
In the ivory tower of economic theory, all needed adjustments in an economy can take place by setting the “right” price. If, for example, a large body of workers are unemployed, demand for labor is too low at the existing wage rate. If one lowers wages sufficiently, all workers will be snapped up by employers. So goes the theory.
By way of further illustration, the capital markets may find that too much savings and too little investment is taking place. This can theoretically be corrected through lower interest rates, which increase investment and spending, and reduce savings, but theory and practice are often at odds.
Economists have noted for a century that wages are “sticky” to the downside. It is very difficult to push wages down by an appreciable amount. Workers typically reject large cuts in pay. So the price mechanism of adjustment breaks down.
In our investment example, sometimes the interest rate needed to bring savings and investment into equilibrium is significantly negative, but interest rates cannot go into deep negative territory. The price mechanism of adjustment once again breaks down.
Perhaps the most important aid to large, macro adjustments is the price of a country’s currency; its exchange rate. Recent world and local events in Brazil have caused a reduction in economic activity. Fortunately, the Brazilian Real has been able to drop in value, causing Brazilian goods to cost less outside the country. This has arrested the rise in unemployment.
In Greece, this particular mechanism of exchange rate adjustment no longer exists, since Greece has adopted the euro. Greece is in desperate need of lower wages to increase employment and diminish a dire depression.
Since wages are sticky, a small country like Greece could avoid a depression by a drop in its currency. This would leave wages relative to the rest of the world lower, but leave wages within the country unchanged.
Without the currency option, Greece could also stimulate the economy through increases in government spending, but this would require deficit spending, which the European Union has forbidden. What a mess!
This brings us back to last week’s discussion about multiple equilibria, the situation in which two or more very different prices may satisfy both buyers and sellers of a good or service.
Since Greece has lost its own currency and the accompanying adjustments which an independent currency offers, they are faced with an interesting paradox. If the European Central Bank were to announce that they unconditionally guarantee all Greek government debt, Greek borrowing costs, i.e., Greek bond yields, would immediately drop to around one percent or a shade higher.
This would make Greek debt service easy and affordable, thereby insuring the central bank would never be called upon to make good on its guarantee. This is equilibrium number one, the good one.
In contrast, as the bank has wavered in its support of Greece, investors have gotten nervous and pushed Greek borrowing costs to over 10 percent, a level inconsistent with Greek liquidity and perhaps Greek solvency. This is equilibrium number two, the bad one.
It is unfortunate that many of the eurozone nations find themselves in a situation where their former adjustment mechanism of currency appreciation or devaluation has been removed through the single currency, but other mechanisms for macro adjustment have not been adequately developed. Millions of families are needlessly suffering as a result.
It is as if the jazz soloist has moved in a new direction, but the other players have not gone with him.
(Marcus Hutchins, MA, M. Phil, Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)
