The Fed and American Manufacturing

President-elect Trump’s success in the rust belt has drawn the nation’s attention the hardships of American manufacturing workers. While the causes of this are many, I would like to highlight an important role the Federal Reserve has played in their plight. In short, the Fed’s zero-interest rate policy (ZIRP) has encouraged a substitution of capital for labor in the manufacturing process, contributing to the low wages and depressed labor market participation we have experienced in the wake of the Great Recession.

The Fed has kept rates artificially low for the last eight years. In theory, low interest rates promote borrowing and investment by companies, encouraging economic expansion and hopefully putting people back to work. The rate on 10-year Treasury has been about 2% since the start of the Great Recession, compared to an average of 4% in the 8 years prior. However, in spite these efforts, economic growth has been anemic, and labor market conditions are abysmal.

So what is the problem? Certainly, costly regulations have discouraged expansion and Obamacare has increased the cost of hiring workers, especially full-time workers. But interest rates have played an important role as well, by lowering the cost of capital and encouraging the substitution of capital for labor in the production process.

Let’s divide capital into types: complements to labor (tools) and substitutes for labor (robots). Lowering the interest rate lowers the cost of both types of capital. This incentivizes manufacturers to shift away from labor to more capital-intensive production methods. The recent explosion in the use of robots and automation is partly due to technological progress, but partly due to the Fed’ policy. Lower interest rates make the investment in robots, automation and other capital substitutes for labor more attractive than they would otherwise be. Low interest rates make capital substitutes less expensive relative to the labor.

How large an effect is a 2% reduction in interest rates? The annual cost of using a capital asset, such as a factory or a machine, is the rental rate of capital.  The rental rate is calculated by adding the interest rate to the depreciation rate. Seemingly small changes in the interest rate can have large effects on rental rates.

For an asset depreciated over five years, a 2% decrease in the interest rate lowers the rental rate of capital from 24% to 22%. This is an 8% reduction in the rental rate of capital. The same 2% decrease leads to a 14% reduction in the rental rate for 10-year assets and a 22% reduction for 20-year assets.

Workers would have to accept wage reductions of these magnitudes–between 8% and 22%–to discourage companies from substituting of capital for labor in the production process. Obviously, accepting even an 8% reduction in wages to keep your job is difficult if not impossible for most workers to accept. Downward “stickiness” in wages lead to unemployment, as workers prefer to quit rather than accept the pay cut.

It may be that the increasing use of robots and automation is inevitable, a necessary consequence of technological progress. But the low interest rate policy of the Federal Reserve Bank has made a bad situation worse for American workers.

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A Prayer by Aleksandr Solzhenitsyn

How easy for me to live with you, O Lord!
How easy for me to believe in You!
When my mind parts in bewilderment
or falters,
when the most intelligent people see no further
than this day’s end
and do not know what must be done tomorrow,
You grant me the serene certitude
that You exist and that You will take care
that not all the paths of good be closed.
Atop the ridge of earthly fame,
I look back in wonder at the path
which I alone could never have found,
a wondrous path through despair to this point
from which I, too, could transmit to mankind
a reflection of your rays.
And as much as I must still reflect
You will give me.
But as much as I cannot take up
You will have already assigned to others.

– Aleksandr Solzhenitsyn

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The Case of Anna Ossovskaya

“The scope for any successful work for a defence lawyer under the Soviet criminal law system is necessarily limited. A few instances of economic crimes of which the author was connected during his many years’ practice in the Crimea and in Leningrad may give some idea of Soviet economic criminal law in practice. There was the case of Anna Ossovskaya, tram conductress in Leningrad, accused of an offence under Article 107 of the Code. When, following a denunciation by her own son-in-law, the police searched her one-room flat, they discovered several new shirts, pieces of underwear and a total of eleven sheets; it may be added that Ossovskaya had a husband and two unmarried children living with her. Although there was not the slightest evidence that the accused had brought the linen for resale, the court held that the total exceeded the normal needs of a Soviet family and therefore resale could have been the only plausible intention of holding these large stocks. Ossovskaya was sentenced to 5 years’ loss of freedom, a sentence which was not reduced on appeal although it could be shown that the underwear and shirts were in the sizes suitable for the husband and children of the accused.” (A Russian Lawyer, “Economic Crimes Under Soviet Law,” Res Judicate 45(5), 1951: 48-49)

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Romanian Camps

“[T]he Romanian camps most closely resemble the Gulag, even to the extent that they carried out absurd, overambitious projects of the sort Stalin himself favored in the Soviet Union. The most famous of these, the Danube-Black Sea Canal, appears to have no real economic function at all. To this day, it is every bit as empty and deserted as the White Sea Canal which it so eerily resembles. A propaganda slogan declared that the ‘Danube-Black Sea Canal is the tomb of the Roman bourgeoisie!’ Given that up to 200,000 people may have died building it, that may have indeed been the canal’s real purpose.” (Applebaum, Gulag: A History, p.456)

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Betrayal of the Cossacks

“In May 1945, British troops, under what they were told were direct orders from Churchill, undertook to repatriate more than 20,000 Cossacks, then living in Austria. These were former anti-Bolshevik partisans, some of whom had joined Hitler as a way of fighting Stalin, many of whom had left the USSR after the Revolution, and most of whom no longer held Soviet passports. After many days of promising them good treatment, the British tricked them. They invited the Cossack officers to a ‘conference,’ handed them over to Soviet troops, and rounded up their families the following day. In one particularly ugly incident at a camp near Lienz, Austria, British soldiers used bayonets and rifle butts to force thousands of women and children onto trains which would take them to the USSR. Rather than go back, women threw their babies over bridges, then jumped themselves. One man killed his wife and children, laid their bodies on the grass, and then killed himself. The Cossacks knew, of course, what would await them upon their return to the Soviet Union: firing squads–or the Gulag.” (Applebaum, Gulag: A History, p.437)

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Bolshevik Retribution at Yalta

“Scattered throughout Europe, most notably in Yugoslavia, there were also anti-communist emigres: White Russians, that is, who had lost their fight against the Bolsheviks and settled in the West. Stalin wanted them back too: no one was to be allowed to escape Bolshevik retribution.

“In the end, he got them. Among the many controversial decisions they made at the Yalta Conference in February 1945, Roosevelt, Churchill, and Stalin agreed that all Soviet citizens, whatever their individual history, must be returned to the Soviet Union. Although the protocols signed at Yalta did not explicitly command the Allies to return Soviet citizens against their will, that, in effect, is what happened.” (Applebaum, Gulag: A History, p.436)

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