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.


About Joseph Burke

This entry was posted in Economic History, Microeconomic Theory and tagged , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s