there were more sellers than buyers. But nobody really knows why.
I did not come up with an explanation for the 2004 episode, and I decided
that it must be just another odd passing event not to be repeated. I
was mistaken. In February and March of 2005, the anomaly cropped up
again. Reacting to continued Fed tightening, long-term rates again began to
rise, but just as in 2004, market forces came into play to render those increases
short-lived.
What were those market forces? They were surely global, because
the declines in long-term interest rates during that period were at least
as pronounced in major foreign financial markets as they were in the
United States. Globalization, of course, had been a prominent disinflationary
force since the mid-1980s. I was still intrigued by the vast pattern
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TH E "CON UNDRUM"
of change that I'd sketched out for my colleagues on the FOMC in December
1995, telling them, "It is very difficult to find inflationary forces anywhere
in the world.Something differentisgoingon."Atthatpoint,Icouldn'tyetprove
it, but I explained what I thought was the answer:
You may recall that earlier this year I raised the issue of the extraordinary
impact of accelerating technologies, largely silicon-
based technologies, on the turnover of capital stock, the fairly
dramatic decline in the average age of the stock, and the creation
as a consequence of a high degree of insecurity for those individuals
in the labor markets who have to deal with continually changing
technological apparatus. One example that I think brings this
development close to home, even though it is an unrealistic example,
is how secretaries would feel if the location of the keys on their
typewriters were changed every two years. We are in effect doing
that to the overall workforce. To my mind, this increasingly explains
why wage patterns have been as restrained as they have
been. One extraordinary piece of recent evidence is an unprecedented
number of labor contracts with five- or six-year maturities.
We never had a labor contract of more than three years' duration
in the last 30 to 40 years... .The underlying technology changes
that support this hypothesis appear only once every century, or 50
years.... In addition ... the downsizing of products as a consequence
of computer chip technologies has created ... a significant
decline in implicit transportation costs. We are producing very
small products that are cheaper to move.... [Equally important]
is the dramatic effect of telecommunications technology in reducing
the cost of communications.... As the downsized products
have spread and the cost of communications has fallen, the globe
has become increasingly smaller.... We are now seeing ... the proliferation
of outsourcing ... ever increasingly around the globe.
What one would expect to see as this occurs—and indeed it is
happening—is the combination of rising capital efficiency and falling
nominal unit labor costs.... This is a new phenomenon, and it
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raises interesting questions as to whether in fact there is something
more profoundly important going on [for] the longer run.
We could not be sure of the appropriate assessment of our changing
world for probably five to ten years, I told them, but the passage of time
only brought the phenomenon of worldwide disinflation into sharper relief
With the new millennium, signs of it became increasingly evident, even
among developing countries whose histories were rife with inflationary episodes.
Mexico in 2003 was proudly able to market a first-time-ever twenty-
year peso-denominated bond, only eight years after the nation faced a
severe liquidity crisis in which the government could not find buyers for
even short-term dollar-denominated debt and required a U.S.-led bailout.
Admittedly, Mexico had taken a number of important steps to get its fiscal
and monetary house in order following its 1995 near default. But there
was nothing in those steps to suggest that it would quickly gain the ability
to sell a relatively low-yield twenty-year peso-denominated bond. Mexico's
checkered macroeconomic history had hitherto required long-term
debt issues to be denominated in foreign currencies in order to attract
investors.
Mexico was not an isolated case. Governments of other developing
countries were increasingly issuing long-term debt in their own currencies
at interest rates that developed countries would gladly have welcomed only
a decade earlier. And I've noted, Brazil, contrary to previous experience,
had been able to absorb a 40 percent devaluation of its currency in 2002,
with only short-term and relatively modest inflationary consequences.
Inflation had been subdued virtually across the globe. Inflation expectations,
reflected in long-term debt yields, plunged. The yields on developing
nations' debt shrank to unprecedented lows. Double- and sometimes
triple-digit annual inflation rates, historically a hallmark of developing
economies, had, with a few exceptions, disappeared. Episodes of hyperinflation
became extremely rare.* Developing countries averaged an annual
increase of 50 percent in consumer prices between 1989 and 1998. By 2006,
consumer price inflation had fallen to less than 5 percent.
*Zimbabwe, which has mangled its economy, has been the principal exception.
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TH E "CON UNDRUM"
But even though globalization had reduced long-term interest rates, in
the summer of 2004 we had no reason to expect that a Fed tightening
would not carry long-term rates up with it. We anticipated that we would
just be starting from a lower long-term rate than was customary in the past.
The unprecedented response to the Federal Reserve's monetary tightening
that year suggested that in addition to globalization, profoundly important
forces had developed whose full significance was only now emerging. I was
stumped. I called the historically unprecedented state of affairs a "conundrum."
My puzzlement was not assuaged by the numerous bottles of Conundrum-
label wine arriving at my office. I don't recall the vintage.
A little-noticed event in Europe offered the first clue to unraveling the
new puzzle. Siemens, one of Germany's formidable exporters, had informed
its union, IG Metall, in 2004 that unless the union agreed to a pay cut of
more than 12 percent at two plants, Siemens would contemplate relocating
the facilities to Eastern Europe. Boxed in, IG Metall acquiesced, and the
exodus of Siemens's plants to the newly freed economies of Eastern Europe
was stayed.* This event struck a chord for me because I had seen reports
of similar confrontations earlier. It led me to review the pattern of
wage increases in Germany. Employers had long been complaining that high
wages were making them uncompetitive, even though average hourly compensation
had not been rising very fast—at an annual rate of 2.3 percent between
1995 and 2002. Their message was obviously now finally getting
through. Starting in late 2002, hourly labor cost growth was abruptly cut to
half that rate, and it stayed very slow through the end of 2006.
Siemens and the rest of German industry, assisted by reforms allowing
wider use of so-called temporary workers, were able to damp German
wages, costs, and hence prices. Inflation expectations declined with the decline
in the recorded rate of inflation. IG Metall1 s loss of bargaining power,
of course, was wholly the result of forces outside German borders—the
entrance on the competitive scene of at least 150 million low-priced, well-
educated workers, released from the grip of the Soviet empire's centrally
planned economic system.
*In September 2006, Volkswagen negotiated a similar agreement to lower average hourly earnings
in exchange for securing jobs threatened by plant relocation.
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The end of the cold war—the stand-down from the brink of war by the
world's two nuclear superpowers—has little to challenge it as the second
half of the century's most significant geopolitical event. The economic significance
of the demise of the Soviet Union has been awesome in its own
right, as I noted in chapter 6. The fall of the Berlin Wall exposed a state of
economic ruin so devastating that central planning, earlier applauded as a
"scientific" substitute for the "chaos" of the marketplace, fell into terminal
disrepute. There was no eulogy or economic postmortem. It just disappeared,
without a whimper, from political and economic discourse. As a
consequence, Communist China, which had discovered the practical virtues
of markets a decade earlier, accelerated its march toward free-market
capitalism without, of course, ever acknowledging that that was what it
was doing. India began to awaken from the bureaucratic socialism of former
prime minister Jawaharlal Nehru. And any notions emerging economies
might have had of implementing or expanding economy-wide forms of
central planning were quietly shelved.
Soon well over a billion workers, many well educated, all low paid, began
to gravitate to the world competitive marketplace from economies that
had been almost wholly or in part centrally planned and insulated from
global competition. The IMF estimates that in 2005 more than 800 million
members of the world's labor force were engaged in export-oriented and
therefore competitive markets, an increase of 500 million since the fall of
the Berlin Wall in 1989 and 600 million since 1980, with East Asia accounting
for half of the increase. Lesser numbers in Eastern Europe moved
from behind the "protections" of centrally planned regimes to domestic
competitive markets. Many hundreds of millions of people, mainly in China
and India, have yet to make the transition.
This movement of workers into the marketplace reduced world wages,
inflation, inflation expectations, and interest rates, and accordingly significantly
contributed to rising world economic growth. Even though the aggregate
payroll of the newly repositioned workforce was only a fraction of
that of developed nations, the impact was pronounced. Not only did low-
priced imports displace production and hence workers in developed countries,
but the competitive effect of the displaced workers seeking new jobs
suppressed the wages of workers not directly in the line of fire of low
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priced imports. In addition, migration from Eastern to Western Europe of
low-priced workers exposed part of the homegrown workforces of Western
Europe to enhanced wage competition. Finally, exports from previously
centrally planned economies competitively suppressed export prices
of all economies.
Had these billion-plus low-cost workers arrived in world labor markets
en masse overnight, I do not doubt that chaos would have ensued. The Soviet-
dominated economies of Eastern Europe made the transition in a decade,
but scarcely smoothly. However, they represented only a fraction of
the potential tectonic shift. Most dominant by far has been China, where
labor force data, to the extent they can be relied upon, suggest a slow, but
gradually accelerating, government-controlled shift of the workforce of the
rural provinces to the dynamic market-dominated regions of the Pearl River
delta and other export-oriented areas. Vast numbers of Chinese workers
left agriculture-related pursuits for manufacturing and service jobs in urban
areas. Privately controlled businesses rose to claim a significant share of
China's near 800-million-person workforce. By 2006, agriculture was down
to little more than two-fifths of total employment. Chinese manufacturing
employment has held steady in recent years despite massive workforce reductions
in state-owned enterprises. The largest gains in employment over
the last decade have been in services.
Importantly, it is the pace, the rate of change, of movement from centrally
planned employment to competitive markets that determines the degree
of disinflationary pressure on developed nations' wage costs and hence
prices. Because of the indirect effects of competitive imports and immigration,
the addition of new low-priced workers affects the whole structure of
labor costs in developed countries. The greater the rate of worker additions
to the competitive market, the greater the downward pressure on developed
countries' wage costs and prices. The initial overall impact was perhaps
a reduction of only a couple of percentage points of annual wage growth at
best. That major systemic effects could stem from such an apparently modest
initial impact may seem like a man lifting a ton of steel. But if he has a
lever, he can. The trajectory of growth has been altered, engendering a circle
of lessened wage costs leading to lesser inflation expectations, which in
turn further depress wage growth and put a brake on price increases.
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China is by far the dominant contributor to the trend. Over the past
quarter century, the rising rate of worker migration to the export-oriented
coastal provinces imparted an ever-increasing degree of wage (and price)
disinflation to the developed economies. But this also suggests that once
the shift of erstwhile centrally planned workers, desirous and capable of
competing in world markets, is complete, the downward pressure on developed
countries' wage rates and prices, at least from this global source, will
cease. In 2000, half of China's workforce was still employed in primary industry
(mostly in agriculture). South Korea had reached that level in 1970
on the way down. Today, primary-industry employment in China is roughly
45 percent, and in South Korea it is under 8 percent. If China were to follow
South Korea's historic path over the next quarter century, its rate of internal
migration (which is still rising) would not peak for another several
