Friday, June 25, 2010

Getting the Unemployment Rate Down in Uncertain Times

By now you know that I am fond of simple analogies. Economics can be really boring to most people. When I learned macro it was all about five equation systems with reduced form solutions and stability conditions. Multipliers were the rage. I think we had equation-envy – how come nuclear physicists get to have all the fun? So with the help of Paul Samuelson and others, we economists can now bore to tears almost anyone at the best of cocktail parties. Of course, we can become almost orgasmic with our physics friends over a nice pińa colada and the Heisenberg principle. .
Okay, I also love to exaggerate. But there is some truth to this. President Obama understands that VEEP Joey B. and most members of Congress want things laid out plain and simple – unemployment bad; government rescue good. Now you may not be an expert in five equation models, but there is a little bit that macro can add beyond unemployment bad; government rescue good.
When I studied macro we started with the Classical School and subsequently covered Keynes, Keynesians, Unreconstructed Keynesians, Neo-Keynesians, Monetarists, New Classical Economics, Supply –Side Economics, and JoeBidenism. I am just kidding about the last one – but all the rest are real. What was the point? Was it like a religion course where you needed to understand all the religions of the world so you could choose one or more religions that maximized your chances for salvation? I don’t know, but I think all those schools of macroeconomic thought helped us focus on the many reasons why macro and macro policy are so complicated and controversial.
Dr. Smith thinks my fainting spells are caused by a serious internal blood flow issue. Dr Jones thinks I have a mild case of the flu. The body is a complicated thing. It might take time to study the symptoms, how medicines work, and perhaps time for a little exploration inside the body. Finally the two doctors agree on the problem but then they might have different opinions about the remedy. Let’s use drug X or let’s wear compression pants. I don’t know but hopefully you are getting the point. Why should Macro be any simpler than the anatomy of a human body? After all, what we mean by macro is the summary results of all the millions or billions of interactions between buyers and sellers, and investors and renters and workers and executives and Congressmen, and so on.
We usually break down the economy into segments or markets for labor and other inputs, goods and services, money, bonds and other financial, and so on. Decisions in each market respond and react to each other. A financial change impacts interest rates. But since spending on goods depends on interest rates, a financial impact spills over into the market for goods. Firms produce more goods and that has implications for the labor market and employment. And so on. It is fun. Inverting a matrix is really cool too.
Theory helps us understand how these markets and their participants respond to stimuli. The past helps us to understand HOW MUCH they usually respond. It is very complicated – and the outcomes for tomorrow are not always going to be exactly like the results from yesterday. Though we like to think we incorporate everything important in our macro analysis – the truth is that the economy changes over time – and therefore the HOW and the HOW MUCH changes too. Controlling and forecasting the economy is like trying to hit a moving target.
This last paragraph gets me a little closer to the subject of this harangue – unemployment. Our experts keep telling us that unemployment is a lagging indicator (it must have been sleeping in school) and that in this recession, it will be even more lagging. What a laggard! How can that be? Are we suffering from some bad karma (polyester suits of the 1970s?) Why is it so much slower to adjust than in the 2001 recession; than in other recessions?
Well maybe because those past recessions were different from this one. What wisdom you learn here! What is different about this one? First, it wasn’t your usual-run-of-the-mill Main Street induced slowdown in spending. It was not particularly your 1970s supply-side contraction either. While Main Street did get impacted, the onset was a problem in housing markets that spilled over into financial markets…and then to Main Street and the Champs Elysees, Unter Den Linden, Oak Avenue and lots of other streets around the world. Second, this recession which started at the end of 2007 scared the crap (sorry about the four-letter words – please don’t let your teenagers read this) out of most of us and then when the politicians started wringing their hands on television – it REALLY scared the crap out of us. Japan had a similar kind of recession a long time ago – and some experts think they never did permanently exit it. Third, we hosed this fire with a lot of cannons. We doused it with tax cuts, spending increases, and enough money to run China for about 20 years. Most of this effort was aimed at revving up spending by consumers. Let’s buy a few more cars and houses folks. Being a good American, I chipped in heartily to the retail liquor industry – with several large bottles of Jack Daniels. Fourth, we managed to combine all this action with a health care reform, financial reform, and energy policy. The upshot of much of this policy is that some social goals will have been advanced and business and high income people will be asked to pay for it. The debts are staggering.
They can argue all they want – but let’s face it – no one thinks that the combined impacts of all that legislation had much positive impact on employment. Firms have produced and earned a little more but they have not yet felt compelled to hire many new workers. Would you? The economy is complicated and it really isn’t clear that the government improved the situation. Profits have recovered but could not possibly have erased the losses of the past couple of years. In fact, it is clear that the government has imposed some significant cost increases and regulatory burdens on firms. The government has also created an adversarial environment for many business firms – BP is only the latest victim of superficial populist government finger pointing. Of course, when it comes to the housing and financial problems that STARTED all the negative stuff – the government still hasn’t done enough to instill confidence.
What’s the point? The point is that none of this is very simple and we find ourselves in a new situation in which the past is not a lot of help. It reminds me of a pinball game with about 50 balls all careening around the table. How and where it will end, no one knows. The bottom line is that between the past macro shocks, the recent macro policies, and the expected future macro policies – we have a perfect storm of UNCERTAINTY. Unemployment is not going to improve until the uncertainty subsides. We are left with a tantalizing question that I’d love to pose to Keynes – given this environment in 2010, is the solution to reducing uncertainty more government policy or less?

Tuesday, June 22, 2010

Payroll Employment Data Releases – Will the fans go Crazy or not?

This post is a little more technical than my usual blather. It applies simple statistical theory to explain why most announcements of employment reports have almost no real significance. Notice how the market went berserk recently after the payroll jobs number for May 2010 came in under expectations. But if one examines the probability distribution of monthly employment changes, you see that most monthly changes fit into a category of “not-statistically significant” or not statistically different from zero percent. That is, I show below why even if the May figure had been closer to 500,000 jobs, the statistical interpretation would have been that this change was not different from zero! The nature of the employment probability distribution is that it will take monthly employment increases of more than 520,000 to be significant at the usual 95% level. That means that it would take even larger gains to be significantly different from zero at the more exacting 99% confidence level. The upshot is that there is a good statistical basis for why the markets do not react optimistically to most employment announcements…and why they might react negatively if they had hoped for real progress.
To come to these conclusions I used monthly data from Jan 2000 to May 2010 – a total of 125 months of data. I used the Total Non-Farm Employment from the Current Employment Statistics Survey ( ) . Employment started at 130.8 million in January 2000 and ended at 130.6 million in May of 2010. Employment experienced some cycles – a peak at 132 million in 2001….falling to 129.8 in 2003 and then rising to 138.0 million in 2007. It hit bottom again at 129.6 million in 2010 and rose to 130.6 million in May.
The average monthly change was .002%. The mode and median were also approximately zero percent. The distribution of percent changes were gathered around zero percent – with 80 of the 125 monthly observations ranging between -0.1 percent and +0.1 percent. This means most monthly changes, if annualized (without compounding), were about 1.2%. In all, 55 observations were plus – ranging from 0.1 percent to 0.4 percent. There were 36 negative changes ranging from -0.1 percent to -0.6%. This implies that the distribution ranges farther to the left but the mass is to the right of zero.
The distribution is not symmetrical but it looks normal with the fewest number of observations at the extreme left and right. The standard deviation of the percent changes is 0.19 percent. To be two or more standard deviations from the mean implies a monthly percent change of more than 0.38 percent. That is, it takes a monthly change of about plus or minus 0.4 percent to be statistically different from the mean. Since the change in May 2010 was about 0.3 percent, it was not outside the 95% confidence interval and thus was not statistically different from zero. With a current level of employment near 130 million workers, it would take an increase of about 520,000 jobs to be statistically different from zero. .
I also evaluated the probability distribution function for private jobs, which exclude government employment. With a current level of about 107.6 million jobs, it would take an increase of 471,000 jobs in one month to be statistically significant. Job increased by about 41,000 in May.
The upshot is that employment changes are tightly clustered around a mean of zero percent. Not many months between 2000 and 2010 have shown large percentage increases. A change of around 600,000 jobs in a month would represent a change of about 0.45 percent and would be statistically significant. It would also imply an annual increase – if kept up for 12 months – of more than 7 million jobs. It will take employment increases in this range to wow the market.

Thursday, June 17, 2010

May data evidence of housing slump?

Below is a quick graph I made (thanks to a data service called FRED at the St. Louis Federal Reserve Bank) Wednesday morning after seeing my wealth once again vanish in an early morning stock market session. There appears to be much hand-wringing over the fact that housing starts in May 2010 came in lower than April’s number – and lower than expected. One Bloomberg story said “…housing is mired in a slump.”The May starts were 593,000 units. So I went to the Census web site to see what the data said.
I decided to focus on the monthly data from January 2008 to May 2010. The data are seasonally-adjusted. It is true that starts fell in May. The decline was pronounced. But what else was true? First, the 593,000 starts figure was not zero! Lots of housing was started in May, 2010. Second, the 593,000 was a bunch higher than January 2009 – in fact about 22% higher. The May 2010 value was also 8% higher than the year earlier May 2009 value of 550,000 starts. Fourth, the 593,000 starts were higher than 13 of the 17 months in my chart – the other four months were very much affected by the end of temporary government subsidies. We can’t really know why the stock market started so low on May 16, but it does cause one to pause and wonder why this housing market information would be interpreted as a negative economic signal. I concur with others that the housing market is critical and I share frustration that it has not sprung back faster. But the graph is hardly a picture of a slump and it wouldn’t hurt for more people to see that housing starts since January 2009 have followed a very positive trend line. The data vividly shows how one month can iron out much of the sales lift of a temporary stimulus. A big question now is whether or not housing buyers will stall their coming summer purchases – knowing that if they don’t buy soon, Congress will rush in with another package.
Note -- as I view the chart on my computer -- it is not all visible. I cannot seem to get it to fit right. I can see most of the data points but not those for 2010. So here are the data for January through May 2010 -- 612,000, 605,000, 634,000, 659,000, 593,000.

FRED Graph

Tuesday, June 15, 2010

Don't be an Unemployment Swinger

Today on I saw this article – “Unemployment Hurts More than Inflation" David G. Blanchflower, former member of the Bank of England’s Monetary Policy Committee.
Blanchflower’s main contention is that we should not worry about inflation now, instead focusing on the need for more policy stimulus. He actually says, “…inflation is a bygone era.” And then he adds, “Inflation is the only show in town right now. Monetary stimulus needs to continue and if that means more inflation, that would be fine, certainly for now.”
Here are a few more Blanchflower quotes…
· Inflation does redistribute wealth from savers to borrowers – but that’s okay.
· Unemployment hurts twice as bad as inflation
· There is little evidence from any developed country that inflation at today’s level ever turns into anything catastrophic.
His main point is pretty clear – don’t worry about inflation – it is actually a good thing. Unemployment is the real worry. As for that last bullet, I wonder how inflation got to 100% or more in some countries if it didn't start from a low level....
I could say a lot of things but today I want to focus on one point – that there is plenty of evidence from the US and other countries that suggest that expansionary aggregate demand policies aimed at reviving spending during recessions often turn into cycles of higher inflation. We have had such a cycle after every recession of the last 40 years. The reflations did not necessarily follow immediately but the urge to keep stimulus going longer than necessary inevitably contributed to economic growth that was faster than normal and rising inflation. Have these bouts of reflation turned into hyperinflation? No, they haven’t. Because policymakers were worried enough that inflation would become a major problem that they changed policy directions and made inflation public enemy #1. And what happened after that? The growth of the economy slowed and unemployment began to rise again.
A short-hand way of summarizing this post is that policies designed to reduce unemployment tend to raise unemployment. If people like Blanchflower explained things that way maybe we wouldn’t be so anxious for the next bout of stimulus. Instead they divert our attention to unemployment being more painful than inflation. That’s not the point. The real question is is how do you keep the rate of unemployment the lowest in the long-run? How do you keep it stable and predictable enough that we don’t have to experience these severe swings in unemployment? In times like these, a little less stimulus aimed at rising unemployment and a little more worry about eventually rising inflation could go a long way to keep the unemployment rate lower and more stable over time.

Thursday, June 10, 2010

Get off the Keynes Express NOW! Or not.

Here’s a quick post for this week. Jeffrey Sachs published an interesting article in the Financial Times on June 8, “A farewell to Keynes.”
Though his title makes it sound one-sided, it is worth reading the whole article because he is very even-handed (in my opinion) in political terms. Sachs is tough on Keynesians since he argues that most of the recent fiscal remedies were useless if not counter-productive. And he gathers up a bunch of evidence that shows how much the world is moving toward fiscal conservatism. While most of us are familiar with the fiscal rectitude being forced on Greece and Spain, Hungary recently jumped in line. Germany also just announced a major reform that promises to put a major crimp in spending, especially on welfare. The G20 nations met recently met and revealed a new position away from fiscal stimulus to fiscal sustainability. The OECD has been preaching both fiscal and monetary restraint. Meanwhile we see reports of the US National Debt approaching 100% of GDP, perhaps in 2011 yet with little discussion of anything but fiscal expansion in the face of worries about a double-dip recession. Many analysts believe the US government is incapable of fiscal restructuring. And plenty of experts keep advising against reversing course. For example, Bernanke explained this week that the FED has no plans to begin increasing interest rates until well into 2011. Others are focusing on deflation – warning that the US has more to worry from deflation – and that underlies their prognosis of continued stimulus. These folks are apparently still on the "Keynes train" with no tearful departure in sight.
What makes Sachs’ article even-handed is his recommendation for what could and should be done in the US to avert a Greek-like sovereign crisis. His main point is critical – he advocates starting fiscal restraint now, though he recommends phasing the changes in over five years. He advocates a supply-side approach to jobs and a sobering recognition that real progress could take many years. While he does not directly ask for more spending, he acknowledges that government must have adequate social policies, investment in education, and green energy. He indicates that the rich will have to pay more in terms of income and wealth taxes.
While Sachs sets out some broad guidelines he is not very specific about how to restructure fiscal policy – how to use spending and taxes so as to create his start now-medium-term plan for reducing government deficits and debt. But what I like is that he readily admits that we must immediately turn from stimulus to fiscal control. I am not sure that the US government believes him – at least not yet. In relative global terms, the US continues to be a flexible economy and a safe haven for assets. This let’s our government leaders continue their bets on stimulus while they stall on fiscal reform. But when the headlines announce we have not made progress on deficits and report debt of 100% of GDP – our relative halo may quickly disappear and it might be too late to heed prudent advice.

Thursday, June 3, 2010

How to become a scratch golfer with one club

I decided in retirement that I should become a scratch golfer. I am not sure what that means but it sounds good to combine playing golf with something fun like scratching. So I went to my friend Bob and he gave me one club – a nice driver that was in the corner of his garage. I dusted off the cobwebs and he looked at it fondly remarking that was all I needed. If I could master that wooden driver, I would become a scratch golfer. He then pointed me in the direction of a golf course.

Is any of the above true? Of course not. But it reminds me of what I am reading frequently about exchange rates. If Greece could just replace the euro with the drachma again all things would be okay. With the dollar rising against the euro, US pharmaceutical exports to the EU will be dramatically hurt. If China would just revalue the renminbi against the dollar, then the US would become a major exporter again. People who are saying these things should be smacked with a wooden driver. You can’t be a great golfer with one club and you can’t salvage a country’s economy by depreciating its currency.

How can I make fun of exchange rate wisdom? Is it wrong? Actually it isn’t technically wrong but it clearly suffers from either wishful or overly simplistic thinking. Let’s suppose that Jose lives in Paris and he really loves French wine. If the value of the dollar falls, will Jose stop drinking French wine and buy a couple of cases of Mogen David? Probably not.

So what’s this exchange rate idea all about? It begins with the idea that some goods are highly tradable across country borders. To some people, a bottle of merlot is a bottle of merlot. They don’t care where it got produced. They walk up and down the wine store aisle talking to themselves until they finally make a choice. To many people, the beauty of the label might be the deciding factor. To others, the price makes a big difference. So if the French wine costs $12 and the California wine of roughly equivalent quality and label beauty costs $10, then this time they buy the local USA product.

So where does the exchange rate come in? The US wine’s price of $10 (from our example) will be determined mostly by domestic factors in the USA – cost of grapes, labor, etc. The dollar price of the French wine sold in Kroger in Bloomington Indiana (the $12 in the example) is based on two things – (1) the cost of the wine bottle in France in euros (mostly determined by local French wages, cost of grapes, etc) and (2) the euro/dollar exchange rate. Putting this all together, the decision to buy the French or the US wine depends on three things:
1. The price of the USA wine in dollars
2. The price of the French wine in euros
3. The euro/dollar exchange rate

This little story helps to understand one thing – the exchange rate is only one of several factors that might impact international trade. For example, let’s suppose Greece has a drachma and suppose they let the value of the drachma depreciate. Would that help Greece sell more exports to the world? On the surface it seems it would. If nothing else changed, that would make Greek goods and services less expensive to consumers living in Europe, America, and the rest of the world. Cool. But as some of my intelligent friends are used to saying – “ceteris aint paribus”. Which is another way of saying that too many people have PhDs – and another way of saying that not everything stays constant.

For example, one reason the drachma might be depreciating today is because local conditions yesterday in Greece made Greek goods very uncompetitive. Thus the drachma price of goods might be very high in Greece. Sure, the depreciation of the drachma might help restore Greek competitiveness, but it might not fall enough to make a person in France want to buy the Greek wine over the more efficiently produced French variety. Or…suppose the drachma depreciates and people begin to buy more Greek wine. How might French wineries react to this? If they don’t want to lose business they might react competitively and reduce the price of French wine. That would make Greek wine less desirable and would reduce Greek exports.

Putting with a wooden driver isn’t very smart if you have some other clubs in your bag. Depreciating a currency might not be enough to improve your exports if international trade also depends on prices of goods and services at home and all over the world.

I wish that was the end of the story since it is getting close to the time of my daily afternoon nap. But let me just say a little more. Let me pull out my nine iron. J LOL…Anyway, there’s more to the story. Let’s suppose the drachma depreciates – how does that affect all those Greek companies that buy materials and resources from other countries? The weaker drachma makes everything these companies buy from abroad more expensive. So if these companies pass along these increased costs into their goods, then it causes more inflation in Greece and makes their goods less competitive globally. Surely this is not good for Greek exports. Finally, if the drachma depreciates, think about what happens to foreign companies who produce goods in Greece. Those companies regularly convert their drachma profits back to the currencies of their home countries. When they do, the depreciated drachma makes their earnings in home currency smaller. Yikes, the profits of a Greek location look worse compared to producing in Latvia or Croatia. What happens if these companies pull up stakes and do their production and exporting in other countries?

Okay – so hopefully I made my point. You wouldn’t go golfing with one club – so please don’t listen to these snake-oil salesmen who want you to believe that a simple appreciation/depreciation of some currency is going to solve all our problems.