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?


  1. Well my bud Little Al from Jersey who use to control most of the action around Princeton use to say you need to make things as simple as possible, and no simpler.

    I always thought the reason employment was a lagging indicator was sticky wages. I also thought the Austrians thought there were way too many "inputs" in a good macro model to make it useful as a predictor. So much for making things as simple as possible, but no simpler.

    But what concerns me most about economics is no matter what school you like, what equations you use, or how good your data collection is you still have to assume rational action by people.

    This is why physics (and even more so math which was my undergrad degree) have an edge over social sciences. Lots of times peeps don't act rationally, while numbers do (unless they are irrational numbers).

  2. Nice points Tom! I like your point about the sticky wages -- and there is some truth to it. But it is old fashioned to speak that way. Since we always mix social policy and economic policy now-- most of our leaders would not think of letting wages fall to clear the market.

    I wish we had a couple of JDs and cigars so we could properly discuss this rationality thing. But let me try anyway. Keep in mind that rationality is not such a restrictive assumption when it is applied to the aggregate. But even if you don't buy that line, you have to replace it with something else if you want to get predictive content. So what do we assume? Should we assume that people would generally rather have less than more? That people would rather have lower satisfaction than higher? When dealing with the aggregate -- 300 million people -- rationality is not so bad. Finally Milton Friedman made the point that it is not the assumptions that matter anyway. What matters is the usefulness of the theory and its predictions. If you don't like economics -- Friedman says to criticize it for its outcomes.

    With respect to hard sciences, let me remind you that physics has changed its mind about relativity more than once and that elections do not always behave the way they should. WE still don't know much about what caused the beginning of the solar system. And of course, our friends in the medical science still do not know how to stop the common cold. Economics is far from perfect and other folks have exaggerated its power to predict the future -- but I think it is a pretty good tool...and it is paying my rent!

  3. Don't get me started on the Standard Model. When some one tells me that dark matter and dark energy (which we can't see and are suppose to be composed of particles we have not discovered yet) have to make up ~96% of the mass of every galaxy we have so far observed to account for the angular momentum of those galaxies the most obvious conclusion I can draw is that we got gravity wrong, again.

    When my bud Little Al proved there were errors in Newtons laws that did not stop NASA from using Newtonian Mechanics to land peeps on the moon since the math was a lot easier than using Einstein's formulas, and the results were accurate enough to get men to the moon.

    But enough nerd talk. Getting back to sticky wages and rationality in economic models, it seems to me that sticky wages make rational sense. Employers are slow to increase wages after an economic down turn so hiring more employees lags. But as you point out the pols don't buy that because they would lose votes. So the pols act irrationally and make bad economic decisions to stay in office.

    I do agree that in the aggregate masses often do make rational economic decisions, especially from their personal standpoint (assuming they have perfect information, or even fairly good information). The problem is that it is almost a given that pols will not make rational decisions.

    Just today Dodd and Frank announced a new bill the Dems are pushing that is suppose to deal with new financial rules. Dodd's comment was "No one will know until this is actually in place how it works." To make matters worse the bill ignores FANNIE and FREDDIE, arguably the biggest offenders in the current economic problems.

    You are probably better able to provide details on the 10 most irrational economic acts by pols. But I don't see how economic models can take into account stupid pols and their irrationality.

  4. And I thought the reason unemployment was high is because there aren't enough jobs!

  5. I love that nerd talk! I was thinking more about my previous points about hard science when I thought of superconductivity and cold fusion. While the latter was a fairy tale I understand the former is real-- but coming very slowly. So it must be a lagging indicator. Why don't they get that working so we can have free infinite energy? That would be a big help.

    Your Dodd quote is reminiscent of a Pelosi healthcare quote. What is with this idea that we are supposed to trust those guys? As for Fannie and Freddie, they seem to have defined that away as a separate issue. Trust them! They will make all our hurts go away.

    Your last point raises the right issue. Keynesians want to assume the government is infallible and trustworthy when it comes to government spending, taxes, and debt. Monetarists and Classicals (Austrians too) do not assume that policymakers act rationally or without self-interest. Thus, not all of us use models that assume rational politicians.

  6. Crashmore -- nice to see that this blog is educational for you.

  7. Larry, I think there is definitely a capital strike going on worldwide. Whether the Illuminati (or pick your own secret organization) is behind it or not is irrelevant. But your key point on uncertainty is spot on. Economic uncertainty has risen to such levels that it would be almost clinically insane to invest in high-risk projects when the prospects of any positive return will be wiped out by either higher taxes or inflation (or heaven forbid both).

  8. And so might your point enter into today's policy discussion? Does it suggest more or less stimulation?

  9. Larry, the "market" is looking to Big Brother for positive steps to reduce the uncertainty. So any incremental move towards REAL fiscal responsibility will be warmly greeted by investors.

    Stimulating the economy doesn't necessarily mean dumping another hundred billion or so taxpayer dollars into the paychecks of public sector union workers. There are relatively simple things that would encourage investors to take money off the sidelines, put it in play, and create jobs.

    First, extend the Bush tax cuts. Obama might just twist enough arms in Congress this fall to make that happen. That would be a purely political calculation however: give the Dems one last positive impression before an angry electorate goes to the polls.

    Second, we don't have to forswear deficit spending altogether. Just keep the yearly deficits to less than the long-run average for annual GDP growth. As long as GDP growth % is greater than deficit spending % of GDP, then deficit spending is sustainable. But once the deficit jumps that shark, it ain't sustainable.

    Now the latter is certainly the harder pill for Obama to swallow as he doesn't want to admit just how much his agenda (Obamacare, FinReg, Cap&Trade, etc) has inflated the uncertainty out there.

    Finally, there should be an certification examination for all members of Congress. They must pass the equivalent of a final exam of Macroeconomics 101! If they don't, throw 'em out. No more economic numb-skulls allowed in Congress!

  10. Good food for thought John -- especially the third one!

  11. With new numbers out on July 2, it surely isn't getting any better. Have a look at his analysis from by second-favorite economist/writer:


  12. Hi Jim,

    Thanks for passing the article along. It is an interesting piece. We are in a recession and we are getting less than helpful policy. So things are grim. But my take is that most of us knew this would be a special recovery -- slow and fitful. Yes, many compare current conditions to past recoveries. That makes things look even worse. We are in a recovery -- just a crappy one and it does not necessarily imply a double dip or an endless recession. If people recognized this then maybe they wouldn't be so ready to accept another wasteful stimulus package. I hope you are having a great 4th.