Thursday, October 7, 2010

A Circular Flow of Ideas and Backward Thinking: Should we attack unemployment first?

This week the news is buzzing about the next jobs announcement. Once the jobs number comes out on Friday morning planets will fall from the sky and well-behaved dogs will bite. I am sure of it because I saw it on CNN. While the House of Representatives will want to enact new laws to protect us from falling planets and viscous dogs, I am more worried that they will do something about the economy. Since they have the story backwards one can only expect more bad ideas in the next sack of legislation.

As I am writing I don’t know what number they will announce for jobs this week – and I don’t pretend to know its value. I can hardly forecast how many times I will get up to pee at night – so how would I know the future value of the unemployment rate?

What I am spouting about has more to do with the idea that if the number comes in as expected (or worse) people will increasingly worry that the lack of strong job growth will further restrain consumer spending and we will be stuck in macro purgatory. So if I can use a little professorial pedantry – I would write on a white board (what was wrong with black or green?) the following to describe the theory behind all this:

Employment → Consumer spending

I apologize for this little fit of mathematical elegance but this is the macro-theory all the talking heads are brandishing. The arrow indicates the direction of causality. This might seem pretty cool but the simple truth is that it is wrong and its policy implications are wrong too. This theory suggests that if policymakers could just find a way to increase employment then more workers would have more income and they would go out and buy lots of diamond earrings, steering wheels, and full body massages. And that’s just the firecrackers. When the first round of fireworks ends – then all those manufacturers (of earrings, steering wheels, and massages) will hire more workers who will buy even more stuff (stuff is a very technical term used by sophisticated economists). Before you know it, the unemployment rate will equal 5.5% and government can declare a holiday and take private jets to exotic islands with their stenographers. Note the essence of the theory – we start with a policy aimed directly at employment and that will generate more spending – and even more employment.

What could be wrong with this theory? To answer that question we have to take another sip of JD and review one of the first simple models first taught in dank caves in prehistoric times called the circular flow of income. In its simplest format, it can be expressed without calculus or a neutron microscope as follows:

Employment → Consumer spending

Consumer spending→ Employment

Here is the crux of the issue – this is called circular flow because there is no beginning and there is no end. We just go around and around and around and around. That’s fun for a while but at some point you wonder if there is some way to stop the merry-go-round because you are late for dinner and your honey doesn’t know that you are at the Office Lounge drinking beers with your students. That’s a no-win situation.

So you look at the model and try to decide where to interrupt it. Here is where such things as common sense or cause & effect come into play. If the circular flow is moving too slow – then the first question you ask is WHY. What is CAUSING consumers to spend and firms to hire workers at a slow rate?

Maybe I am way off track, but it seems to me that the answer has something to do with the recent history of the US economy. Consumers and firms took on too much borrowing/debt/ leverage and got themselves into financial trouble. Of course it is much more complicated than that – but the issue here is which of these two alternatives do you think was the main CAUSE of the slowdown today? Did all this get started because firms decided to lay off workers? Or did we get into this mess because of a financial collapse that led to consumers and firms being unable to continue spending and borrowing as they had in the past. I think the latter is the true cause -- we had a Wall Street Problem that spilled over to Main Street and employment. It was NOT the reverse.

If that is true, then it makes no sense to direct our immediate attention to employment. It reminds me of the physician who comes upon a person who is bleeding profusely from a bullet wound. He is screaming at the blood – “get back into that hole”. Surely, the patient would be helped if he had his blood back. But the doctor would have been more helpful if he attended to addressing the cause of the blood flow – a bullet they opened a wound. It would be better to remove the bullet and close the hole.

If the CAUSAL variable was really the finances and spending, then we should start there. And this is the real challenge right now– how do you make consumers and firms want to spend more? First, notice that since too much spending was a CAUSE of this mess – it hardly seems rational that simply encouraging consumers to spend more could be a solution. So the first part of logic is to accept the fact that households are going to take some time paying off debt and restoring saving before they run out and buy three Lexi (plural of Lexus) and a vacation in French Lick. The data show that households are doing just that and while they are not spending a lot, there is some further recent evidence that there is solidification and gradual growth. In short, if you want households to be more optimistic and you want them to spend more – work on the remaining issues with respect to the housing and financial problems and have some patience.

The second way to improve household psychology is to stop confusing people. I realize we have an election coming up and there are important reasons for the two political parties to clarify their separate and highly superior ideologies but there is just too much uncertainty arising from all this political clatter for households to believe that all is really getting better. Isn’t that sad that things really are getting better but our government is making it almost impossible to believe. And this gets me back to all the talk about the coming employment release. If the number is considered to be a bad one – it will be a lightning rod for even more activism by the President, the Congress, and the Fed. Unfortunately, the popular and wrong thing for these policymakers to do is to try to intervene in labor markets and/or induce households to spend at a rapid rate. This will create even more uncertainty and push them farther away from what we really need.

The employment market did not break down and cause our ills. It makes no sense to begin there. Households are waiting for their own financial situations to improve and for some certainty that the economy is improving. Policies that patiently and realistically address the true causes of a slow circular flow of income are the only ones that have a chance of succeeding now. More fireworks may burn down the barn!


  1. Rather than spending federal $ on job stimulus, how about just paying off the consumer debt? But if that's what should happen, please let me know in advance so that I can run up some debt. (cases of JD on my credit cards)

  2. You must be Un-American Jim if you have not already run up your debt. There will be no help for un-Americans in the next stimulus bill. But in your case if you were to send some of those cases of JD my way, I might make a call for you.

  3. Hi Larry, been a while since I've responded. But I read this from the WSJ this AM and it confirmed what I've already been thinking (with all the talk of a new round of "Quantitative Easing":

    My opinion, Bernanke and the Fed are out of options in Monetary policy and they are just trying to find more and more creative methods of flooding the economy with cheap money. They are deliberately goosing the money supply and would love to see inflation numbers move up. And yet they will continue to bemoan the growing trade deficit! (I hate Weak Dollar policies!)

    But corporate profits have been doing pretty good the last 18 months or so and yet consumer spending is only incrementally better. Corporations and investors are sitting on hoards of cash (or more correctly gold index funds). So why are they not investing in productive assets? I now believe there is a deliberate capital strike going on now and that capital will stay on the sidelines until the government starts acting in a responsible manner.

    A loose monetary policy may have stabilized the system and prevented a collapse. But once stable and growing (albeit slowly), the only thing a loose monetary policy does is set the stage for return of inflation. And if employment continues to lag, then Disco should be king again as Stagflation will be back!

    The uncertainty created by our government's unsustainable fiscal policy is the single largest barrier to investment and higher growth. And it will probably take a crisis in that area before our government gets around to addressing it in a meaningful manner.

  4. John, you and I see this the same way. But it is even worse than you say since the rumors of QE2 are already having negative effects. Basically all that money that is supposed to be goosing up the economy is flowing out of the US and revving up other countries. In the meantime the dollar is streaking downhill. That might eventually help our exports but right now we need broader based strength. QE2 = Titanic?