The Tail is Wagging the Dog

Two weeks ago I proclaimed that macro was sleeping and wouldn’t you know it, all the news lately has been about macro policy. Much of the discussion among economists and journalists shows that macro must have one eye open. These policy discussions are as confused as I have ever seen them.

Here are some of the themes. First, the Fed is pretty sure that inflation is going to rise above the cherished 2% target, and they will have to attend to a potential inflation monster with a more aggressive monetary tightening. But then they admit that inflation is not roaring back yet and there is always the worry that a rough policy would lead us into a recession. Second, recent economic growth news from the UK and Germany have us worried that global growth may be in a new tailspin. Just days ago, we were worried that the world might grow too fast. Wham bam – now we are not so sure. Third, we might be headed into a global trade war pitting the US against China, Europe, and several far-off planets. Or maybe not.

Isn’t macro policy fun? It is true that all of us except for John Travolta cannot see the future, and economists always disagree about best policies for any given 7-minute time frame. But today we find ourselves more confused than ever. Why does macro seem so lame these days? What happened to our rocket science?

My explanation begins with the vivid notion that the tail is now wagging the dog. Nolan knows that a dog is supposed to wag its tail and not vice versa. The dog is short-term macroeconomic oscillation. The tail is everything else. It used to be that everything was about the dog. Central banks and treasuries are laser focused on short-term macro stuff. Is the consumer going to be happy this year and buy another car? 

Will tax cuts cause consumers and businesses to spend more? Are firms going to build inventories? Will rising oil prices rob consumers of money they could spend on JD and potato pancakes? In that world, the dog is our focus and we use monetary and fiscal policies to buff up spending when conditions are weak and the opposite when people are spending too much.

But the dog is a mere pussycat today. And the tail is roaring. The tail is the aftermath of the worst world recession that the Tuna can remember. The world economy never entirely exited that recession. We lumber along. Some wonder if capitalism is doomed. Others worry about the lack of enthusiasm firms have for buying new and exciting equipment. Then there is that debt overhang from beer-guzzling college students to pot-smoking boomers with hip pain.

This dragging tail of an economy is also weighed down by a disenchantment of both the young and old for the labor force and the nonchalant attitudes about investment and the resulting lagging productivity gains.

The sad fact is that our dog-oriented policy makers are in the dark when it comes to the tail. They know how to fix the dog and that’s where they focus their attention. If you are a hammer, then every problem is a nail! But dudes, it ain’t the dog. Focusing on the dog means you miss the point. Focusing on the dog means that you are confused by the macroeconomic data. John Maynard Keynes said that we are all dead in the long-run so we should focus on the short-run. But today the tables have turned. We seem to be very alive in the long-run, and the short-run will be a very dull and confusing place if we don’t take care of the future.

Like a 24-hour news cycle, the Fed is always in our thoughts. But the Fed has little to do with the long-run except to provide ample money for long-term growth. All this noise about whether they are going to raise rates 3 or 9 times this year sells soap but is mainly a distraction. Whack-A-Mole economic performance in the US and abroad is similarly uninteresting. The world economy is stuck in neutral, and it has everything to do with longer-term challenges.

We need to put Keynesian economics to bed. It’s hurting our sleep. Let’s require all decision makers at the Fed and in Congress to take a course in long-run macro. But that’s silly. I doubt most of them are smart enough to understand it. And none of our 24 hour news station would find it interesting enough. 

Out of the Economic Wilderness

Things go in stages. I remember a time when I put a lot of gunk on my hair so it would stand up straight in what was known as a flat top. Then I had a wave. The Air Force preferred something closer to my scalp. Post-Air Force, I let it grow for about four years. My hair had a lot of stages. Today, well, there are a few spots missing here and there.

And so it is with economic thought. I had the luck of taking a wonderful course in the history of economic thought at the University of North Carolina. A main goal of that course was to see that economic thinking evolves over time and very much reflects the natures and problems of a given time or place. This recognition of the temporary nature of economic ideas gives one some confidence that whatever the prevailing wisdom might be today, it is sure to be supplanted by something else in the near future.

As a graying economist, I have seen lots of change during my career. When I was at the University of Arizona getting a masters degree (while stationed in Tucson with the Air Force), the bravado of Keynesians was revealed in their confidence about the accuracy of forecasts of Keynesian models. Keynes had reacted to the failure of previous so-called Classical Models to explain the Great Depression. But it was the eventual failures of Keynesian models that led to a host of competing theories by unreconstructed Keynesians, monetarists, and supply-siders.

Today, we have a mish-mash of models with elements of each of those schools of thought. But there is a very clear and common thread among them that focuses on the apparent short-run instability of advanced industrial (rich) nations. We argue among ourselves about the proper policy in a given country at a given time but the argument is framed within a short-run model that encourages us to focus on moving the economy back to short-run equilibrium. If inflation is running too hot, we try to bring its temperature back down. If the economy is languishing with high unemployment and slow growth, we give it a pep pill. The pill might be designed to alter short-run demand or supply but the focus is always on overcoming an undesirable stage of an economic cycle.

This bouncing around has gone on in the USA at least since the early 1960s when John F. Kennedy announced his famous tax cut that would move us out of a recession. Since then, we have handed the policy ball back and forth between quelling rapid inflation and stimulating recessed spending. One byproduct of this has been a dizzy economic experience. Another offshoot is a national debt that reaches for the sky. There have been a few times when the debt as a share of the economy abated somewhat, but mostly it rises and then rises more. Today, it approaches 100% of the size of the US economy and promises to go even higher than that.

I think the dizziness plus debt is wearing us out. Worse is that it is becoming more and more obvious that this preoccupation with the economic cycle is distracting us from recognizing and treating what has become the new scourge of industrial nations. Today, we debate whether the economy is too strong or too weak. Today, we debate whether or not to have stimulative monetary policy. We argue about the stimulative impact of rebuilding the nation’s infrastructure. Imagine all those workers paving during the day and spending at night! 

But the truth is that short-run policy never seems to accomplish anything as we careen from recession to expansion back to recession. And worse than that is that the experience of industrial nations has changed. Whether this change was brought about by industrialization or by globalization, the result is that we are weakened by modernity. Our ability to grow is at risk. Our main economic challenge has gone from trying to reduce the amplitudes of economic cycles to raising our long-run economic growth path. Last week I used the example of a long distance runner. Let’s try it again. You want to win the marathon. To run 26 miles at a fast enough pace to win, you don’t swallow a handful of sugar. You train hard. You build your wind capacity and your muscles.

We are familiar with the difference between short-run and long-run policies. While the richer nations have been toying with cyclical policies, the poor developing countries knew they could catch up only if they focused on long-run structural issues like energy, transportation, legal systems, and so on. Before they could provide adequate incomes and opportunities for their citizens, they had to build a modern infrastructure. Now it is the industrial countries that need to rebuild to meet the challenges of the day. We should replace our short-term focus with longer-term ideas.

What does that entail? The remedies should mirror the problems. Everyone seems to acknowledge that modern competition has reduced the demand for workers in the US and in other rich countries. Despite the fact that the US unemployment rate is very low, we acknowledge that too many people have dropped out of the labor force, taken jobs beneath their skill levels, or work part-time when they prefer 40 hours per week. This is clearly not a short-term issue especially when we know that technology is bringing robots on that might be smarter and prettier than your average macro professor.

This labor supply challenge is constantly on our minds but we process the information with old and worn-out models of the short-run. We continue to ask for more of the same policy gruel – juice up the money supply or give the middle-class a tax break. But we are not in a recession and we don’t need policies that cause the national debt to grow even more. What we need is to reorient the way we think. 

Tending the economic cycle does not create more sustainable economic growth. Economic growth is the salve that soothes but economic growth requires an understanding of how to compete in a high- tech world that wants to replace human hearts with robot brains.

We had to figure out how to evolve from an agricultural to an industrial economy. The transition was not pretty but we had to quit thinking about wooden plows and mules and focus on tractors. Now it is time to figure out how to move from the tractor to the driver-less, sun-powered robot. Arguments about traditional monetary and fiscal policy while creating mountains of debt, are not going to help. Where do we find someone to lead us out of the wilderness? Who understands that in the long-run we are not dead?

Economic Growth Confusion

Mixing apples and oranges doesn’t sound too bad until you start making an apple pie. That’s the way I feel about the careless use of terms like "economic growth". Economic growth has so many meanings that it is easy to confuse people. These misunderstandings are particularly troubling today, because of the implications for growth-caused inflation and interest rates.

It is common to discuss the growth of the economy. You can talk about national growth last quarter or last year. Or you can average it over many past years. Forecasters discuss economic growth in the coming year. All that is fine.

What is not fine is mixing these popular uses of the term economic growth with the outcomes of an economic growth model. An economic growth model’s output is probably misnamed. What it ought to be called is JD. No, that’s not right. It ought to be called "long-run economic growth". 

A growth model is a simple mathematical expression that posits that economic growth is equal to the sum of the growth rates of the labor force plus the growth of labor productivity. (Note there is something called a two-factor economic growth model but that complicates matters beyond my meager goals today). Let’s write the economic growth equation:

  Long-term Economic Growth Rate = 

  Growth Rate of the Labor Force

                         

  + Growth Rate of Labor Productivity

Don’t you just love equations?

I use the word "long-term" to make a point. This equation is NOT meant to explain or predict changes in a nation’s output (real GDP) from day to day or from year to year. It is meant to explain how our permanent or sustainable capacity to produce changes over fairly long periods of time.

You could ask, How will economic growth in the next 10 years differ from the previous 10 years? That would be an acceptable use of the growth model described above. When answering that kind of question, the growth model ignores lots of short-term distractions and focuses on what it takes to permanently alter the capacity to produce goods and services. It is inherently supply-side-oriented. Clearly how much labor you have available is critical to sustain an ability to produce. The productivity of labor matters too, and that productivity is very much influenced and determined by how the quantity and quality of capital (plant, equipment, software, etc) change.

The trouble comes when people use discussions of the economic growth equation to talk about the next year or two. Capacity growth is important to next year but so are a lot of other things. For example, low labor force participation might endanger economic growth in 2018 but to focus too much on that one indicator is to not be playing with a full deck of cards.

What is the full deck of cards? Macroeconomic models we use to explain and forecast short-term changes in output (and prices) generally focus on events and factors that impact both the demand and supply of goods and services. A tax cut for moderate income people might encourage them to spend more and therefore impact demand. An increase the energy prices in 2018 might cause the cost of running factories to increase and lead to impacts through the supply of goods and services.

The full deck of cards includes Jokers, Queens, and Kings – and anything and everything that might influence our desires to buy and to sell. Thus, it is possible and desirable to intertwine long-run supply-side factors with the many short-term factors that will impact economic growth. To ignore the short-term changes is to imperil our judgment about the short-run.

The upshot of this is that output growth next year could be much faster or much slower than the long-run model predicts. When we hear the words "capacity output", we think of some kind of physical wall or constraint. But the truth is that for a year or two, output can grow much faster or much slower than capacity. How is that possible? 

Think of a distance runner who knows his sustainable pace for the long race. Call that long-run capacity growth. But think what happens at mile 17 when his arch rival moves ahead of him. For a time, he may run much faster than his overall pace to psychologically attack that rival. If he tries to sustain this high rate, he will run out of gas. But he can dig deep for a little while. Similarly, capacity might be growing at 2% per year but the economy could grow faster than that for a little while.

In the economy, labor force and productivity determine the sustainable long-term pace. But in the short run you can jam more workers into stores and factories than can be sustainable. Think of December when so much output gets sold. That’s not sustainable over the whole year.

The main confusion today is about how faster economic growth might influence such things as inflation and interest rates. Suppose spending kicks into higher gear while capacity moves like a snail. In that case, one might predict stresses leading to higher interest rates and inflation. Instead, suppose spending grows faster while short-run supply does the same. In this case, the economy is not stressed and there may be no additional pressures on inflation and interest rates.

Energy, business deregulation, some of the elements of tax reform, as well as the residual impacts of a global surplus suggest a national supply response that will not bring along the usual increases in wages, interest rates, and inflation. At least not right away. All this could change in a year or two and then we have plenty to worry about. It might be a good idea for policymakers to goose the long-run growth model faster. We will need that extra permanent capacity to keep the economy from strangling itself. 

Notice this implies nothing for the usual monetary and fiscal policy and everything about how a country improves its labor force –  its size, its quality, and its productivity. 

IMF says Global Economic Upswing Creates a Window of Opportunity

The International Monetary Fund publishes a world economic outlook every six months. The latest one was just published this month (https://blogs.imf.org/2017/10/10/global-economic-upswing-creates-a-window-of-opportunity/ ) and is entitled "Global Economic Upswing Creates a Window of Opportunity".

This report is not for the faint-of-heart as it is long and treacherous and filled with words and phrases like "raising potential output" and "strengthening international cooperation". Far be it for me to summarize the most current document but I thought I would copy a key table (see the bottom of this post) and then go on and on a bit about some of that.

First, notice that the title of the table says the global recovery is continuing at a faster pace. Yet, the top of the table says that after growing at 3.6% in 2017 (technically this is a forecast since we have not yet shopped for Halloween much less Thanksgiving or Christmas in 2017) we will grow at 3.7% in 2018. For those of you who know a little about statistics, I doubt that 3.7 is statistically different from 3.6.  For those of you who were never punished by a Stats class and don't know a standard deviation from your local neighborhood deviant, this means that the entire publication is suspect. While the thousands of words in the report support this view of faster growth, we all know that the main table of the report says the world will not grow faster next year. It might grow faster. It might grow slower. And Humpty Dumpty had a great fall.

Read down farther and you will learn the following world areas/countries will grow slower in 2018 than in 2017:

Advanced Nations
Euro Area         
Germany               
Italy                       
Spain                     
Japan                     
UK                       
Canada                 
Russia                   
China                   
Emerging Europe 
Mexico 

Given the title of the report and table say that world  growth will be faster, there must be some places that will grow faster in 2018.   The table says these places will grow faster -- the US by a smidge, France, CIS less Russia, India, Brazil, Saudi Arabia, Nigeria, South Africa, and Low Income Developing Countries.

How you can average the growth rates of the slower list with the faster list and come up with faster world growth is a mystery to me. If I was writing this report based on this table I would say that the world seems to be on its last JD of the night. Or maybe -- "While growth in our bigger world markets is stuck in first gear, we see some hopeful spots for growth in some developing countries."
         
Second is the part of the title that claims that 2018 is a window of opportunity. I recall being in high school and thinking that my bedroom window provided a great opportunity to escape in the wee hours of Sunday morning. But when was my bedroom window not a window of opportunity? And so it goes for the IMF -- why is 2018 going to be a window of opportunity that wasn't there in 2017? And the answer is that  the IMF thinks we have kicked the policy can down the road long enough because growth was too weak in too many countries. But now that so many countries are doing so much better, they will button down, quit kicking cans, and attend to important things like economic growth.

Wow --- what is the IMF smoking because I would like some of it. No, the world is not growing any faster according to their own numbers and mostly is growing faster in places like Kokomo (fictional one of the song and not the one in Indiana), Gotham, and Atlantis. And in what places will politicians in 2018 resoundingly decide that long-term economic growth is their number one priority? Watch France. Their child Prime Minister is trying such things and every union in France is suggesting that statues of Emmanuel Macron be broken into tiny little pieces.

If that isn't enough, the IMF has the audacity to imagine that this is a great opportunity for countries to get together in a pro-growth fit and further reduce trade barriers and expand international economic cooperation. Really? Have they looked around? What part of the world is not cracking up? Have they read about Spain or Brexit?  What free trade agreement is universally loved?

From the above you would think that I am either into my third JD of the morning or that I am pessimistic about 2018. I won't comment on the former since children might be reading this but I am not pessimistic. My reading of the world economy is that modest growth is good since it doesn't create huge imbalances and threaten high inflation. Momentum is our friend as more and more countries attach to a slightly stronger world economy. The biggest risks arise from the absence of what the IMF predicts -- that we will continue to kick the growth policy can down the road and countries will outdo themselves with counterproductive protectionist policies. That is -- the economy is fine -- it is the politicians that we have to worry about. Let's hope they take an extended vacation.

Summers Misleads with Secular Stagnation Tilt

Larry Summers recently peered into his cob-webbed trunk of worn out economic ideas and found something that was discarded with Dad’s WWII army uniform – the concept of SS. For those of you unfamiliar with Lucky Cigarettes and Bing Crosby, secular stagnation basically means that your economy has a disease that implies it will forever grow at a rate slower than your mailman on the day the Social Security checks arrive.

SS was coined after WWII. Alvin Hansen thought that the US would go back into a depression since defense spending would be greatly reduced at the end of the war. The logic was clear – Great Depression – war spending up – war spending down – Great Depression. It didn’t actually happen that way and despite three recessions in the 1950s, the US was off and running like Forest Gump.

You cannot blame Summers for wanting to dust this baby off and try it out again. We had a great recession in 2008/2009 and ever since we have had lackluster economic growth in the US. If my fingers are correct it has been about seven years since that recession technically ended. It ended and we had no real recovery stage. And the expansion stage would not put pho on the table for most of us. So Summers is right to wonder if maybe this time we have contracted SS.

Summers is as predictable as Charlie Sheen at a Margarita Bar, but he is also nuanced. He was a college President and you learn a lot of skills in that kind of job. Summers new emphasis on the long-run issue of SS appears to have distanced him from the usual mantra about short-run demand. But he is like the pickpocket who attracts your glance toward one hand while he empties your IU Credit Union Account with the other.

Summers doesn’t exactly say why it is that the government debt shifted to twice its long run average (as a percent of GDP), and increasing debt even more is perfectly fine for long-run economic growth. Recall that he wants to end SS. Hopefully he wants to end it in the next decade but you’d never know it. For example, he wants to stop SS in its tracks with more spending on the environment and education. I don’t care what political colors you wear – there is no way to connect the dots here – you can spend a lot more on both of those things and you might get your pug to leap through a gas-fired ring six feet off the ground. But how long will it really take to get the growth needle to move after more of this kind of spending?

He also wants to tax the rich and redistribute the proceeds to the poor and middle class. Again, that’s a nice thought. It might even increase spending in the short-run. But in what circus do you call that long-run economics? I remember the kid’s comic book wherein Scrooge McDuck (Donald’s Uncle) sat in his vault and played in the money. So it makes sense to give some of that money to poorer people. But please – don’t tell me this is a means to permanent raise the growth of the economy.

Finally, Summers want to increase infrastructure spending. Most of us nod and say that’s a cool thing to do. And despite its budget-busting implications it can logically be classified as long-run policy. But please do not tell me that it is going to do much for growth in my lifetime. Remember in 2008 the term “shovel-ready" projects? 

We learned what many of us knew – government spending is a long and tortuous (and corrupt?) road. Correct me if I am wrong but it took five years before a healthy portion of that money legislated in the last recession was actually spent on something. You know the deal – someone has to advertise for bids and then someone has to type them out on nice typing paper using an Underwood typewriter. Then all the stamps must be licked and pressed on envelopes. Okay I am joshing with you but you get the point. It takes a while to select the contractors and then they have to get geared up to do the work. Bribes must be paid and checks cleared. Then the checks roll and the magic happens. Hold on to your kiddies -- the Summers express is ready to take-off.

I have hit my six million word allotment for the day. While our liberal and revered soothsayers are talking long-run policy or not, the truth is that they are asking for the same policies they always ask for. These policies are not working. A real durable supply-side policy is possible that might find compromises by all the parties that address our current economic slowdown. But you are not going to get it from the usual hacks. Their faux SS argument means little. It is time to try something else. 

The Services Growth Engine

I often hear people lament the decline of real production and wealth as our nation has evolved from agriculture and mining to things like manufacturing and then finally services. To these people there was something real and tangible to digging stuff out of the ground.  Even manufacturing seemed lame compared to endowments of real landed wealth. Imagine their thoughts about basing a nation’s economy on services. The definition of a service is something that disappears upon production! How can you base an economy on something that disappears and soon as it is delivered!

But let’s face it, some countries do quite well when it comes to surviving and growing without having natural resources and some do it today mostly with services. According to the CIA Factbook the services sectors comprise nearly 80% of national output in the USA and UK. Bermuda counts 92% of its GDP as created by services. In contrast, Afghanistan, Burma, Ethiopia, Somalia, and Togo were among the countries where agriculture represented more than 30% of total output. A quick look down the list of countries makes it pretty clear that most higher income countries live off services production. See the table below for recent US data on employment. 

What are these services? Some of the largest services providers in the USA include real estate sales, state and local government, finance, banking,  insurance, healthcare, retail trade, wholesale trade, entertainment, education, tourism, transportation, and more. In each of these cases, a service is provided to a customer. When the cruise ship kicks you off the boat, the only tangibles you possess are the selfies you took and those extra 10 pounds hanging over your alligator belt. Yet GDP was created, workers were paid, and importantly capital was created and retained.

People worry that since there is no land or metals involved, somehow economic power expressed within services can disappear as easily as it arrived. But that is not true of services alone. Locusts or other such things have destroyed land and its ability to produce crops. A good red tide can kill fish and other sea creatures in the millions. Tsunamis, earthquakes, tornadoes, and asteroids can easily undo the value of natural wealth. A new invention makes one commodity almost obsolete as it is replaced by another.  So it is no great advantage or staying power guaranteed by land and commodities.

Think about tourism. No good is produced when a travel agent sells you a trip to Sanibel Island. You consume touristic output as you travel to this lovely destination. But notice how much lasting capital gets created by this event -- not because you want to buy a Chevy – but because you want to spend a few days getting a sunburn and indigestion. Your vacation wouldn’t be much fun if you didn’t have at least a Trump Hut for shelter and a bevy of restaurants and bars to quench your thirsts. Why are those buildings that produce touristic services any less real, enduring, or impactful than a tomato farm's harvester or a shoe manufacturing's factory?

Some people argue that many services are very low price or low skill. They worry that a transition from manufacturing makes a country poorer. They see manufacturing replaced by, say, retail outlets. But let’s be honest – not all manufacturing is high value added and many of these same people have complained that manufacturing companies take advantage of US workers or worse yet ship the jobs abroad. We still have a lot of low wage low skills manufacturing jobs in the USA but how long will they last? So maybe this claim is a bit exaggerated. And of course, it is easier for foreign countries to entice these lower skill manufacturing companies from our shores. It is a little harder to do the same with the Macys store in Bloomington.

And what the above argument completely ignores is the existence and importance of very high skilled services. Not all services workers push brooms or wash cars. People who dream up convenience Aps for our phones sell no phones yet they provide a lot of employment. Medical research professionals are indispensable to high tech manufacturing companies who will use the inventions and innovations to support superior goods. Since high tech services (in finance, health, transportation, tourism, etc) rely on higher paid and highly educated professionals – growth in these areas take advantage of US prowess in education and training.

I get my telecom services from AT&T. My monthly combined bills for TV, phones, and Internet are sizable. I pay much more for those services than I paid for the phones, TV, and computer. Think of the range of employment offered to service workers at AT&T. Think of all the capital invested by AT&T to support these services. Maybe not all those jobs pay super-high wages, but most of them defy the usual stereotype of the broom pushing service-worker.

We have enough to argue about. Going back to an economy based on land, commodities or even manufacturing just doesn’t make sense for the USA. Services are here to stay. They produce jobs and they are supported by huge capital stocks. Let’s appreciate our US trade surplus in services. Let’s appreciate what we have today and build on it. There is no guilt in a services economy!

Below is a table I created with data I took from the Bureau of Labor Services of the US Government.

Employment in February of 2016 (bls.gov) Thousands of jobs
                                 
NonFarm Employment Total      139,343

Goods                                                19,042
Mining & Logging                    861
Construction                           5,962
Manufacturing                      12,219

Services                                             98,042                                
Wholesale Trade                     5,816
Retail Trade                          15,239
Trans and Warehousing          4,738
Utilities                                      552
Information                             2,729
Finance                                   8,016
Real Estate, Rental, Leasing   1,481
Professional and Bus Svs      19,137
Education                                3,591
Healthcare                             14,847
Social Assistance                    3,449
Leisure and Hospitality         14,374
Other Services                         5,555

Government                                       22,259
Federal government                 2,730
State government                     5,227
Local Government                 14,302