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 (http://www.bls.gov/ces/#tables ) . 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.

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. http://www.census.gov/const/startssa.pdf

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.

Don't be an Unemployment Swinger

Today on Bloomberg.com I saw this article – “Unemployment Hurts More than Inflation" David G. Blanchflower, former member of the Bank of England’s Monetary Policy Committee.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aHU3sPFwC56c

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.

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.” http://www.ft.com/cms/s/0/e7909286-726b-11df-9f82-00144feabdc0.html

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.

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.

A Wolf in Sheep's Clothing

Martin Wolf is one of the better print journalists writing today. I see his articles in the Financial Times – the salmon-colored daily newspaper out of London. He must have been really inspired because he wrote back to back articles on May 28 and May 29. Both articles are well-written and thoughtful. Together they illustrate a very broad range of policy choices available for today’s challenges. They also reflect a very soothing (the sheep) but potentially dangerous (the wolf) potion offered by modern day Keynesians.

In Friday’s article (http://www.ft.com/cms/s/0/6a75d8d4-69f0-11df-a978-00144feab49a.html ) Wolf takes issue with the OECD’s current policy advice that countries soon begin fiscal consolidation and monetary tightening. Wolf appears to agree with the OECD but then wavers on the fiscal suggestion with respect to the UK. He likes the idea for the long-term but frets that engaging too soon would threaten the recovery. He suggests waiting until “recovery is assured.” Wolf then goes on to suggest that in the context of a fiscal consolidation, a loose monetary policy might not be effective. He says with respect to tighter money, “Why the OECD makes this recommendation is beyond me.” The upshot of his article is to control government borrowing but not too quickly. I am not sure what he is recommending about monetary policy since he seems to not prefer monetary expansion or contraction.

Wolf’s Saturday article ( http://www.ft.com/cms/s/0/7f55fe18-6a8c-11df-b282-00144feab49a.html scares the crap out of a fictional boy named Bobby using the idea that economic aftershocks are inevitable and will contribute to an unstable world economy. These aftershocks are the natural aftermath, according to Wolf, of excessive private and government borrowing. Combining this bad news with problems in transforming nations, China’s bubbles, and instabilities on the Korean Peninsula, Wolf concludes with this advice to Bobby, “It is going to be miserable. But you can learn Chinese and go east.”

Wow, I wonder what Wolf had for dinner Friday night! On Friday he was very unhappy with the OECD’s conservative policy advice but willing to consider a way out of the woods. On Saturday he seemed to indicate that developed countries don’t stand much of a chance. He recommends that we move to China. What’s up?

What’s up is what I have been saying for months – but I am not nearly as pessimistic as Wolf (before you call me a simplistic optimistic, please read the final line of this diatribe). The Whack-a-mole economy is a reality. Call it after-shocks or whack-a-mole – the story is the same. We went on a spending binge and now – now when we are at our weakest – the bill is coming due. While this situation is no cause for celebration, it is also not a reason to tell Bobby to pull up stakes and move to China.

Wolf’s problem is no different from the indigestion and confusion of other Keynesians. They live in a world of tradeoffs and zero-sum-games. They live in a world of seeming short-run political realities that offer only palliatives and no means to deal directly with real fundamental problems. The fundamentals are simple. People in the US spend and borrow too much. The cure is already in place. No one asked for a recession but the truth is that it sparked an awakening that is causing us to rethink the notion of debt-related risks. Wealth-ravaged consumers are already saving more. The government is discussing how to restructure. Just as saving was lost during the decades when we spent too much – now some spending will be lost as we reverse engines and save a little more. How can that be bad or worrisome? Wolf laments that it will cause another recession but that knee-jerk Keynesian reaction misses the boat.

How can it be wrong to point-out the true sources of our problems and directly address them? Would it really be better for policymakers to say they are going to fix the real problems sometime in the indefinite future? In the meantime instead of solutions we get speeches and weak populist-inspired temporary rebates that support and incent the very behaviors that landed us in this mess. It seems to me that the more governments credibly and quickly do something REAL about deficits and debt, the sooner people will be assured that things will get better. Those aftershocks or whack-a-moles will be minimized by market reactions that are based on credible policies that address what’s really wrong with this country. Convincing people that we are on an unwavering path to addressing our worst economic problems should send a message of optimism that can only create a climate conducive to economic growth. It might take a while, but it sure beats the hand wringing and negativism of Wolf and his fellow Keynesians.

Last line – before you call me names – please note that my optimism is based on policymakers doing the right thing… and soon. That is, my optimism is conditional. If our government and Fed continue to stall on the right policies, then I would suggest that we all move to Vietnam. It is cheaper than China and the beaches are beautiful.

Is the sky falling?

After the operation, Mrs. Weiner was told by her doctor that the operation was a success but that the recovery period would be long and challenging. “You will be improving, but there will be set-backs. There will be times when your temperature rises, you will experience pain that comes and goes, and your strength will oscillate. There will be some days when you will have to stay in bed.” The first day back at home her temp went to 101 and she panicked. Doctor, what’s wrong? Please help me!

What are we to assume about Mrs. Weiner? Does she have a bad memory? Does she not trust her doctor? Or does she simply have little experience with this kind of recovery and isn’t so sure that 101 degree temperature is something to ignore?

This little scenario seems appropriate for our current situation with global stock markets. Didn’t we all hear that this would be a rough recovery? Didn’t we know that the road to economic health would be long and with times of regression? Was the latest batch of bad news really enough to cause such panic in global stock markets? Are things about to get much worse? I don’t think so, but there is much we need to attend to as a nation before these apparently disproportionate attacks subside.

Think about all the tidbits of news you have heard about the economy in the last few months. No, the news did not make us want to light firecrackers or pop champagne corks – but it has provided some reason for confidence. Inflation seems well under control, employment may be firming, earnings have been decent and sales have been growing. Compared to a year ago – clearly the news from Main Street has been quite cheery.

So what’s all the fuss about in the markets? Much print has been devoted to our friends in Europe. Some relevant news relates to Asia. But it is hard to believe that this could have caused such chaos in financial markets. Asia is growing so rapidly that we are worrying that they may need abrupt pullbacks in China, India and a few other places. Too much strength hardly seems a reason for the value of wealth to decline as much as it has. Mudslinging in Europe also seems unlikely to cause the financial earth to move. It really isn’t news that Germany plays to its own drummer. The script has been the same for at least 50 years. Some event calls for more control in Brussels and it takes a lot of time and sausage on the wall before the members of the EU (now 27) give up a little more of their independence.

I know I make light of the current challenges – but I find it very hard to believe that the euro or the EU is going to disappear anytime in the near future. Would Spain really have done better this year if they were not in the EU? Sure, the peseta would have depreciated -- but my guess is that it would have dropped like a rock – not something anyone in Spain would have enjoyed. They know they are much better borrowing the credibility of the union than off on their own with one more tool of macro policy! The last time I looked, countries are lining up to be part of the euro – not asking to leave it.

So what’s the rub? Why are stock markets crashing down around our ears? I think it has something to do with the fact that most of us don’t trust our economic doctors. They tell us they fixed things but all this is pretty new to most of us. If you have some financial wealth you want to protect it. When times are good you want the money generating nice big returns. But the second you think that things are going to worsen you sell and put the money in safer places. We have our collective ear to the ground for the slightest hints of a rumble of trouble.

Will this ever change? I think so, but it will take a while. First, we know this will be a long recovery. Until employment is rising in a sustained way, we are going to be skeptical about Main Street. I am optimistic that we are not so far from that point. Second, we are still watching various governments work on financial market fixes – legislation that changes the way that Washington or Paris or Brussels interacts with the world’s banks and financial institutions. We don’t want these companies to cause another financial crisis – but we also don’t want them so hamstrung that they can’t do their jobs. This regulation is slow coming. It will take some time before the public trusts that it will be done right.

Finally – while Greece and a few countries have bitten into fiscal reform – the rest of us have done very little to stave off a future attack from what are now colorfully called bond vigilantes. It is real to worry about the fiscal health of the US. Recently a couple of good economists – Alan Blinder and Martin Feldstein – independently wrote articles (http://www.csmonitor.com/Money/Tax-VOX/2010/0513/Feldstein-says-don-t-make-the-Bush-tax-cuts-permanent ; http://online.wsj.com/article/SB10001424052748703315404575250341585092722.html )suggesting that it is not too hard for Congress to show good faith with respect to fiscal problems. They argue for tax and spending changes that could be announced today but which would begin to bite in the near future. Such legislation, however, would take compromise by both political parties – something which appears impossible today. Until the fiscal imbalance is dealt with, I suspect Mrs. Weiner would be crazy not to call her doctor as frequently as her symptoms arise. She will be nervous for quite a while and so will we.

How low will she go? Limbo like the euro.

European officials publicly put on the brave face and exclaim that the euro is a strong currency and will stay that way. The European Central Bank (ECB) has had an exemplary record and thus, there is no reason to worry about the value of the euro, they say. Apparently a euro traded for as little as $1.23 early in the week. Once a fine Finnish lass could command as much as $1.60 with a euro – compared to that the current value represents a depreciation of almost a quarter of its value. Of course, when the euro debuted in 1999, the first monthly average was $1.16. After its opening bow, it subsequently fell in value and remained at less than par ($1.00) for a couple of years. While fluctuating, it remained above par from 2003 onward. Right now we have some forecasters saying it could go back down to $1.16 – since the opening value was thought to be close to the expected long term equilibrium.

If you are not already sleeping or emptying the trash, you might be wondering how and why a currency could fluctuate from around 85 cents to $1.60 and have a long-term economic value of about $1.16. So let’s work on that.

Economists often use a concept called purchasing power parity (PPP) to determine long term equilibrium value of an exchange rate. It focuses on fundamentals – and ignores the many things that might lead to short terms changes. Most of us, by the age of 60 know our long-term average weight. After a week on vacation, we weigh a good bit more than our average. After an extreme and often stupid diet we may look like Twiggy, but such sveltness doesn’t last. Anyway, our weights can fluctuate around an average and so can an exchange rate. This fundamental long term value is thought to be determined by the key factors that impact a country’s trade competitiveness (usually measured by prices on traded goods). Based on competitiveness of Europe versus the US and based on the past performance of the dollar versus a precursor of the euro called the ecu (this link takes you to a graph of the euro/ecu versus the dollar http://research.stlouisfed.org/publications/net/page18.pdf ) we once thought the long-term value was about $1.16.

The long term equilibrium rate is important since, like our average weight, it represents a sort of magnet that keeps pulling the exchange rate back to a specific value. It is also a clue as to whether or not the currency is under- or over-valued. I am guessing that this long-term value is no longer $1.16 and is somewhat higher. Let’s just guess that is it somewhere around $1.20.

Why did the euro get so strong in past years? Why was it recently well above $1.20? To answer these questions economists usually use a supply and demand model – supply and demand for foreign exchange. These models usually assume that changes in the short term value of an exchange rate are driven by three main factors – (1) fundamentals that drive trade, (2) government pegging, and (3) the behavior of speculators.

Any change that might have led to world consumers and investors purchasing relatively more (less) goods, services or assets in the EU (US), would increase the demand for euros and cause the value of the euro to rise. And any significant speculation that the US economy was encountering difficulties would find speculators smelling the blood – dumping dollars and causing the value of the euro to rise. It was easy to see much concern over the US economy leading up to the recession – a concern that was not as evident with respect to Europe. It was easy to see why the euro was rising before the recession began.

It is very interesting that along with this worry about the US was a belief that much of the world’s economy had decoupled itself from the US. This was a strange idea given the size of US trade but it led to an expectation and a confidence that even if the US entered a recession, it would not spread to Europe or Asia with anything like the intensity of the past. If anything what helps to explain the recent weakness of the euro it is how badly Europe fared during the global recession. Whereas the US has exhibited many signs of recovery, fewer indicators point to a strong rebound in Europe. Then when you add the Greek crisis you have even more reason to sell riskier euro-based assets in favor of US bonds.

The red herring is how the speculators behave. EU policy has been dramatic – which can be taken one of two ways – as a sure sign that doom is around the corner or that smart policymakers have adequately handled the problems. It is not hard to see a very negative tone in the press. If EU policymakers act responsibly and vigorously attack large government deficits across Europe, this will weaken Europe in the short run and have negative consequences on the euro. If EU policymakers do not act responsibly then people will lose faith in Europe and the euro will decline in value. In as much, speculators might push the euro lower and clearly many won’t be satisfied until they push the value toward parity. While Euro policymakers made a big show of defending the euro and taking on these speculators, should things get worse these policymakers could be mightily tested.

Luckily the EU is not alone. We in America can out-deficit our friends in Europe in a flash. This is a great opportunity for us to show leadership in fiscal responsibility. And it would be fun to sing IWanna Hold your Hand with the Beatles. Meanwhile Europe will have an impossible time coming to grips with almost insurmountable social and economic challenges of defining what fiscal responsibility means in a union with 27 independent states. Until that gets solved I am betting on continued euro weakness. Prague is lovely this time of year.

What’s around the Macro-Corner?

I have some personal business this weekend and won’t be on line again until Monday. So please write your comments but note that I won’t be able to approve and publish them until I return.

There is a lot of concern about the US and global economy. Will we have a double-dip recession? When will the unemployment rate come back down to normal? These are just a couple of the macro-things on our minds. They weigh on us in a time when there seem to be no easy answers. This may not be a replay of the Great Depression, but it is definitely the worst economy that many of us have ever seen. And we are worried the future might be worse.

So “What’s around the corner?” is a very legitimate thing to be asking. We have a lot of people competing with each other to help us know what is coming around the bend. In fact, it is hard to escape all these newscasters, politicians, and various talking heads. Many of these people base their views of the future on models. Some economic forecasters use very complex and complicated models with 100s of variables and theoretical inspirations from Keynes or Friedman, or other great economists. Other forecasters focus on what they consider to be a few key trends. Others seem to speak from their guts. Still others simply want fame and/or money.

But let’s all agree with George Will who said, “The future has a way of arriving unannounced.” You don’t have to take what I am about to say as a rejection of all forecasters. I think they are very valuable. And a lot of times they get it right. But let’s be realistic. No matter how complicated or sophisticated a model might be, its forecasts are extrapolations of the past. They are extrapolations based on theories and concepts that are as thorough as we can make them but admittedly they leave out what could turn out to be critical information that makes the future different from the past. WE DON’T KNOW THE FUTURE AND NEVER WILL. THERE WILL ALWAYS BE THINGS LEFT OUT OF THESE FORECASTS. Clearly in today’s wacky environment there is much we could be overlooking.

Here are some examples that show how far off we can be in knowing about coming big changes?

o In the 1950s, despite the end of World War II and the economic stimulus it provided, we did not enter a new age of Economic Stagnation as many economists predicted. These models missed something about confidence and private spending.

o In the early 1960s models did not account for the impact that growing government deficits and monetization of those deficits might have on the future course of aggregate demand.

o In the late 1960s and early 1970s a growing expectation of future inflation and how that would impact unemployment and inflation was not well understood.

o When oil prices rose from $3 to $12 and then from $13 to $39 in the 1970s, many economists predicted that oil prices would soon spike at $100 per barrel. They didn’t. In fact they never got much above $13- $18 for a long while.

o When the Fed pushed the Fed Funds Rate to around 20% in 1980, many hoped but few people believed that this effort would be followed by a long-term period of disinflation and economic growth.

o When productivity growth was growing much faster than anyone expected at the end of the 20^th century in the USA, few people knew why it was growing so fast and few predicted that strong economic growth could come without increases in inflation.

o Aside from a few people, who really saw the bursting of the bubbles in the US and Europe in 2008 and the consequences that would follow?

The point is that there are plenty of time periods when the future had a way of “arriving unannounced.” We get surprised a lot! So how do we use that knowledge now? First, let that be a form of assurance – maybe some of these logical folks who are worrying the crap out of you right now, should be given a little less credence. What are they missing? Second, things might turn out to be even worse than those people are saying – but then again, they might turn out better.

In the name of brevity, let me summarize this with the following. Whatever happens in 2010 and 2011 won’t be fully expected and probably won’t be the end of the world. “S__t happens.” We react and then we adjust. We adapt EVERY year whether they call it a recession or not. Every year people get unemployed and have a difficult time dealing with it. Every year firms go bankrupt. Every year there are people who hate their bosses and it makes them crazy and unhappy. Whether it is 10 million or 5 million people unemployed next year, we will deal with it. But the truth is that we can’t know the future so let’s not let it ruin a very nice day – today. Have a great weekend.

Monetization for Europe – Take two aspirins and your head should clear up soon.

The front page headline of the Financial Times on Saturday May 8, 2010 is “European banks in bonds plea.” What’s the story here? Basically the commercial banks of Europe are worried that spillovers from the Greek sovereign debt crisis are going to result in much higher risk premiums and tightened credit across Europe. So instead of the banks going to the individual governments of Europe and asking them to do something about national creditworthiness, they are instead pleading to the European Central Bank to become the “lender of last resort for Europe.” Clearly, if the problem is caused by large government deficits and debt, it can only be truly solved by rebalancing these equations.

Now maybe there is some fine print somewhere that would let the ECB become the lender of last resort for Europe, but the last time I looked the ECB was an independent central bank and could not monetize debt of European countries. The ECB can conduct a looser monetary policy and it can buy more government bonds to do so – but it can do this only if inflation is not near or above 2%. With inflation in the 16 countries of the Eurozone at about 1.5% in April, this clearly gives them some wriggle room – but probably not enough to accommodate the begging bankers.

It goes without saying that there is a financial crisis in Greece that is spreading through Europe and beyond. It is true that the Fed vigorously acted as a buyer of last resort in the last years. But one wonders where this will all end. Yes, inflation is low in most countries today. Yes, there is plenty of slack on world labor and goods markets to prevent inflation from suddenly rising in the very near future. But it is also true that the most past virulent hyperinflations got started somewhere -- and mostly from central banks monetizing large government deficits. At what point do which governments begin leading the parade of fiscal responsibility? At what point do banks and private citizens begin to worry about the devastating impacts of runaway inflation associated with excessive national and world liquidity?

Let me end by cutting to the chase. The deficits, debts, and ensuing financial problems we are experiencing today are the result of governments who fail to pass the fiduciary test. They have been warned for years and in some cases for decades about getting their fiscal houses in order. Well – the day of reckoning has finally arrived and few are talking seriously about real fiscal solutions. Mostly we get smoke and mirrors. Instead we put pressure on central banks to bail us out. But the truth is that there is no end to these problems without fiscal solutions. Monetary remedies will do no more than a couple of aspirins when it comes to solving the drunk’s problem.

Mixing can lead to headaches. How much did employment increase in April?

My father always drank Vodka on the rocks. He warned me that mixing liquor with anything except ice cubes would produce undesirable results the following day. While I mostly drink bourbon or sour mash, I generally follow his advice. And as a good son, I try to follow it regularly.

I wish the press had learned from my Dad. On Friday the US employment data for April was announced with most headlines noting that payrolls rose by 290,000 while the unemployment rate rose from 9.7% to 9.9%. This seeming incongruity was swept away with a passing reference to growth in the labor force. None of this is incorrect but unless you are a macro-nerd and go to the appropriate place -- http://www.bls.gov/web/empsit/ces_cps_trends.pdf -- you could be seriously misinformed.

You will not learn from most of the headlines that employment actually increased by 550,000 persons in April. The issue and confusion – did employment rise by 290,000 or 550,000 – seems worth discussing further. One television commentator was trying to calculate how long it would take the unemployment rate to reach an acceptable (lower) number if job growth continued by 290,000 per month. Of course, she was using the wrong number – it would take about half as long as she calculated if employment continues to rise at 550,000 per month…

So what is all the fuss here? The source of the problem is that the Bureau of Labor Statistics of the US Department of Labor publishes two surveys each month – the Current Population Survey (which tells us employment and unemployment numbers) and the Current Employment Survey (which tells us the number of jobs created). Or more briefly, these are called the Household Survey and the Payroll Survey.

The Payroll Survey is a measure of jobs but not employment. The monthly sample covers 390,000 nonfarm establishments – government and private. These nonfarm establishments tell the government the number of jobs on their payrolls. If a person works for two firms – one full-time and one part-time – they would be counted twice. Anyone self-employed or working for a company categorized as agriculture, would not be counted in the Payroll Survey.

The household survey involves about 60,000 households. They are asked about the labor force status of each household member. The survey classifies each person in the household in one of three ways – (1) in the labor force with at least one job (employed), (2) in the labor force and looking for a job (unemployed), or not in the labor force (16 years old or older and not looking for a job). If you want to know exactly how they categorize people through the survey, go to http://www.bls.gov/cps/cps_htgm.htm

The household survey counts you as employed or not – so it underestimates the number of jobs. It also includes self employed persons, people who work in agriculture , and unpaid members of a family business. Because it is a sample and prone to errors, the BLS explains that it takes a change of at least 436,000 to be statistically significant. So the 550,000 has meaning for April.

The April Household Survey estimated that the labor force increased by 805,000. That means that 805,000 people wanted a job and 550,000 of those people found them. It also means we added 255,000 (=805,000-550,000) to the pool of unemployed. Thus the April unemployment rate (all people unemployed of 15.2 million divided by all people in the labor force, 154.7 million) rose to 9.9%. But surely the good news is that 550,000 persons found work and there were 255,000 encouraged enough by current conditions to move from not looking for work to looking. Compare that to most of 2009 when the civilian labor force was declining.

Greece, Grease, and Wazzup wit U-Rup?

There is a lot of macro going on right now but much of it is being pushed below the surface by car bombs, Ahmadinejad’s nomination for the Nobel Peace Prize (just kidding), Steve Hogan’s win in the Bloomington primary, and Greece. So I thought it might be a nice time to take a step back and talk about Greece and Europe. Most of us Americans know that Grease was a cool musical with John Travolta and Olivia Newton-John. We also know cool stuff like who sang Under the Board Walk, who won the Kentucky Derby, why the Dodgers left Brooklyn, and how many Mannings play quarterback in the NFL. We Americans know a lot of cool stuff.

When I was growing up in Miami, Europe was a continent and a place that had a lot of World Wars. I heard it had a lot of cathedrals but none of that was ever much of a draw for me until my dear friend and mentor Chuck Bonser invited me to join him on a program in Europe. I think I went three times – two weeks each time – and I heard lectures by Europeans about Europe in places like Paris, Brussels, and Berlin. What a lucky duck! I am not an expert on Europe but I do know enough to try to add a little perspective to what is going on there and why it is such a big mess.

What we call the European Union or EU started shortly after World War II mostly because Germany and France decided that if they created more economic trade (iron and steel) between their two countries they might not want to kill each other so often. Before you know it they added Belgium, the Netherlands and Luxembourg and created a union of five countries. I suspect these three additions had less to do with coal and steel and more to do with really good beer. Anyway, I digress. From there we see an expansion from five countries to 27 and some 450 million people. Sixteen of those countries decided to drop their own currencies and adopted the euro when the Maastricht Treaty was signed. Since 1999 we began thinking of the euro as Europe’s currency despite the fact that many European countries are not part of the Euro-Zone and still have their own currency (E.g. Britain).

Enough history. Now some facts and wild guesses. First, despite the EU and the Euro-Zone, the countries of Europe are NOT like states in the US. They remain independent countries ruled by their own governments. They have made scores of agreements with each other that help facilitate European-wide trade and monetary union. These agreements bring wealth and prosperity to the people of the EU. They have great value and will not be reneged easily.

Second, it somehow APPEARS to some of us that there is more union than there really is. For example, the EU has government institutions that sound a lot like a federal government. There is an Economic Commission and an Economic Parliament. There is also a recent agreement that looks a lot like a Constitution. There is a new EU President and someone who acts a lot like a Secretary of State. Sounds like a country to me.

Third, appearances can be misleading. For example and relevant to 2010 and Greece (but not to Grease or the Drifters) is that while those in the Euro-Zone agreed to give up their currencies and let the European Central Bank determine their joint monetary policies – they did not give up their FISCAL POLICIES – that determine government spending and taxation. All 16 Euro-Zone countries have their own government spending and tax policies. For the sake of the monetary union they did agree to some constraints – to keep their fiscal deficits at no more than 3% of GDP and national debt at no more than 60% of GDP.

So when Greece (and Spain, Portugal, Ireland, and others) were found to be exceeding these fiscal limits, the rules required that these countries grapple alone with their fiscal problems, subject to fines if they habitually exceed the fiscal limits. Despite all the agreements within the EU and the Euro-Zone, there is no agreement that provides a European solution for countries that have debt problems. Germany’s original response was something like – let them charge higher taxes on gyros. Good German citizens are not going to bail out Greeks who spend so much time at the beach. Strange thing happened then – their shared currency, the euro, started to depreciate as if all those 16 countries were scofflaws.

Accordingly, the Germans and the French and the rest of the countries felt compelled to act. Only problem is that there is no legal EU means to do so. So now they are being more flexible and more innovative. Only trouble is that they are not yet being very convincing despite the fact that the IMF jumped in with their considerably deep pockets. It took a while to come up with a solution for Greece and now the world is wondering just how bad things are in the rest of the countries. Until more of this is digested and understood, the euro is bound to be under some pressure. The members of the EU are under a lot of pressure to restructure their rules. Until they do, the world’s financial markets are watching. This is BIG STUFF since the very act of restructuring means another round of compromise—individual countries giving up sovereignty.

Okay – so now I feel better. I feel good enough in fact to find a nice Belgian Wit in my fridge. If only I could find some Dutch pommes frits. Yummy. I hope you all had a nice May Day. Today is Cinco de Mayo which in Spanish means a big headache on May 6^th.

The game will be well into the first half before the Fed gets on its uniform!

Who Controls Interest rates? The Fed or the Market?

Since we are spending so much time oohhing and ahhhing about the Fed, it isn’t a bad idea to get into some arcane but straight forward realities about interest rates.

The markets were so happy to hear on Tuesday that the Fed is NOT going to raise interest rates yet. A collective global sigh was heard as we learned that the economy is still too soft to withstand tighter money and higher interest rates. The price of gyros firmed in Athens!

But does the Fed really control interest rates? It depends on which rates you mean. Does it control mortgage rates? Rates on business loans? Rates on commercial paper? Car loan rates? No, No, No, No. Hmm – so what does the Fed control?

To make a long story short, the Fed directly controls the discount rate – the Fed can “dial-up” a higher discount rate easily. The discount rate is what the Fed charges when it lends money to commercial banks. Second, it controls the target rate for something called the federal funds rate (ffr). I say it controls the target because the ffr is really a market rate driven by the supply and demand for short-term funds that commercial banks lend to each other. If the Fed decides on a higher ffr target than exists today in the fed funds market, it will sell part of its bond holdings, essentially draining liquidity out of the banking system. As funds become scarcer, the usual buying and selling of federal funds will generate a higher ffr. If the Fed hits its target rate– and it usually does – it really sets the ffr (and not just the target). To summarize – if the Fed wants to lift the ffr to 1.0% , it would sell some bonds and watch the market ffr rise. When the market rate rises to 1% then the Fed will know it sold enough bonds. Viola!

So the discount rate and the ffr are about the only rates the Fed really controls. That is worth knowing – especially in this environment of wondering when the Fed is going to begin its drive to increase interest rates. The main point is that when it comes to car loans and mortgage loans, and various other financial transactions, the interest rates are set by the interplay of supply and demand. While the Fed’s actions are part of the supply and demand and the Fed’s decisions influence these markets, they are by no means the only factor to impact these and other interest rates.

For example, we know the Treasury needs a bunch of money. So they are selling a wagonload of bonds each month and will be doing this for quite some time. As the economy recovers in the coming year we expect demand for houses, cars, business equipment, Jack Daniels, and many other items to increase. This means that more and more households and firms will be borrowing – taking out banks loans and selling bonds. Even without any change in the Fed’s monetary policy there will be a cyclical reason, therefore, for interest rates to rise as more and more borrowers compete with each other for a given amount of funds.

So rates can rise even if the Fed’s policy is unchanged. Now here is the fun part. Let’s suppose the Fed does NOT want the rates to rise – what can it do? Keep in mind that one of the market rates that might begin rising is the ffr. If the Fed has a goal to keep the ffr no higher than 0.25%, then it will have to PEG THE MARKET RATE AT THE TARGET RATE – which means supplying more liquidity to the market. Notice that when the Fed tries to peg the ffr rate in the face of rising loan demand – this means injecting even more liquidity into the banking and economic system. THIS MEANS INJECTING EVEN MORE MONEY AT A TIME WHEN THERE IS ALREADY MUCH TOO MUCH MONEY IN THE SYSTEM. THIS MEANS THAT THE JOB OF REMOVING THE LIQUIDITY AT THE MAGIC MOMENT BECOMES EVEN HARDER AND THE RISK OF HIGH INFLATION GETS BIGGER.

Okay so the money supply grows but what about the interest rates? It is hard to say. The Fed might try to prevent the ffr from rising but if the market knows that fundamental factors are driving interest rates upward, then the pegged ffr might not reduce the pressure on the other rates. And if the risk of future inflation is truly perceived to be higher – this too will add to interest rates today.

Hmm – so is the Fed or the market driving the interest rates? My guess is that in the coming year, Fed policy will be a lagging indicator of interest rate change. Once the Fed does announce a policy to tighten money and withdraw liquidity, the rates will have already risen and the ffr and discount rate will come in line with the rates that have already risen….Upshot – keep your eye on the markets. The game will be well into the first half before the Fed gets on its uniform!

The Fed Can't get No Satisfaction

There is a blurb this morning on Bloomberg.com titled “Fed ‘Squeezed’ by Recovery Momentum May Affirm Low-Rate Pledge.” The experts are predicting that the Fed will not change its language about policy and will continue to guarantee virtually zero interest rates for an extended period of time. They note that while there has been much positive economic news and financial markets are awaiting some sign the Fed will begin to worry about inflation, the Fed is compelled to continue to focus on high unemployment, especially since inflation continues to be tame.

That’s the story. And it underscores a worry that there may not be a clear signal for when the Fed really does begin to suck out all that liquidity that threatens economic stability. Let’s face it, the economy grew at a strong pace in the latter half of 2009 and appears to be growing at 3+% in 2010:Q1. Is a zero interest rate compatible with US economic growth averaging 4% or more for three-quarters of a year? If you answer yes, then what happens if the economy grows at a mere 3% in 2010:Q2? Then we will have had a full year with real GDP averaging almost 4%. Is that enough to change policy? What if the unemployment rate is still high in July? Will these same experts be ready to prod the Fed away from zero interest rates? I think you are starting to see the policy risk here.

Simmer down Larry. So what if the Fed is a bit late in coming to the inflation party? Why should we care so much about inflation when so many people are unemployed? The ANSWER is that we care about future inflation MOSTLY because it will lead to a cycle in which unemployment gets WORSE. We care about inflation BECAUSE we care about unemployment. When do you start your diet – only after you have nothing left to wear but a potato sack? I hope not! It might be better to start just before your current jeans are so tight that you have to unbutton them to breathe now and then. Anyway, let me keep this short and summarize the issue:

First, there will be no AHA time when everyone agrees it is time to start tightening. There are always expects who see softness or the next recession around the corner. Please Mom, my pants are supposed to look like that.

Second, tightening money growth will mean higher interest rates and will cause consternation among many groups. It will take a very tough Fed to deal with the ugliness that arises when a phase of tightening begins – even though this phase largely will be meant to remove a ton of excess liquidity. Notice that raising the Fed Funds rate to 1% would be considered a big jump from the current 0.25% -- but also notice that a 1% Fed Funds Rate is VERY low in historical terms. Please Mom, let me have one more piece of cake!

Third, the policy change will probably come later rather than sooner and will lead to higher unemployment than necessary because it will have to deal with rising inflationary expectations and higher prices for commodities. Geez Mom, this diet is making me dizzy.

In the US we have an independent Fed with a newly reappointed Chair. The Fed has a choice. It can play to popular opinion a while longer and risk much higher inflation AND unemployment. Or it can move quickly (and gradually) to reassure domestic and international publics that the best way to keep a strong stable economy with low unemployment is through price stability. So which ways is it going to be? I guess we will learn more tomorrow.

Monetization challenges in India -- leading indicator for the rest of us?

Monetization is playing itself out in India this week. One of my previous posts (In The Black Trunks…, Monday, April 12) I discussed monetization in the context of the USA. Monetization is a very specific term meant to describe how (even independent) central banks act as if they are “printing money” to help governments finance their deficits. Since US deficits are VERY large, the worry is the monetization could lead to a very large wave of money growth and future inflation. But since inflation in the USA is low and stable right now, this future tsunami is not taken very seriously….

But India is in the eye of the storm right now. A report out this week portrays the Reserve Bank of India as in quite a pickle. India’s robust recovery from the recession is already generating double-digit inflation and the RBI has already begun draining reserves from the system and raising key policy interest rates. But whoa Silver (the Lone Ranger’s horse was named Silver) – it turns out that the RBI is concerned that the government of India has a lot of bonds to sell to cover large government deficits. As the government sells these bonds this adds even more pressure for interest rates to rise. So what – isn’t that what they want? Yes, the RBI wants to cool off the economy with higher interest rates, but India is just like Little Red Riding Hood who wanted her porridge warm but not too hot. The RBI wants a cooler economy but considering that the economy is not quite out of the recession woods yet, if interest rates rise too much and too soon, the RBI could find itself with a double dip.

The astute reader at this point might recognize that the RBI might solve this dilemma easily -- just suspend its open market bond sales and let the government suck the money out of the system with its bond financing activities. But that would not work. The government of India is raising funds so they can spend them! The result is that any money they collect through bond sales gets injected back into the economy as more spending. So if the RBI stands back and does nothing – the money or liquidity problem remains and they have put off or stalled a policy designed to reduce future inflation.

So there is the pickle or the rock and hard place thing. What’s a good central bank to do? The RBI wants to stop the inflation rate from rising through higher interest rates. The government is sending rates even higher than desirable so the RBI responds by buying government bonds to try to bring the rates back down. If they tighten too much they risk a recession. If they monetize too much they threaten inflation. It just doesn’t seem fair! But, of course, India is just a little ahead of the inflation curve and most nations could be in the same situation later this year.

Geez, how did we all get in this jam? The answer is that the recession scared the wee wee out of us and we asked our policymakers to inject historical amounts of stimulus. There we are – lots of juice running through our veins and it needs to come out. The most intuitive approach is to begin removing the stimulus before it creates devastating inflation. It would help if at the same time we come up with appropriate reforms that effectively address the causes of the recession. Finally, I will say the S-word and note that an aggressive supply-side policy which focuses on raising national productivity relative to business costs is known to have the desirable impact of reducing inflation and unemployment at the same time. Now where is that cake that I want to have and eat it too?

Should wages be determined by the market?

I saw an editorial recently that concluded that it might be better to not let the market determine wages. This article made me see how bad economists are at communicating their most important concepts, in this case market determination. As you will see below (if you are still awake) it makes good sense for the market to determine wages. In future posts we might apply similar points to market determined interest rates, stock prices, profits, and rents.

What market determined wages (MDW) DOES NOT mean. First, MDW are not set by the government. Second, they are not determined by some guy (or gal) named Market. Third, wages are not determined in a big workers’ tent similar to the goods tent where people buy and sell used goods like cuckoo clocks, Depression glass, and Barbie dolls.

MDW means that wages change according to the laws of supply and demand. AHA – says the skeptic – that’s a bunch of bunk. My wage is determined by that creep they call my boss who sits in the big office by the window. It is true. Depending on where you work there is always someone or some committee who tells you your wage. Or maybe you tell them what wage you will accept. “Listen here Fred, unless you guys give me a 10% raise this year, I am going to retire and play third base for the Yankees. “ Maybe your wages are set as a result of a big negotiation between your union and the management.

Let’s call this person/committee/negotiation the One who sends you the Wage News (or THE ONE, for short. Okay? So the relevant question becomes, how does THE ONE decide that you are worth an extra 10% this year? This is where THE MARKET comes in. This is where SUPPLY AND DEMAND comes in.

Let’s suppose you are a website designer and it turns out that a new report forecasts that many companies are going to need new websites next year. You look in the newspaper and there are hundreds of ads for web designers. Wow! Clearly the demand for your services is up and this is the kind of year when you might be able to get a good wage. Your skills haven’t changed a bit but the demand for your services is much higher. That’s an example of the impact that demand has on the labor market and your wage.

What about supply? This is the example that bothers people – especially people who compete with low-to-medium-skilled workers globally. Globalization has increased the number of people globally who compete with you when it comes to producing various kinds of manufactured goods. You continue to be a good citizen and hard worker, but the truth is that labor supply has increased substantially. When there are other workers who really want to work and who are willing to work for a lower wage, this is an example of labor supply increasing. If labor demand does not automatically increase as much as the supply, then the market wages declines.

Summary of the theory of the labor market:

o If labor supply increases and/or labor demand decreases – the market wage rises less than expected or it declines.

o If labor supply decreases or/or labor demand increases – the market wage rises more than expected or increases.

The One Who Sends You the Wage News will usually use this theory of the labor market to determine your wage. If he/she does not, then the organization’s costs are not being managed efficiently – that he/she is wasting the organization’s resources. If THE ONE consistently pays you more than the market values you, then the organization might have been using the surplus payments more wisely. If THE ONE pays you less than the market wage, then the organization has saved money but it will result in less productive employees and probably higher turnover costs. Of course, YOU might be worth more or less than the average wage or you might be married to the boss so The ONE will naturally bring all that into the equation as well. Normally not everyone will receive the exact same wage increase.

Is any of this FAIR? It depends on what you mean by FAIR. A market system’s main goal is to use a nation’s resources as efficiently as possible. That means the system tries to minimize waste. That seems like quite an undertaking. In doing so, it cannot also make sure that every human resource is paid equally. That’s why we have a mixed economic system in which the government attempts to offset the worst income inequalities through taxes and spending. If the government can reduce the worst wage inequities while not creating perverse long-term disincentives, then a mixed system might be able to achieve two goals – near-optimal efficiency and near-optimal income distribution.

We are in this together -- let’s throw out the bums!

An asteroid is going to hit the earth in 24 hours destroying us all. Okay – so you prefer tsunamis or earthquakes or a visit from your mother-in-law. Whatever. Let’s assume we all have very little time left. What are you going to do? Will you argue with your neighbor about the leaves from his tree that blew into your yard? Will you complain to the Mayor about excessive traffic calming devices? Will you argue with your Dad about the unfair burden left to you by spendthrift baby boomers?

Most of you probably won’t do any of those things. If you really only have 24 hours left, there is a lot to do. So what are you going to do? Of course, you will do things that are most important to you. Some of you will spend time with your families. Some of you will pray. Some of you will make apologies to people you might have harmed. Some of you will go to Vegas one more time. Get the point? There are things that are really important to each of us and there are things that are less so.

Why am I saying this? Just to remind you that we all have a lot in common. It is pretty naïve to think that we are all alike in this regard – but it seems to me that most of us share a lot of values. In the economic sphere we want to do the best we can to provide security, food, and general well-being for our families. Most of us would like to see more effective ways to reduce crime, improve education, reduce discrimination, and so on. Most of us would like to find effective ways to take care of the earth’s resources and not waste them. Most of us want to be healthy. I don’t know many religions, community groups, or political organizations that stand against any of these things. We have common bonds and we share in the need to attain our goals in the best ways. We are deprived when we can’t attain our goals.

Today we are involved with very large short-term and long-term challenges. If there was ever a time to see our shared interdependence it is now – when the stakes are the highest. We don’t have a lot of time to mess around. Solving these challenges unites us and brings us all benefits.

Yet we fiddle while Rome burns. We point fingers and call people names. I talk to so many people who are sick and tired of the process. It really is outrageous yet the solution is simple. We are in it together. Okay – so we come from a lot of different backgrounds and we don’t agree on a lot of things. But we do agree on the key things. My liberal friend tells me that conservatives are rich, hateful jerks who don’t want to help people get out of poverty. Do you REALLY believe most conservatives are such cold-hearted brutes? Is it possible that they have different beliefs about the best ways to approach the poverty issue? My conservative friend says that liberals are all heart and no brain and won’t rest until they have spent all our money. Are most liberals really like that or do they have a different way of viewing the problem?

The sad truth is that NOTHING will get done to relieve poverty or our other challenges because we won’t even talk to each other. Rather than spend a little time actually listening and talking to each other, we spew invectives and platitudes and all manner of ugliness. Where did we learn this behavior? Why do we prefer to do nothing about our most pressing problems? Is there no stomach left for real discussion and negotiation? Could we not go into discussions with good faith -- with the understanding that all parties want a good shared outcome? Could we not honestly negotiate knowing that we might win a few – lose a few.

You probably think I am off my rocker. And maybe I am. But I really think change is going to come because the average person is starting to realize that we now have the worst group of politicians in memory on both sides of the aisle. The change will not be a red/blue Party thing so I am betting that the middles of both parties are going to get rid of the trouble-makers. Major political change can happen but only if we demand it. What can you do to get the message to these troublemakers? It is a very simple message – all of us need to require than political candidates pass the intuition test. First they have to stop all the self-defeating name-calling. Second, they have to show to us they are acting logically and in good faith with respect to our many challenges. At minimum we need to know that they are willing to: identify the problems, discuss and debate their solutions, and give us results that make us better as a people and a nation.

In the Black Trunks weighing in at 3% is inflation

As a result of Mike's comment on my last post, I want to dig further into the issue of inflation. Some economists are very worried that the government will monetize its historically large deficits. Monetizing a deficit in the USA today means that the government does not borrow by issuing new bonds. Well -- it's a little more complicated than that. They actually do borrow but when the ensuing competition in the credit markets drives up interest rates, there is much pressure aimed at the Fed to bring them back down. How does the Fed do this? They buy government bonds in the market. Summary -- (1) government sells bonds to the public, (2) the Fed buys bonds (not necessarily the exact same bonds but it doesn't really matter), (3) bonds in the credit markets are replaced by money. While the government did not literally PRINT money to finance its debt, the result was the same.

Economists believe that money is the root of all evil -- just kidding -- money is the root of spending. Since money has no real interest associated with it -- its main purpose is for spending. Unless prices are falling it does not make a good saving device. In the long-run this money will eventually raise spending. A large injection of money will eventually increase spending at a much faster pace than supply can respond and the difference is inflation. Now this is getting to be as much fun as a colonoscopy. Right?

So it is appropriate to worry that today's government deficits could lead to higher long-term inflation. But many just shrug their shoulders. Why should we care so much about high and rising inflation? There are a lot of answers to this question but the one I want to focus on today is the bout between inflation (Black Trunks) and unemployment (White Trunks). Let's face it -- very few leaders are going to say openly and repeatedly that they want to focus on inflation stability when so many people are unemployed in the USA. Most of these leaders base this PREFERENCE on a so-called TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT. Any policy that would reduce inflation today, according to this trade-off, will reduce the growth of spending, reduce the rate of inflation and raise the number of people unemployed. So -- if you are worried about inflation and you activate a policy to reduce it, then you must "pay for it" with fewer jobs and employment. This is not the stuff of reelection.

Did this piece of trade-off economics come down from on high? Not really. In fact, while the trade-off might exist at times, there are also plenty of times in recent USA history when policy was able to reduce both the inflation and the unemployment rate. There have also been some times when both inflation and unemployment rose. Hmmmm -- so much for a reliable and predictable tradeoff.

What causes the inflation/unemployment tradeoff to vanish at times? Answer -- an active supply-side. The trade-off is totally spending or demand based. But surely the expectations and behaviors of firms matter as they decide how much to produce and at what price to sell. Of course expected demand for computers is important to Dell -- but also of importance to Dell and its competitors is the expected wage, the price of commodity inputs, the level of productivity, tax on healthcare, and many other supply-side factors. Notice that any factor -- policy induced or otherwise -- that will have the impact of increasing business productivity and confidence relative to their business costs will have the interesting effect of reducing the cost per unit produced -- allowing them to produce more without raising prices markedly. Viola. Supply can make the trade-off disappear.

Did you ever believe that an economist would say "you can have your cake and eat it too?" But that is the magic of supply-side economics and supply-side policy. Right now we are faced with policy choices with huge implications. Monetizing the government deficits will have a predictable trade-off that could lead to high and rising inflation. But we have other choices. We know that firms are the ones who create the jobs. It seems very sensible to me that part of our policy arsenal should be devoted to finding ways for them to be permanently more competitive, especially if this frees us from undesirable trade-offs and lets us have our cake and eat it too.

One more point about supply. Letting inflation rise in the next couple of years as we use demand remedies to increase demand and employment is a very risky policy. If the increases in ACTUAL inflation causes a rise in EXPECTED future inflation, then the result will be an adverse supply shift as business costs rise faster than productivity. That will lead to higher unemployment and inflation. The trade-off is a very tricky theory to use. There is a lot more to say on this topic but I think I will leave it right here for the time and see if you post any comments.

Macro Bits and Pieces

As I peruse my usual sources of information I am overwhelmed by the lack of excitement this week. Butler lost to Duke. The healthcare reform vote is over for the time being. Spring is slowly arriving and our neighborhood deer are feasting on new green shoots. We postponed our China finger-wagging. The US and the world economy seems to be generating some momentum and the stock market is making us feel rich enough to maybe purchase an Ipad (whose market entry finally happened).

This is the usual environment surrounding Macro when we aren't in a recession -- ho hum. It isn't easy to get people excited about bits and pieces. But lurking below all this information is a scenario that has both good and not-so-good implications. Two stages usually follow the worst part of the recession -- one (the recovery) in which the declines get smaller and then one in which true expansion takes place. We now appear to be in the expansion phase and we are already seeing tell-tale signs -- including rising commodity prices and increases in interest rates. This is normal. This is expected. This shows that resource slack is declining and we are starting the movement toward normal capacity production. If this continues for a while it will eventually impact labor and employment. Once this occurs the signs of the expansion will be broader and should engender a more optimistic stance from consumers.

So far so good. But now think about your latest battle with the flu -- the bug left your body and you felt stronger so you decided to cook dinner, wash your car, and mow the yard. Hmmm -- you did a bit too much and now you are back in bed. The economy is no different. While the patient is feeling stronger right now -- this won't lead to a lasting recovery until three things happen. First, the disease has to be gone before a full recovery is possible. Note that we still have not done much to resolve the housing or the credit problems that preceded the recession. If excessive use of leverage by private companies and government precipitated the recession, this too needs to be addressed. Second, even with the original disease gone, we have to make sure that we don't overdo the recovery...we don't want to do too much too soon. If the world economy jumps into fifth gear too quickly and oil prices rise to $90+ per barrel or if long-term interest rates, including mortgage rates, jump another 100 basis points -- surely this will negatively impact the pace of economic growth. Third, we have to pay close attention to side-effects of whatever drugs we took. That is, in the past year or two the government spent a lot of money. The Fed emitted a great deal of liquidity into the economy. We now have future prospects of inflation and much larger deficits and debt that must be financed. This means we will have to make collective decisions about the future course of expenditures and taxes.

The point of this post is to emphasize that while the news seems a little boring right now -- there is much to think about and much to do. We should not get lulled to sleep by a nice cup of calming tea. Avoiding a double-dip recession or an extended period of slow growth is possible but it means sticking to the medicine and the right treatments.

New Comment Procedure

With the growth of the blog and the number of comments I was having a very hard time keeping up with and finding your new comments. It seems that the best way for me to keep up and respond in a timely way is to use the permissions option. Now when you post a comment I will receive an email notifying me. I then approve the post. Please understand that this is NOT a means for me to edit or filter your comments. I have no intent to do that -- I welcome all respectfully written comments whether they agree or disagree with me. Note that even without this option, as the author of the blog I have always had the ability to edit/delete your comments and I have never used that option. I hope you had a great weekend. I was away from my computer since Friday morning so I was very inactive this weekend. I hope to get back in the saddle soon.