LFPR and the New Macroeconomics

The civilian labor force participation rate (LFPR) tells the percentage of the population that wants to work. That is, it counts those with jobs and adds those who are looking for jobs and relates that number to the size of the population. Not everyone wants to be in the labor force -- some are too young or too old. Some are busy getting education. Some are sick. Some don't want to work for a variety of reasons. So LFPR is never close to 100%. 

US LFPR generally increased after World War II until early 2001 after it reached a little more than 67% of the population. Since then it has been falling and was recorded as 62.7% in May 2017. This roughly 4% decline is meaningful -- 4% of the US population of 230 million people is about 9 million people who no longer participate in the labor force. To put that number of 9 million in perspective – that’s about how many people work in manufacturing. That’s like everyone in New Jersey deciding they would no longer take or look for a job. No New Jersey jokes please. 

This new 16-year trend is important. I am going to argue that it is very important and may constitute the beginning of a new phase of macroeconomics and policy. As I said last week, macro is becoming obsolete. Monetary and fiscal policy are out of bullets. Supply-side policy has political downsides. So what’s left?

The answer might reside in the LFPR. Today’s experts repeat over and over that the lackluster economic growth predicted for the future is caused by lack of business spending on capital and a reluctance of people to join the labor force. One could go further and say that the former is related to the latter – firms are pessimistic and won’t invest more because they see LFPR as a major problem and do not see a government that is doing anything about current economic challenges.

Future macroeconomic theory and policy, therefore, should be focused on LFPR. I have mused in this blog in the past that if labor is not forthcoming and if the labor that does come is not prepared for the jobs of the future, then maybe we should focus on that mismatch. In macro we usually take that mismatch as secondary and hope it will be solved by national economic growth induced from traditional monetary and fiscal policies. But that puts the cart before the horse. Maybe today we need to focus on labor mismatch and if we solve that then maybe economic growth will improve in the process.

This post today is a humble beginning in this direction, and my only goal is to shed some light on the data. Today I look at some of the data as it relates to the LFPR. I got the data from the FRED service at the St. Louis Federal Reserve Bank. I look at data from 2002 to 2017. The goal is to better understand or break down the above-mentioned roughly 4% decline in labor participation in the USA.

Consider first, men versus women. The table below shows that LFPR for both men and women fell between 2002 and 2017 – but it fell more for men – falling almost twice as much.

                        Women    Men   Gender Gap

2002                 59.6          73.9    14.3

2017                 57.0          69.0    12.0

Change             -2.6          -4.9    

Next, look at age. In 2002 almost 84% of those in the prime work ages (25-54) looked for and/or found work. Younger people worked too – 76% was the LFPR for those aged 16-24. Those 55 years or older had a much lower rate at 34%. The changes in the next 25 years are interesting. For the regular working ages the LFPR went down by only 2%. Those at the younger end found participation rates falling by at least twice as much as their seniors. As for the older folks, they are participating dramatically more – an increase of almost 6% in their LFPR!

                        25-54    55+  16-19 20-24

2002                83.7      34.2    76.7   75.4

2017                81.7      39.9    71.9   70.4

Change            -2.0      +5.7    -4.8    -5.0

Finally I look at education. The first column looks at high school graduates 25 years and older; the second is college graduates 25 years and older. The impacts of college education on LFPR are dramatic. While college-educated people did participate somewhat less in 2017, the change for high school grads was much larger – almost five times as large.

                        High School              College

2002                          64.4                75.4

2017                          58.0                74.0

Change                      -6.4                 -1.4

This excursion through some data is meant to be a first step in looking deeper into a major macroeconomic challenge. Surely this is not enough data to form solid conclusions. Curious minds would wonder about other and finer breakdowns as they relate to education, training, age, race, location, industry, and more.

What is going on in the last 16 years? This data suggests that the largest groups to explain a slowdown in labor participation are young males with less education. Surprisingly, older people who should be enjoying time on Alaskan cruises sipping JD seem to be increasing their participation.

A scientific friend of mine said that most good science starts with data and ends with understanding. Labor force participation data needs to be better understood. Then perhaps we will know WHY participation is flagging and perhaps what we can do about it. Let's get back to work!

Do We Need a Bigger Pot?

You planted your lovely Japanese Maple in a nice pot and it flourished – at least for a while. So you added some fertilizer and moved the plant to a sunnier location. That helped but only for a while. Your neighbor suggested JD but you didn’t agree. Other friends suggested you try moving it to a bigger pot.

The economy is not so different from the Japanese Maple. When growth slows, we want to do something to restore healthy growth. It is not always obvious which is the best remedial path to follow. So we will always have some difference of opinion as to how to proceed. History helps us think about these competing policy ideas.  

Macro has a history of policy preferences. Before the 1940s arrived, we had no strong preferences for active policy and we preferred to let the markets work. Adam Smith’s invisible hand would heal the economy. As policy makers stood by, it was believed that prices and wages would fall enough to restore weak demand to stronger levels. Competition and markets would ensure growth in the longer term.

The Great Depression shook that theory. Despite large reductions in wages and prices, the economy did not return quickly to its former strength. John M. Keynes was among a number of economists whose theories supported a stronger role for government in rehabbing a sick economy. While Keynes was not a big fan of monetary policy, he did believe that fiscal policy could be used to kickstart a weak economy. If people were too pessimistic about the future to spend, then the government could spend or perhaps induce people and companies to spend through tax breaks.

This was the start of Keynesian aggregate demand policy. It was notable for three reasons. First, it gave a stronger role and perhaps an obligation for government to intervene when an economy was in recession or headed for one. Second, it was very specific that the intervention had something to do with reviving flagged demand for goods and services. Third, other followers of Keynes were less negative about monetary policy and added monetary policy to fiscal policies as acceptable government macroeconomic tools.

This approach to macroeconomic policy became the status quo until the late 1960s and 1970s when we experienced a series of supply shocks and a run of stagflation. Increasing AD was not the remedy for this disease, since a policy to get people to buy more would worsen inflation. And worse yet, with inflationary expectations high and rising, any increase in spending would cause even more supply shocks and stagflation.

What to do? Nixon threw up his hands in frustration and landed on wage and price controls as the solution. Even Spiro Agnew knew that wouldn’t work. The controls were stopped in 1974 after three frustrating years of failure. We were eventually treated to a remedy in the early 1980s when the Fed stopped AD and inflationary expectations in their tracks with 20%+ interest rates. We had two recessions as a result. Lesson: don’t let AD get out of the corral. Getting it back in is too painful.

Reagan and Thatcher wondered if there was an easier way to combat stagflation. And they hit upon aggregate supply policy. The idea is that sometimes a weak economy is not primarily caused by reluctant consumer spending, but rather by uncertain business firms who don’t want to take risks involved with producing more. It’s not easy to tell what is causing an economy to slow. But clearly there are times when uncertainty of business firms is what is mostly responsible for low levels of employment and output.

Depending on which famous economist you bribe, he will tell you that AS policy is either the best thing since sliced bread or worse than a Syrian Bar Mitzvah. But the sad truth is that the concept has been thoroughly trashed by people who refer to AS policy as a Trojan Horse, Voodoo, or Trickle-Down Economics. You would never give your kid any of those names. The challenge is that AS policy is aimed to increase the incentives of business firms to produce. So instead of AS policy directly impacting your ability to spend, it starts by stimulating firms with the idea that they will then produce more and probably hire more workers and then they will spend like the Tuna after winning the lottery.

So what about now? The situation now is that AD policy was tried, and it is out of bullets. The Fed has kept interest rates at zero so long that interest no longer impacts spending decisions. Of course, old fools like me are constrained from spending because the interest earnings of our retirement accounts are producing very little spending power. And if monetary policy is out of bullets, fiscal policy did about all it could to give us cash for clunkers and now the government is in debt with all projections showing the nation’s debt situation getting worse and worse. Don’t count of the usual fiscal policy to get spending roaring again.  

So if AD policy won’t work, what are we left with? Yup, we are pretty much left with the Voodoo. I think AS policy is worth the risk. Maybe it won’t directly and immediately improve the distribution of income. But most of us would be more than happy to have growing job opportunities and rising incomes. Okay, maybe all those rich business executives will gain more than I will from an AS Policy – but right now many people would be pretty happy to just get a job and/or a fat raise.

AS policy is like making the pot bigger. The plant already has too much fertilizer on it. The roots need some room to grow. This might not lead to a miracle but tax reform, deregulation, and a number of other AS policies can lead to more economic capacity and growth. AD will follow. So will our incomes. 

The Fed and the Feds

Add an “s” to a word and it becomes plural. Simple. One JD tastes good. Two JDs taste even better. There is no real confusion. The meaning of “s” is pretty clear. The same goes for the possessive “s”. That one is Larry’s JD. The “apostrophe s” is pretty clear. That is my JD and not yours.

But add an “s” to the word Fed and you get chaos. The Fed is the Federal Reserve, the central bank of the USA. The Fed is not your typical branch of government. For years, I taught that the US Fed is independent of the US government. It is not a part of the administrative, legislative, or judicial elements of the government. Ms. Yellen and the board of the Fed make important decisions about monetary policy without approval from any of those branches. It is true that the Fed itself and its administrators are created/confirmed by the government, but once in office they pretty much do what they want to do.

If you add an "s" to Fed you get the Feds. The Feds are the government, or in this discussion today, the US Treasury Department. The Treasury carries out the financial aims of the President and Congress. When government spends more than it receives in revenues, the Treasury sells government bonds or borrows from the public. That government budget deficit is what accumulates into a large national debt when the government continually spends more than it takes in. 

The confusion between the Fed and the Feds arises because they both play in a sandbox called the bond market. The Fed buys and sells already outstanding government bonds (and a few other things) as a means to carry out its monetary policy. The Feds (the Treasury) sell brand-spanking new bonds to finance the government's annual deficits. 

There was a time when the Fed was required to buy government bonds from the Feds. But in March 1951 an agreement between the Fed and the Treasury called “The Accord” let the Fed buy Hondas. Just kidding. The Accord said the Fed could no longer buy bonds from the US government. This freed the Fed from being a lap dog to the Treasury and gave it more independence to pursue its preferred monetary policies. 1951 is also known by some as the day rock 'n' roll was born. 

What a relief to not have to buy all those government bonds. Life would be easier for the government if the Fed just printed money and gave it to the government to spend willy nilly. But the Accord said no way. The government would have to find real suckers to buy all those bonds.

Are you art history majors keeping up? Great! This story has an ending. Ms. Yellen and Treasury Secretary Mnuchin run away to Ukraine together and lived happily ever after. Just fooling with you again. But there is a conclusion here about interest rates.

While the Accord agreement prevents the Fed from buying bonds from the Treasury, it does let them buy them from Pete and Charlie. You might have read that the Fed has a ton of government bonds. Experts use fancy phrases like the “Fed’s balance sheet” but those of us who got Cs in accounting know that means the Fed owns enough bonds to paper the entire Great Wall of China. They bought those bonds because the government sold them to the public and this flood of bonds caused interest rates to rise. Since the Fed hates it when interest rates rise, they bought these bonds from the market (not from the Treasury). The Fed's intent was to stabilize the government bond market and keep interest rates lower than a limbo stick at a Gary Coleman convention. 

Thus, the Fed has a lot of government bonds despite the Accord.

What the Fed does with this gargantuan pile of bonds in weeks ahead is why I wrote all that stuff above. The Fed could simply sell the bonds. Just as you advertise that you have a rusted patio chair to sell, the Fed can let the world know it wants to sell its government bonds. Since the Fed has a lot of bonds, this announcement would send bond prices plummeting and interest rates soaring. While the Fed is looking to normalize interest rates, they don’t want them soaring. So selling a bunch of their bonds too quickly is not in the cards. 

Even if the Fed sells them gradually, markets are not stupid. There are a lot of bonds.

One smart cookie noticed that many of these bonds are maturing. That is, the Fed will receive a final payment from the government and the bonds will disappear. But that is not the whole story. Where does the Treasury get the money to pay off these maturing bonds? Since the government has a whopping deficit, it can only get the money by selling even more bonds. As they do that action, interest rates would  rise and the Fed would buy more bonds from Charlie and Pete. Hmmm – an action by the Fed to reduce its bond holding causes the Fed to hold more bonds. Dern. No cigar here.

So for sure the impact of the Fed reducing its balance sheet will be upward pressure on interest rates. Whether the Fed sells its portfolio tomorrow or the next day, whether they sell the bonds or simply not renew them, the result is the same. Higher interest rates! What is the moral of the story?

A doughnut store opened across the street, and you gained 100 pounds. Despite your protestation and decision to drink one less JD per day, you are in for quite a challenge to restore normalcy.

You can swear off doughnuts but that just makes you hungrier. So long as the store is there and you don’t like hunger, you will not lose much weight.

The government has huge deficits and debt. That’s the candy store. The Fed hates 
owning all that debt but it also hates what happens when they sell it or don’t buy more of it. That's the Fed getting fat. 

The process of returning to financial normalcy starts with a government that balances its budget. It also goes with a Fed that attends to its monetary policy goals and adheres to both the wording and spirit of the Accord. The Fed is not the problem. The Feds are the problem. If government stops having large deficits then monetary policy is easier. It won't matter if the government sells short-term bonds or long term bonds. A balanced budget means they won't be selling much of either. Ms Yellen can then go fishing. 

Lord of the Flies

Lord of the Flies is a book I read in high school. It is fiction. Experts say it is about loss of innocence and about the constant conflict between savagery and civilization. Heavy stuff. I was thinking about Lord of the Flies because I keep searching for explanations for current political behavior.

Maybe it was Lord of the Flies that formed me. Maybe it was Atlas Shrugged. Maybe I am giving away more about myself than I should. I also loved Hesse's Magister Ludi. But the point is that today we are suffering from an age of optimism. How can one suffer from optimism, you ask? 

Optimism is good. But we can suffer from optimism after events start to shake our foundations. In Lord of the Flies, an airplane carrying schoolchildren crashes on a deserted island. The children are very civilized English kids. But it doesn’t take long for the tea and crumpets to disappear and for raw human behavior to take over.

Which made me think about today. We are optimistic. We think of ourselves as being sophisticated and mature. We know we are much better than those savages that lived hundreds of years ago. We go to school for many years and we become experts on things. We can afford to buy and read books. We give money to worthy charities. We value finding balance between work and play. We take time to worry about those who are less fortunate than ourselves, and we devote time and thought to helping them.

We do all this because we can. We are not living in caves, and we are not constantly threatened by beasts lurking outside our caves. Productivity allows us to work less, and labor saving devices let us manage our non-work lives with minimal effort. We don’t have to grow our own food, and we don’t usually make our clothing.

We are incredibly civilized and nice. Think about politics and government in the US. In the past eight years, we devoted ourselves to equality and fairness. Okay, maybe we didn’t get any medals for achievement but the Obama administration and the Democratic Party reminded us continually about the unfairness that remains in our modern and rich society. And today as we discuss healthcare, tax reform, and government debt, we cannot escape expectations that any and all reforms be fair and not abandon those with lower incomes.

I am not complaining. I am just describing what is. We are a very optimistic, caring society. Those little English boys came from a very caring society before their plane crashed on that fictional island.

What then brought out their savage sides? The savagery arose when the society they used to know vanished and was replaced by fear and uncertainty. Living on a deserted island isn’t easy. It is downright scary. Living right before the great recession was not so bad. Economic growth, employment, and wages were good. Income inequality worsened but overall we felt pretty good.

But then the recession pulled the rug out from under us. Like landing on a far-away island, we “landed” on a new economy full of perils.  And worse than the actual dismal economic effects were the thoughts that our economic system had failed us. Every time the government added a new stimulus package and/or a new regulation, they sent out a message that said, "Times have changed for the worse, we don’t know where this is heading, and we are going to have to do very extreme things to save the day. But don’t worry, the government is here to save us all."

If that isn’t scarier than a plane wreck and a deserted island, then I don’t know what is. Obama’s team was cool as they went about turning this country upside down. Whether it was cars for clunkers or some crazy Dodd-Frank program that took a wrecking ball to small banks, they plowed ahead to forge a new world.

This is not to criticize either the Bush or Obama administrations. It is meant to be a description of what we have been through since 2008. Bam, there you are on a deserted island that only mildly resembles your previous home and bam, people start trying to fix things.

The result in Lord of the Flies was horrible. As the boys grappled with life-threatening issues, the worst of their personalities came to the surface. As the US economy struggles to regain its balance, we are seeing the same kinds of things. It’s not just our political leaders. It is all of us. We thought we were sophisticated but to me, it isn’t sophisticated to treat your friends and neighbors with disregard at best, rudeness at worst. 

Sadly, Lord of the Flies resolved nothing. The book ends when the boys are rescued by adults. They go back to being boys again. How is our book going to end? Who is going to save us from ourselves? When will we be able to go back to not walking on eggshells whenever we discuss current economic policies? When will we kiss and make up?

Lesson 17 Interest Rates

Everyone knows what an interest rate is. But today the interest rate is more talked about than Howard Stern’s new personality. The Fed has a new policy to increase interest rates, yet interest rates go in the opposite direction. Is this a Putin plot to control the US economy? Maybe, but it is also true that most of us don’t know squat about interest rates, so let me waddle into the fray and try to make us all experts. I also explain why I think US rates will rise, and the prediction is not mainly the result of Fed policy.

There are more interest rates out there than new expensive bourbons. Dang, even Washington State is making bourbon. That should really infuriate our Kentucky friends. Interest rate is a phrase that means if you let someone have some of your money for a while, they will give it back with a little bonus. Consider my savings account at the local credit union. I gave them several thousand dollars, and I got 18 cents back in interest this month. Not all financial assets are that crappy thankfully, but in today’s financial scene, we talk about interest rates being very low. You can earn interest on savings accounts, short-term government bonds, long-term government bonds, private bonds, and so on. 

In macro, we talk about things like national output, the price level, the wage level, and so on, even though we know there are many different goods and types of labor. So it is with interest rates: we often refer to “the interest rate” even though we know there are many of them out there. So my first order as macro blogger-in-chief today is to say that the 10-year US government bond is often used as a statistical indicator of the US interest rate. Today that rate is at about 2.3%. To put that rate into perspective, it achieved a high in the early 1980s at 15% and as recently as 2007, it peaked at more than 5%. So it is pretty clear that at 2.3% interest rates are very low today. If you buy a bond for $100 then you would expect to receive roughly $2.30 in interest over the course of a year. That will not buy you one espresso mocha at Peet’s.

So why is the interest rate so low today? Why is the Fed having trouble raising it? And what explains the future course of interest rates? Wow – lots of questions.

Let’s address the various things that impact interest rates. If you lend money to a company, they are going to use it to improve the company. So if prospects are good for companies, they are very apt to be borrowing. Suppose a company borrows money to expand the capacity of one of its manufacturing plant. If prospects suggest a 5% return on money they borrow, then they don’t mind paying 3% to borrow the money. So a major factor affecting interest rates is optimism about the future economy. The more optimistic firms are, the more they are willing to pay for funds. The more pessimistic they are, the less they are willing to pay to borrow.

A second factor is inflation expectations. Paying back a loan takes time. The lender receives these payments and that constitutes their return. If the prices for goods and services rise during the payback period, the lender receives dollars that are worth less in terms of goods and service. Thus, at the beginning of the loan, it behooves the lender to anticipate future inflation. Imagine if they think inflation will reach 100%. A 4% interest rate would be lame. Maybe 104% would be better and would protect them from the expected inflation. So we say that today’s interest rates have an inflation premium. The higher expected inflation is, the higher is the interest rate.

What else affects the interest rate? A third factor is risk. Risk relates to the expectation of the lender receiving no payments. That is, if the economy tanks sometime in the future, then the lender gets nada. The riskier the economic environment is, the more the macro risk rises and the more lenders want today in the way of an interest rate.

That’s a long list of factors affecting the interest rate – optimism about business prospects, inflation expectations, and risk. What else? The general idea of supply and demand as it impacts bonds points to other factors like returns in the stock market, real estate, insurance policies, and foreign assets. One has choices in holding assets. Instead of owning bonds which give you a rate of return, you could also choose to have stocks, real estate, savings accounts, and similar assets from other countries. Thus, anything that makes these other assets relatively more attractive will reduce the demand for bonds and raise the interest rate. For example, if interest rates begin to rise in Europe, investors might sell US bonds so as to buy more European bonds. This would lead to a rise in the interest rate in the US.

Finally there is the Fed. Usually the Fed tries to impact short-term interest rates but quantitative easing suggests they attempt to influence the entire term structure of rates from short to long-term.

I probably have forgotten something but you can see the list of things that could impact the US interest rate is pretty long.

Anyone who wants to think about the interest rate today or in the future has to grapple with all these factors. What do you think about these?

US business confidence?

Inflation expectations?

Macroeconomic risk?

Stock market gains?

Relative desirability of real estate, life insurance products, banking products?

Interest rates abroad?

Fed policy ?

Price of JD?

Here is my quick outlook. As the distance from the great recession widens, the world economy is going to continue to slowly improve. Along with these improvements will come more optimistic assessments of US economic growth.

Worries over long-term changes in labor force participation and productivity will remain but will be lessened. As these worries recede aggregate demand will get even stronger and the result will be higher employment, wages, and inflation.

While I am not predicting a resumption of very high economic growth, I am projecting a more positive response than is now envisioned. With the Fed slightly more worried about inflation, their policies combined with the more sanguine macroeconomic outlook will produce a clear cycle of rising interest rates. Since the US will likely be leading this global parade, our higher interest rate will spill over to higher rates abroad and will create international impacts that will raise US rates even more. 

I hesitated about going further but no economist makes a prediction without covering his butt. Nations are prone to making horrible policy choices. It will take some doing but a general recognition that new policies will be inherently bad for economic growth could lock us into interest rate purgatory for a long time. The US, China, the EU, and several other places need to keep their collective foot on the growth pedal. Stupid stuff will keep it all low --  interest rates, economic growth, investment spending, productivity growth, and labor participation. Focus on the growth ball, guys. Plain and simple. Interest rates will go up and we will enjoy it. 

Marching for Science is Like Marching for Air

According to the Wall Street Journal, the March for Science last week “drew tens of thousands to more than 500 rallies world-wide.” The organizers proclaimed the purpose was because of attacks on science.

I am not sure how people can attack science. And where are these bleeding hearts when people tell the same stupid economist jokes every time I show up at an event? People attack economics all the time but no one really seems to care. And what about meteorology? How would you like to be a weather forecaster at the annual gathering of Florida Flood Insurers?

What is this thing called science that people braved inclement weather and dog poop as they strutted their stuff in 500 places around the globe? It seems to me what these people really want has little to do with saving science and everything to do with promoting their own agendas. So let’s get into it.

Science is an elusive topic. Most of us discuss it by describing its characteristics or elements. For example, hard sciences include biology and chemistry. Defending biology and chemistry is a little like promoting spinach and kale. Yuck. Or you might discuss science by mentioning microscopes or lab coats. While all that helps one get closer to describing science, the truth is that such an approach is at least incomplete if not very misleading. You can know a lot of biology and/or walk around in a cool lab coat but neither brings you much closer to the definition of science.

Science is elusive but simple. Science is anything that uses the scientific method. That’s all there is to knowing the definition of science. Tuna, wake up. This is getting more exciting.

Using terms like “the scientific method” is a lot like talking about diminishing total factor productivity. It sounds technical and difficult. But the scientific method is way cooler than disco music. It is like the air we breathe – it is right there in front of us making life better and easier. It’s very practical and useful.

Here is my list of steps involved with defining the scientific method:

1.    Pose a problem – e.g. people drive too fast

2.    Think up a reasonable explanation for that problem – people love the excitement of going fast

3.    Study the problem – when police officers give people speeding tickets, have them ask the people why they were speeding. Sir, were you speeding because it was exciting, or are their other reasons why you were speeding?

4.    Compile the data from a sufficient sample of speeders and draw a conclusion – 10% of the people said they speed because of the excitement. 90% said they speed because they forgot to look at their speedometer. We can reject excitement as the main cause of speeding. 

5.    Solve the problem – suggest that all highways present signs that say “Drivers, please look at your speedometer more often.”

6.    Keep studying the problem to see if the solution worked.

7.    If you aren’t satisfied with the degree of problem remediation, go back to step 2.

Wasn’t that fun? But that’s all there is to the scientific method. It works for all sorts of problems and questions. That’s what makes it so cool. Because you use science does not mean you will always get things right. But it does say you will always strive to get improvement.

What is also notable is that scientists NEVER (am I yelling?) say they proved something. They ALWAYS say they either rejected or failed to reject a reasonable explanation for a problem. In the above example, we rejected the importance of thrill seeking in speeding. We did not reject the importance of driver attention. But we didn’t prove anything because the next study may find a new outcome – yup, distracted driving might be more important as a cause of speeding in your next scientific study. And then there is always JD.

In a nutshell, the scientific method never really ends for any important problem because we assume that important problems are complicated and because the world changes over time. The number of truly immutable scientific laws are very few. The Law of Gravity is one of them. That baby works well nearly all the time. But much of what we call science and cause and effect are temporarily held conclusions and truths. That means we expect that they will need to change and be revisited.

If that is science, I don’t really know anyone who is trying to stop scientists from doing their thing. The group behind the March for Science seemed to implying that some people don’t believe the facts, models, and predictions about climate change. But that seems odd – because the true basis of science is to be skeptical. The true foundation of science is knowing that models are incomplete and static, data are notoriously fallible, and truths are both durable and fleeting.

Unfortunately what I hear in the March stuff is asking that people not be skeptical about today’s models. They are asking people to stop questioning. They want folks to support them in taking a political position.

One more point. What is good today is that real scientists are studying climate change and environmental issues. These people are asking the right questions, and I am optimistic that their hard work will produce a better world.  I realize that a slow pace of policy remediation has its risks – but so does rushing to conclusions. Let’s let the scientists duke it out in an open and competitive scientific space without interference from either the political left or right. Only then will we eventually get the best results. I don't see how marching does much to accomplish that.  

We are all Conservatives Now

We are all conservatives now! I knew that would get your attention. No, I am not into my third JD of the evening. But something is going on out there – or not going on out there – that supports my wild contention.

First, I am focused on financial conservatism – not the social variety. Second, I am speculating about conservatism as it plays out in macroeconomics policy. This idea has been ruminating in the dark recesses of my brain and jumped to the surface this week after I read one brief article online worrying over the uncertainty about US policy under Trump and then read another lengthier piece about the global economy by the International Monetary Fund.

The shorter Bloomberg article thought that stalling new policies for infrastructure spending and tax reform would injure corporate profits and lead to a slower economy. The IMF piece – a magnum opus on the world’s future output growth published this month – was more sanguine and predicted that the world and US economies would grow faster in 2017 and 2018. http://www.imf.org/en/Publications/WEO/Issues/2017/04/04/world-economic-outlook-april-2017

These two recent pieces see different futures but agree on one thing – it is the lack of traditional policy that underlies our economic futures. In macro, we learn two opposing schools of thought. The conservative macros believe good macro outcomes are the result of less government intervention. The liberal macros believe the opposite. The liberal macros believe that activism known as monetary and fiscal policy are necessary to rev up spending and will lead to full employment and strong economic growth. This liberal belief has become traditional. 

While the IMF often shows a liberal tilt in their outlook reports, much of what they say in the April installment is lacking in liberal spirit. From this I conclude that we are in a new economic policy conservative era – at least for a while.

While the IMF is forecasting marginal improvements in economic growth around the world, they mostly see an economy stuck in neutral and not ready for the next drag race. Summarizing from a long and technical report, the IMF describes an economy hampered by dismal expectations. The usual monetary and fiscal policies are having little effect on spending, and the more they fail to work, the more pessimistic we become. And therefore the policies have even less impact and we become even more dismal.

Low and negative interest rates spurred some activity in housing and autos but firms are sitting on their hands when it comes to expansions and modernization. Despite record amounts of fiscal stimulus, there is little bump to spending in the economy. The more the government lingers with these policies, the more dismal people become. The IMF wishes that governments could magically raise optimism. But how do you do that when the usual policies are not working?

What is refreshing is that the IMF is recommending some very conservative policies—policies that could be called supply-side. Imagine that. They admit that government is out of bullets. In fact they admit that there is already too much money outstanding and too little fiscal space (too much high debt) for most countries to resort to the usual policy practices.

The IMF names two major trends that are holding back the advanced countries. The first is a decline in the labor force participation rate. People are not wanting to work as much as in the past. Various reforms could help on that score but these reforms have nothing to do with the usual macro policies. They focus on the reward to work and on labor market mismatches. The second major challenge is in firms' willingness to buy new capital and to innovate. Firms are reluctant because of a dismal outlook but there are many ways that government can try to raise the return to capital without resorting to demand management. Reforms with respect to regulations and tax rates could go a long way to creating a more sanguine future for business firms. Raising the reward to work and to buy new capital will make firms more productive and profitable and should improve the growth rate of the economy. 

In addition to these trends are two global factors that dent our ability to grow faster. The first is recovery and reform in China. As these reforms start to work, China will resume its role as a locomotive pulling the rest of us along with them. Finally, there are the lingering impacts of commodity and energy prices. While we all love a low price of gasoline, the low prices of energy have stunted exploration and development of oil and gas. Emerging markets prospered with high energy and commodity prices. They tanked with low ones, and the contagion was global. 

None of the above supports a role for the usual liberal macro policies of monetary accommodation or fiscal expansion. In fact, making people more optimistic might involve admitting the ineffectiveness of these old tools – and thus we come away thinking that monetary normalcy and budgetary restraints are the key to optimism and spending. But better than that is the simple idea that policy should fit the nature of our problems. Right now our problems are from the supply side. Demand is low BECAUSE supply is low and because global challenges add to an uncertain outlook. Policies that directly target supply issues are what the IMF is recommending. What a refreshing change of message! 

Can We Kick the Budget Can down the Road Again?

We've kicked the can down the road so many times, we have a sore foot. This month our friends in the Federal government will create another ring in their circus called shutting down the government. It will be a colorful display of clowns before they get all serious and make another short-term compromise that will get us through the end of October. I'll drink a JD to that! Cheers.

The can-kicking has put us in one of those rock-and-hard place situations. We are used to the fact that government likes to spend more money than they raise from taxes. So each year the government borrows, and each year what the government owes to its creditors gets bigger. But a funny thing happened on the way out of the last recession -- our Federal Government Budget Deficit increased more than usual. And as a result, the US national debt has reached a size that we are not comfortable with. In terms of the size of the US economy, the net national debt is now double what it was way back in the good old days of 2008.

Put it on a personal scale. You have a large student debt. But now you want to spend the summer in Europe with your friends. Banks have your photograph in their lobbies, and you cannot borrow a penny for your business-class seat to Barcelona. Something has to give. You might have to sell your new car but you owe more than its worth. Or maybe you will need to get a part-time job. Ouch, whatever, the choices are not easy.

Republicans who want to spend more on X will scream about the stupidity of spending on Y. Democrats will decry the heartlessness of lowering spending on Y and the waste of more spending on X. Of course they could compromise on spending but it's more fun to wear a clown suit and honk horns.

As part of my therapy, I thought I might look at some numbers that compare the US to the rest of the world. Luckily, the International Monetary Fund publishes figures on government deficits and debts. In October 2016, they published a report called the World Economic Outlook where they looked at the world economy and made forecasts about the future. The table below comes from their online data appendices. The data for 2017 are forecasts made last October.

The table contains government deficit figures for selected countries. The column marked 2008 has deficits right before the great recession. The column marked Peak has data from either 2009 or 2010 depending on when the deficit was the biggest. The next column measures how much the deficit increased to the peak. Then comes the forecast deficit for each country in 2017 and how it has adjusted since 2008. Deficits are measured as a percentage of GDP for each country. Some thoughts from the table:

World investors are watching all these countries for signs of economic weakening. And with emerging market deficits rising so much, any hint of weakness anywhere has the potential to spook investors and move capital around the globe in gusts.

The US is a major country but is not exempt from investor decisions. Right now we don't look like the worst kid on the block. But if we kick the can down the road again while other countries appear to be more grown-up, then we may be amazed at how nasty those global investors can be. We won't be complaining about the value of the dollar being too high then.

Most countries had budget deficits in 2008. Most countries had deficits in that year though a number of resource-rich countries like Norway and Saudi Arabia had surpluses. The average deficit for advanced nations was -3.5%. The US was among a few with the largest deficits in 2008 with -6.7% of its GDP.

Then the great recession happened. This impacted the deficits in two ways. First, the weak economy automatically generated less tax revenues and more spending. Second, governments used expansionary policy to pump up the economy with more spending and less taxes. Notice the US had one of the largest increases from -6.7% to -13.1% of GDP.  Spain, Ireland, Russia, and a few other places managed to increase their deficits even more than the US.

The good news is that by 2017, most countries reversed their deficits. A combination of recovery from the recession and less accommodative budget policies brought deficits down. Most advanced countries will end up with deficits in 2017 that are smaller than those from 2008. The positives signs in the last column show the movements toward surpluses or larger surpluses. The average budget betterment for advanced countries amounts to almost 1% of GDP.

The more interesting and challenging part of the table relates to the developing or emerging countries. The table shows that their budgets were not quickly impacted by the great recession. But as the global contraction spread, they were increasingly affected. Emerging markets started with surpluses (0.8%) in 2007 which worsened to -3.8% within a couple of years and are expected to be -4.6% in 2017. Russia began the time with a surplus and now has a deficit. Venezuela, Saudi Arabia, and Libya each have extremely large budget deficits in 2017.

So what? While many countries have moved towards smaller annual budget deficits, the lasting impact of years of deficits is that most debt loads are larger. The US net debt load is now double what it was before the recession. Germany and Canada find themselves without increased debt burdens, but most of the other advanced countries have higher loads ranging from 30% for Italy to 140% for the UK.

	2008	Peak	Change	2017	Change
			08 to Peak		08 to 17
Advanced	-3.5	-8.7	-5.2	-2.7	0.8
USA	-6.7	-13.1	-6.4	-3.7	3
Euro Area	-2.2	-6.3	-4.1	-1.7	0.5
Germany	-0.2	-4.2	-4	0.1	0.3
France	-3.2	-7.2	-4	-3	0.2
Spain	-4.4	-11	-6.6	-3.1	1.3
Greece	-10.2	-15.2	-5	-2.7	7.5
Ireland	-7	-32.1	-25.1	-0.5	6.5
Japan	-4.1	-10.4	-6.3	-5.1	-1
UK	-4.9	-10.5	-5.6	-2.7	2.2
Norway	18.5	NA	NA	3.2	-15.3
S. Korea	1.5	NA	NA	1.1	-0.4
Canada	0.2	-4.7	-4.9	-2.3	-2.5
Emerging	0.8	-3.8	-4.6	-4.4	-5.2
Russia	4.5	-5.9	-10.4	-1.5	-6
China	0	-1.8	-1.8	-3.3	-3.3
India	-10	NA	NA	-6.6	3.4
Brazil	-1.5	-3.2	-1.7	-9.1	-7.6
Mexico	-0.8	-5	-4.2	-3	-2.2
Turkey	-2.7	-6	-3.3	-1.6	1.1
Argentina	0.2	-2.4	-2.6	-7.4	-7.6
Venezuela	-3.5	-8.7	-5.2	-26.1	-22.6
Libya	27.5	-5.3	-32.8	-43.8	-71.3
Saudi Arabia	29.8	-5.4	-35.2	-9.5	-39.3
Sub-Saharan Africa	1.3	-4.5	-5.8	-4	-5.3
Source: IMF Tables World Economic Outlook October 2016
Tables from B Appendix
file:///C:/Users/davidson/Downloads/_tblpartbpdf%20(3).pdf

The Marx Brothers International Trade Policy

If you didn’t notice, two weeks ago we had some name-calling and hair-pulling in this quiet little blog. What fun! Chuck T posted a guest blog that argued against protectionism, and this energized the Tuna to take the other side. The battle was on, and I was among a few others who jumped into the fray. Along the way I was accused of being a two-handed economist, and after I figured out what that meant, I decided I needed to keep pursuing this topic. Two-handed economist indeed! 😊

The last time I looked, I had two hands. The issues of hands and economists apparently started when President Harry Truman got fed up with economists who couldn’t make up their minds and he demanded a one-handed economist who would not say on the one hand this and on the other hand that. He wanted someone who would take a firm position one way or the other. He realized that all national policy topics were multifaceted and wanted an economist who would weigh all the important elements. But he wanted someone who would then take a stand. Be on one side or the other!

So I am going to do that today. International trade and the benefits of trade are definitely complicated and multifaceted. No question. But this one-handed economist has little use for recently posed ideas about trade and trade policy.

But let’s start with the apparent problem with trade. Widely quoted data show that manufacturing employment in the USA has declined. They also show a deficit in our trade account and many stories corroborate that companies have moved their production abroad attracted by apparent favorable business conditions. These conditions might be lower wages or tax rates, but they also include closer locations to key parts of their supply chains, including materials or proximity to rapidly growing customer markets.

Some argue that policies that would thwart either imports of goods or the relocation of US firms will solve employment problems in America. A novel recent policy proposal would essentially make trade part of corporate taxes – wherein any export of goods from America would not be taxed while all imports would be. This pretty much reverses what used to be and would greatly favor firms that export from the USA. A second but complementary policy would somehow prevent other countries from depreciating their currencies so as to favor their exports in world markets while damaging US exports. A third policy would aim America-first principles at past and future trade agreements. Let’s call this set of three policies the Marx Brothers (Harpo, Chico, and Groucho).

There is much intuition to these polices. On the surface they seem to directly improve the situation. If other countries can’t cheat, this will help US export sales and jobs. If America matches subsidies given to exporters in foreign countries with similar subsidies at home, then those companies will have higher sales and employ more workers. If America penalizes companies for moving abroad, then even more jobs would be preserved at home. If past US trade negotiators “gave away the factory,” a new group of negotiators can get the factories back.

But just as a sticking one’s finger in the hole in a leaky dike sounds good in a moment of panic or frustration, such an act endangers the dam and all that live below it. What we need is a policy that works – not one that sounds like it might. So let’s think about what’s wrong with the three Marx Brothers.

First, economists who have studied the new tax proposal believe it will cause the value of the dollar to rise enough to offset the impacts of the tax incentives on the trade deficit. Thus, the desired remediation would be at best temporary. In addition, a permanent increase in the value of the dollar could make potential producers wary of locating in America, because it makes investment in the US more expensive. If they project a continued rise in the dollar that makes America a great place to import and makes it more expensive for foreigners to locate in America. 

Second is retaliation. A quick review of figures shows that US exports of goods and services is a mere 13% of US GDP. While we think this is large, exports are much more important to key trading partners. World Bank data for 2015 includes these ratios. Japan exports 19% of its GDP, China 22%, Canada 31%, Mexico 35%, Germany 47%, Vietnam 124%. Some might say Aha!  But that Aha! misses the point. These are countries whose medium-term survival is predicated on export success. They will not quietly nod as the US employs a new policy that threatens to harm their exports. They will retaliate quickly and with gusto. They will make it very difficult for their citizens to purchase US goods.

Third, it is possible that a new team of negotiators will do better with respect to past and future trade pacts. But keep in mind that the new team will be faced with increasingly motivated adversaries and a single unbending truth. The truth is that all sides to an agreement want the best for their own country. In doing so they have to make tough decisions because they know that every negotiation requires one to “give a little” to “get a little.” As in the above discussion about taxes and trade, the US is not going to be the only player in the room.  If the US wants to open services markets, protect intellectual property on foreign shores, or ask countries to reduce non-tariff barriers against US goods,  the US is going to have to give something up. If the US wants lower foreign tariffs on some of our manufactured exports, we may have to lower the tariffs on some of their manufactured exports. Whatever they choose, these negotiators will not be coming home with only trade benefits.

Finally we might need to come to grips with the idea that we are in a difficult transition, and whatever policies we impose to restore things to ways they used to be might work in surprising ways. Be careful what you wish for. 

We can close our borders to wonderful products produced abroad. Recall the cell phone took off when a Finnish company named Nokia made our lives incredibly better. We can make it unprofitable for US companies to locate abroad – when they are already not producing good results in the USA. Or by preventing our companies from locating abroad, we can deny them opportunities of innovation-sharing. If we are not careful, we will get what we ask for:  things like they used to in 1954. Aside from the TV show Father Knows Best, I think I like 2017 better. 

The Marx Brothers  and other America-first trade policies are most definitely not a slam dunk. Working to root out cheating. Trying to update relationships to current realities. These and other approaches are necessary, but even modest changes can backfire if not approached correctly. In today’s hypersensitive world with leaders who speak in riddles – even the smallest of changes can evoke recollections of Attila the Hun and reactions that go beyond the pale. Walking on egg shells is a better way to go. Meanwhile, we in the USA must figure out how a very rich country can grow and prosper as we fit into the world economy of the next 100 years. 

What's Up with Inflation?

Nathan and Brad are known troublemakers. The rest of their gang is well-mannered and even-keeled. I soon learned that I could understand and predict the behavior of the whole group by focusing mostly on Nathan and Brad. If Nathan had a few too many JDs the night before, then the gang would be quiet and slow the next morning. If Brad had been turned away from Night Moves the night before, the gang would be surly over Eggs Benedict.

That’s my take on inflation. Let me explain. The Fed awakened from its midsummer's night dream of slaying the unemployment dragon to discover inflation. Responding to an inflation rate in early 2017 that approximates the Fed’s goal for inflation, the Fed mightily raised the Fed Funds Rate by 0.25 points to a towering 1%. As my followers know, I have consistently implored the Fed to raise rates, so I should be happy. But alas, an economist rarely finds solace, much less happiness, as a practitioner of the dismal science. The rub here is that the Fed is doing the right thing for the wrong reason.

Returning to my opening paragraph, imagine that the gang started acting out. Someone not experienced with the gang would immediately point out the gang’s improper behavior and impose a harsh regulatory regime on all the gang members. But someone with more information would readily know the real cause of the problems – Brad and Nathan. As such, the appropriate remedy would focus on those two and not the innocent, sweet rest of the gang.

Okay, I am ready to be more specific. The Nathan/Brad nexus for inflation is the inflation behavior of two of the hundreds of prices of goods and services we buy in this country –  food and energy. The Fed has mistaken movements in the overall US inflation rate with changes in the prices of F&E. This mistake matters a lot – the remedies for a general rise in the nation’s inflation rate are very different than those associated with food and energy. For example, a policy to restrain buying of all goods and services might impact the prices of F&E. But surely that would be overkill as it would “punish” the whole gang of prices when they had little or nothing to do with the higher inflation.

Back up, Larry. What is inflation, and why are we concerned with it? Inflation is another one of those macro-thingies. Inflation measures how much the national price level is changing. Since most of us hate it when the price of JD or other necessities rise, we wonder about the course of the prices of most of the things we buy. Luckily, the Labor Department publishes the CPI each month, and we can oooh and ahhh about its ups and downs. When it goes up, we curse. When it goes down, we go to Tacos Guaymas and drink Tequila until we get acid reflux.

But it is not that simple. Sometimes a rise in the inflation rate is accompanied by rising employment and wages. That doesn't sound so bad. Sometimes it is associated with rising unemployment or what we call stagflation. That is not so good.

And worse yet, the CPI numbers are averages over many consumers. The last time I looked I was not the average consumer buying average stuff. In fact, if you know the average consumer, please have her give me a call. When the Labor Department constructs the CPI, they average together prices of food, beverages, fuel, recreation, education, Uber rides, and bunches more. But they don’t average all this equally. The prices of men’s golf shoes might have gone up by 1000% this month but men’s golf shoes are a very tiny part of what the average consumer typically buys each month – so 1000% has a very small weight and little influence over the CPI.

Here are some of the weights used to produce the CPI on various spending categories:

            Food and Beverage  .15

            Shelter                        .34

            Apparel                       .03

            Fuel for transport      .03

            Medical                       .09

So when the Labor Department averages prices in a given month, they pretend that the average person spent 34% of her income on shelter and 15% on food and beverages. Now let’s suppose you are on a diet that month and decided to live in a teepee. That month you spent a ton of money on your hair and nails and very little on everything else. Guess what. The price level may have gone up 3% for the average dude, but for you that would be very misleading.

General point. Inflation is a macro phenomenon and any month’s reading might have very little to do with changes in your welfare. The devil is in the details.

Let’s get back to the Fed. I looked at the data, and I think the lens is pretty fogged up. The Fed is mistaking an energy thing over which it has no control with a macro thing. They worry that inflation is rising but mostly what is happening in 2017 is that price change is returning to normal. From 2013 until the end of 2016, changes in macro inflation were almost totally driven by changes in food and energy. To be more precise, F&E were declining and were dragging down the average of all prices. Those low national inflation rates were not driven by national macro factors but instead by sectoral impulses originating in the food and energy components. Those impulses bottomed in August of 2016 and then turned marginally positive in 2017.

To be more explicit, what I did was look at the ratio of F&E inflation as a percent of total inflation (which includes F&E and everything else we buy). I won’t bore you with every month but below are a few data points from 2016 and 2017. In February of 2016, the annual inflation rate (from March 2015 to February 2016) was 1%. That’s a very low rate of inflation. But notice that prices of F&E were down 1.4% during that year. Thus the overall inflation rate was low because of the drag by F&E. You see similar results for most of 2016.

            Month               Inflation   F&E

February                   1.0      -1.4

            March                        0.9      -1.3

            September                1.5      -0.7    

For 2017, we have two months of data for January and February. Notice the much higher annual inflation rates in those two months. That’s quite a swing. But notice even more the swings in F&E from negative to positive change. For example, from September to February, the swing in the overall inflation rate was +1.3 points (1.5 to 2.8). The swing in F&E was from -0.7 to +0.6 or about + 1.3 points. Hmmm.

Month               Inflation   F&E

January                     2.5      0.3

            February                  2.8      0.6

Just in case you think I am cheating, the Labor Department publishers the CPI less F&E which tells you how much the prices of non-F&E goods and services change. Non-F&E prices seem to be stuck at about 2.2%. Over the 15 years from 2002 to 2016, they averaged about 1.9% per year. Is inflation higher in 2017, maybe a smidge.

Month               CPI w/o F&E

February 2016          2.3

March                        2.2

September                2.2

January 2017            2.3

February                    2.2

Point? Over the last several years, Brad and Nathan have been acting up like it’s Mardi Gras while the rest of the gang have been sleeping like babies. With regards to the overall economy, nothing much has changed. The Fed can’t do anything about food and energy prices. It should focus on creeping inflation of non-F&E prices but by no means is any of this heart-stopping. The Fed knows it should return its policy to normal. The recent rise in the inflation rate has nothing to do with all that. Interest rates of 1.0% are not normal. Gradually raise those rates and forget the inflation nonsense.