Wage Growth in a Tight Labor Market

Much has already been written about the employment report for May 2018 that was published on Friday, June 1. The unemployment rate, like your friendly mole, once again dug deeper and went to an 18-year low of 3.8%. This means that the labor market is growing tighter, which means that firms are finding it harder to find the right employees. There are many articles being written now about this business challenge as firms use innovative ways to try to attract new employees or to hold on to existing ones. Of course, a common approach to attracting and keeping workers is raising wages and benefits. 

Wages, therefore, become a critical economic variable these days. This week I decided to look at wage behavior in the USA to see if there are signs of firms using wages to ameliorate labor market tightness. The graph at the bottom looks at monthly percentage changes in average earnings for all employees. 

Reading graphs is definitely an art form. I ain't Picasso but let's give it a shot. Each dot on this graph records how much earnings grew in that month. If you go to the very last dot on the graph, it says that in May of 2018 earnings grew by 0.298 compared to the value in April of 2018. The one-month percentage change was 0.298%. For sake of our eyeballs, let's round up and call that a one-month increase of about 0.3% in May. If that one-month increase lasted for a full year, then wages would increase by about 3.6%. 

That's a big if and is only suggested so that we can put the one-month gain into an annual perspective. If Lebron scored 12 points in the first quarter of a game, he scored 12 points! But we could say something like -- dude, that's like scoring 48 points in a whole game. Wow. Groovy. He may or may not score 48 in that game but the 48 gives us another way of understanding the 12 he did score in Q1. 

Whew. I am thirsty. So if you read the above, you know that the 0.298 increase in May of 2018 is about a 3.5% annualized increase. That sounds pretty good. If the cost of living went up by 2% in May, then you might be happy that your wages grew faster than your expenses. 

The reason I placed the whole graph below is that we can evaluate the most current increase better by looking at past changes. This graph has monthly ups and downs from April of 2006 to May of 2018, so we can compare over a 13-year period. My task today is to evaluate the 0.298 of May 2018. 

Is it the highest point on the graph? 

     Absolutely not. Just in the last couple of years there were many months that had stronger growth in earnings. 

Is it the lowest point on the graph? 
     Absolutely not. There are even more months in which earnings grew much slower than 0.298. 

Is there any pattern to the monthly changes? 
     It looks like whack-a-mole to me. Most ups are followed swiftly by downs and vice versa.

Do you observe an upward or downward trend in the dots? 
     From about April 2006 through June 2010, there seems to be a downward trend. That is, on average, wage growth seemed to decline. Wages were growing but at a slower pace.  
     But from June 2010 to about October 2011, the wage growth picked up. From my eyeball, it appears that the average monthly percentage change during that time was about 0.2 or an annual rate of about 2.4%. 

     Then from 2012 to now, there appears to be no discernible trend change in earnings. For six years, we got ups and downs around a mean that suggests wage change at about 2.4% per year. If you removed the crazy negative data point in October of 2017, you might see some increase in trend starting around October of 2016. Of course, you might also see pink elephants.

Why go through all this madness? Because there is nothing like the data. You will see a lot of interesting and intelligent articles about wage change in the USA. Smart people will discuss the May data point and tell you that the 3.5% growth in May is higher than the 2.4% rate that prevailed over the last eight years. These folks may want to convince you that wages are spiraling higher -- and maybe they are. But looking at this graph from beginning to end does not make me very confident that we are on a new upward trend. I remain skeptical that the 3.5% means much of anything. I wonder what we will learn in July about June. 

Inflation Part 2. The Real GDP Gap

Last week I tried to explain why I am not a big fan of the Phillips Curve. If you were not bored by that little detour then maybe you won’t fall asleep this time either. We in the USA are clearly thinking about inflation these days. Is it going to come back and scare the bejeezers out of us? Or not. Since my crystal ball is at the Hyundai place for its 30,000-mile service, I won’t regale with you with any forecasts. But I will pull out some data that I think is pretty interesting with regard to inflation. To give away the ending -- it is not easy to see a 70s style inflation roast.

Last week I punched at the Phillips Curve and concluded it was a fake for the real thing – a supply and demand analysis of inflation. Since supply and demand puts most people to sleep, I decided that I would use a close cousin called the real GDP gap. The real GDP gap measures the difference between actual output and something we call potential real GDP. Remember when you were a little kid and they said you had the potential to be the next Liberace? You were not yet the equal of Liberace and probably were not even equal to Elton John. But they thought that you had a lot of potential. Potential real GDP is similar in that it is not what we actually produced but is a measure of what we are capable of producing (if all of us were working).

When we subtract actual GDP from Potential GDP we get a gap that is a measure of how far off from potential we are. If that gap is very large, then we would be saying that demand is not strong enough to lead to output equal to our potential. That is the kind of time when prices and wages are not growing very fast. But if real GDP is a lot higher than real potential GDP, then we have a gap that represents a lot of demand compared to what we can usually produce. During those times we produce more than potential output because more of us are out of the house and into jobs! These time periods are not sustainable because most of us don’t like to work that much all the time and because it often causes inflation.

Today I look at those historical time periods in which output was a lot higher than potential real GDP. It turns out that since 1960 we have had six of those episodes. The table at the bottom contains information for those six and for the seventh one that just recently started near the end of 2017. Since the latter has lasted only three quarters, it ain’t much to look at. But those three quarters make us wonder if this will be like any of the past six time periods when real GDP exceeded potential.

The six episodes were as short as three quarters (1989) and as long as 24 (1964). The average time was about 11 quarters or just short of three years. Based on these almost 60 years of experience in the USA, output has a tendency to be higher than potential for just about three years at a time.

How much output was above potential varies too. During the 1964 episode, output started out a tiny bit above potential (0.7%) and was as high as 5.6% greater than potential during one of those quarters. It averaged about 2.6% above potential over those 24 quarters. This shows it is possible for real GDP to grow very rapidly relative to its potential. Only in the 1972 episode did output again show such strength when it averaged 2.3% above potential. Since 1978, we have very few cases of real GDP being 1% above real GDP.

What about the inflation rate? In five of the six episodes, the inflation increased. In the 24 quarters from 1964 to 1969, the inflation rate rose by 3.2 points, from 1.5% to 4.7%. In the next time frame, it increased by 6.7 points as it went from 3.3% to 10% in the early 1970s. Of course you could say the inflation rate tripled in both of those time periods.

Notice that the inflation rate responded heartily to gaps through 1980 but much less thereafter. This mostly reflects that gaps became smaller but might also question the response of inflation to any given gap.

            Change in the Inflation Rate

            From Beginning to End of Period

            1964-1969     3.2

            1972-1974     6.7

            1978-1980     4.2

            1989-1989   -0.4

            1997-2000     1.3

            2006-2007     0.3

            2017-2018     0.3

Nothing is proved here. But clearly it will take a while before we can say anything about how much inflation will rise in the coming years. If the growth rate of real GDP does not pick up substantially in the next years it is hard to see how a gap analysis would yield a large change in the inflation rate. If the inflation rate is close to 2% right now, then should we be worried about it rising much beyond 3%? If so, would that be a disaster? If not the gap, then what else might cause inflation to rise in the coming years? 

Table: Gap and Inflation

                           GAP*                Inflation Rate**

1964:1    0.7  5.6  0.5  2.6      1.5   4.7   4.7  3.2

1969:4          

1972:2    1.6  4.3  0.6  2.3      3.3 10.0  10.0  6.7

1974:2

1978:2    1.8  2.3  0.1  1.3      6.8  11.0 11.0 4.2

1980:1

1989:1    0.2  0.2  0.2  0.2      4.5   4.1  4.1 -0.4

1989:3

1997:2    0.3  2.0 0.7  0.9      1.8  2.5   2.5  0.7     
2000:3

2006:     0.5  0.4  0.4 0.2       3.0  3.3  3.3   0.3

2007:4

2017:    0.2  0.7  0.7  0.5      1.5  1.7  1.8   0.3

2018:1

 *Gap is the percentage that the actual GDP is above potential GDP. The four numbers represent that % gap during the first quarter, the highest quarter, the end quarter, and the average of all the quarters in that time period

** Inflation is measured by the annual change in the Personal Consumption Expenditures Deflator in that quarter relative to the same quarter in the year before. The four numbers reflect the measurement in the first quarter, the highest quarter, the end quarter, and the change from the beginning to the end quarter.

Lesson 22 The Phillips Curve

Below is something called the Phillips Curve. I thought it had expired but I read an article in the Wall Street Journal last week and realized it is back to haunt us. So I am on a mission today.

Like the Laffer Curve, the Phillips Curve is one of those graphical devices named after an economist that is misunderstood and totally abused. Like a good training bra, these curves have their time and place but can easily be misapplied.

I'll save Art Laffer and his curve for another time. A.W. H. Phillips studied wage change and unemployment in the UK from 1861 to 1957. I am not sure why his parents gave him so many initials and that deserves a lot of study, but I won't go into that today either. To make a very long story short, we Americans who wanted to be great again in the 1950s decided to steal Mr. Phillips' curve and apply it to our study of inflation and unemployment in the US.

The result of this study is to think that there might be a stable relationship between inflation and unemployment. Thus we draw the curve with a negative slope and pretend that it sits there until hell freezes over.  For you friends who are not mathematicians, this means that any reductions in the unemployment rate should cause the inflation rate to increase. Or, in other words, when the economy grows rapidly enough to reduce the unemployment rate this puts pressure on markets. Tight labor markets mean that wages rise faster. Tight goods markets mean that prices rise faster. That doesn't sound so crazy, does it?

In our current context in the US, we recently saw the unemployment rate decline to 3.9%. Applying the Phillips Curve means that inflation should be rising. Applying the Phillips Curve to the future means that if the unemployment rate remains low or heads lower -- then surely inflation will rise even more. Again, that doesn't sound so crazy. Of course, we wonder why inflation has not already soared given the tremendous declines in the unemployment rate.

The confusion is that economists are used to models that focus on supply and demand. And while discussions of the Phillips Curve often involve throwing around those words, the Phillips Curve is neither a supply curve nor a demand curve and this drives us crazy. What is it? Basically, it is a useful construct that amalgamates supply and demand but in ways that satisfy only the user. One user says one thing; another user says another.

This lack of consensus arises because we are using this construct as a proxy for an inflation forecasting equation. An inflation forecasting equation stems from a model. This explicit model has two components -- the aggregate demand for goods and services (AD) and the aggregate supply of goods and services (AS). To understand changes in the inflation rate, you must examine all the major things that impact a country's AD and AS. One of those things is the unemployment rate.

Did I underline the word one? I should have. Only one of the zillions of important things that impact inflation is the unemployment rate. Don't get me started because a zillion is a lot of things to discuss. But consider some of the important ones. Oil prices are starting to rise again these days. Might that impact inflation in the USA? What about when prices of mobile phone services fell? Would that impact the national price level? Declining productivity? Global competition? Agricultural surpluses?

Some economists understand that when any of these other inflation-causing factors change, then the whole Phillips Curve shifts. Things that cause inflation to rise cause an upward (leftward) shift. Things that cause inflation to fall cause a downward (rightward) shift. The Phillips Curve is not an immutable object nailed to the floor. It bounces around like Nolan in a bounce house. Thus, pretending that the Phillips Curve just sits around all the time is bound to lead to errors in one's inflation forecast.

Notice what we are saying these days. As the unemployment rate falls we are pulling our hair out about rising inflation. We are sure that the Fed will, then, more aggressively fight inflation. And because the Fed will react like Pavlov's pup, many are already forecasting a recession. While all that might be true, it ignores a lot of other things going on that might preclude the inflation rate from rising. Maybe the global economy is slowing down? Maybe we have plenty of workers ready to jump into the labor market or at least switch their status from part-time or from underemployment. Maybe tax reform will improve productivity and facilitate more competitive pricing. Maybe continued innovations and competition in IT products will reduce prices we pay for all sorts of products. Maybe Alexa will wash your car for free.

The Phillips Curve is a pedagogical device. It doesn't sit still for anyone. Focusing on the impact of unemployment on inflation is like trying to forecast how your kid will behave after eating a cookie. While the cookie might  have one impact, myriad environmental and emotional factors should not be ignored. Give the kid the cookie!

The Tail is Wagging the Dog

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

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

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

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

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

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

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

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

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

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

Unit Labor Costs

One of the creepy things about learning economics is all the technical jargon. Diminishing marginal utility, gross private domestic investment, and the production possibilities frontier are good examples. What the hell are these things? That can be the subject of another post because today I want to focus on another term economists throw around like salmon at the Seattle Fish Market.

Today I want to discuss unit labor costs. Say that 30 times and I promise you and all those within 50 feet of you the best sleep you have had in months. It's better than a My Pillow. To make sure I don’t lose you, let’s rename it ULC. ULC rhymes with sulk but that has no consequence here. 

ULC could be the most important macroeconomic variable in town this year. So you should know her. If you saw ULC sitting alone at the end of a bar, you would ordinarily tip toe quietly in the other direction. But this year, ULC is the Queen of the Ball.

That’s quite a claim. Yet I don’t hear anyone talking about her. Before I am done with you today, I want to convince you that ULC is at the heart of many issues we discuss today – rising wages, rising prices, the next recession, and of course, the size of our new tariffs on Armagnac.

Imagine any product – let’s think about a bottle of JD. Most of the cost of producing one more bottle of JD is what you pay the employees to produce it. This includes their wages and any other earnings they might receive in the way of benefits. Logic suggests that, if everything else is the same, a rise in labor costs means the company will have to charge more for a bottle of JD. If it used to cost $10 to produce another bottle of JD and now it costs $12, then one would expect the price to reflect that cost increase. 

The labor representative will interrupt us now and point to the fact that the extra wage won't lead to a price increase because the JD workers were more productive this year. The price of a bottle of JD depends on the labor cost and the labor productivity.

For example, suppose wages go up 5% this year. Don’t we have to charge more for a bottle of Jack? Nope – it depends on how productive labor was. Suppose workers got really jacked up this year and produced 10% more bottles of Jack. That is, you got 10% more Jack for 5% more money. In that example the cost of labor in each bottle of Jack was lower! Thus they can sell the Jack at a lower price.

ULC is, therefore, a delicious macro concept that summarizes the key factors impacting the cost of goods and service:

• ULC went up – cost per unit is higher and therefore we ought to raise price (or take lower profits)  
• ULC went down – cost per unit is lower and therefore we can lower price and be more competitive (or keep prices the same and take higher profits)
• ULC did not change – cost per unit is the same. Go fishing.

So you can see that ULC is a vital part of the economy and yet most of you thought it meant Underware Latex Creep.  

Here is the most fun part. The graph at the bottom of this life-saving exercise shows you the history of changes in ULC since before Joe Biden was born. I won’t bore you millennials with all that history stuff but you can see that before 1980, ULC was quite the party animal. It was all over the place – rising by almost 13% in 1974 not long after a mere blip of 1% a few years before. Imagine if you were selling Kool-Aid in the front yard and the cost of getting your mom to make the Kool-Aid for you rose by 13% one year. If you passed that cost increase on to your customers, they might decide to go down the road to Peter's house.

Notice that since 1980, ULC became more well-behaved. It has its cycles but they are much less pronounced. The mean change of costs per unit is about 2.5%. Notice also that just about every recession —the grey bars – was preceded by a rising trend in ULC. Clearly, when costs per unit are on the rise the resulting higher prices of goods and services seems juicy – but if this keeps up the economy can no longer handle it.

This brings us to the present. The average change in ULC is remarkably less than 2.5%, and there is no discernible upward trend. After it dropped into negative territory recently, it jumped back to positive territory but there is no clear upward trend. In fact, if you look at behavior since around 2011, you might see a downward trend.

If it ordinarily takes a few years of rising ULC to cause a recession, there is little in this graph to suggest an imminent recession or slowdown in the economy. But aren’t wages beginning to rise faster? Won’t that make ULC jump and signal bad times ahead? Yes, wages might rise but remember ULC is impacted by productivity changes as well. If productivity changes as much or more than ULC – then ULC won’t change at all.

So fasten your seatbelts, kids. This is a race between wage growth and productivity. Which one are you betting on for the next few years?

Nero Fiddles as Rome Burns

As I was writing last week’s post about Macroeconomic Fuzziness, it occurred to me that there are some things that are not so fuzzy. It not only made me think of Nero but also reminded me of a book written by Herman Hesse titled Journey to the East. A traveler boards a train taking him to a very clear destination. During his travels, however, the traveler gets off and on the train. Somehow the destination got obscured each time, and he found himself lost or moving in the wrong direction. Luckily, he found his way back to the train and moved again towards his destination.

Hesse was writing about spiritual things, but this story says much about macroeconomic policy. There is nothing so fundamental to survival and standard of living as economic growth. Whether the location is Catalonia or California, the truth is that economic growth makes everything easier. This should not be interpreted to say that economic growth is everything. It isn’t. But it is to say that without economic growth, everything else struggles. When the economic pie is growing, we might fight over our share of the increase, but when the economic pizza stays the same, the only way for Jim to get more is for Toni to take less. Like Hesse's traveler, we often get lost and forget that growth is so critical. 

Inasmuch, it is important to keep economic growth on the front burner. It does not have to grow at a lightning pace, but it does have to grow enough to keep us out of each other’s hair. Nowadays, we keep referring to populism. I looked at a couple of definitions of populism and they contained the words “ordinary people”. Populist policy is aimed at improving the lives of ordinary people. It follows that economic growth is a perfect part of populism because there is no way to improve the economic situation of ordinary people without it.

Yet, we hem and haw. Sometimes Republicans appear to be helping rich people at the expense of ordinary people. Sometimes Democrats appear to be assisting minorities at the expense of ordinary people. And these Republicans and Democrats often have good reasons to be doing these things. But if they go too far and ordinary people are injured, then they make their complaints known. And so, we get back on the train and head in the right direction.

That brings us to our present government. I am told repeatedly that this government is populist. But I don’t see it. I do see some smatterings of policy supporting economic growth. I applaud those. But then I see just the opposite. Most recently, the proposals relating to protectionism seem to fly in the face of economic growth. I can’t find a single rational explanation for why one would want to save a few thousand jobs (steel and aluminum) in America while at the same time destroying tens of thousands of jobs (drink and auto manufacturing and other users of steel and aluminum) in America. 

Maybe the political optics of helping some manufacturing workers seems attractive to some politicians but surely this cannot help economic growth. If other countries retaliate against the US, then the gloom spreads to many other US firms that export to those countries.

Or better said, how does protectionism fit the description of populism relating to ordinary people? Or worse, how does protectionism fit in with anything good for the USA?

This story is not hard to understand. Local manufacturers of steel and aluminum want less competition. They want to be freer to charge higher prices. To whom do they charge these higher prices? They charge these higher prices to all those companies in the US that use steel and aluminum to produce Miller Lite beer and Ram Macho Power Wagons. Then these companies pass along these cost increases to ordinary people. But let’s not stop there. Our tariffs on foreign products make countries like Canada and Mexico wonder what it means to have a free trade agreement. Any country wounded by these tariffs will ponder assessing similar taxes against products from the USA. So guess what happens to ordinary people who work to produce goods going to those countries?

The world is a tough place. Companies and countries cheat and skirt the rules of international trade. It is always easy for a politician in any country to promote protectionist policies. But do they really work? We have had subsidies against imported steel in the past. Yet steel is still not viable and needs yet more protection.

I looked at employment data from the Bureau of Labor Statistics for the primary metals industry. These numbers include employees in the production of iron, steel, and aluminum. Clearly, this is an industry with declining employment. From 1990 to 2017, the number of jobs decreased by 317,000, or 46%. During that same time, all US manufacturing jobs declined by 5.2 million, or 30%. All private sector jobs in the US, in contrast, increased by 33 million, or 36%. It makes one wonder what can be done in the way of tariffs and protectionism to an industry in job decline for more than a quarter of a century. If protectionism is our game, then how do we best help ordinary people?

That brings me to my final point. There are ways we can create growth. There are ways we can augment and develop a skilled labor force that is the envy of the world. But guess what? The more we get diverted into arguing about the pros and cons of protectionism, the more time we are wasting with respect to moving this parade forward. Is anyone seriously putting forth proposals to permanently expand employment opportunities in the USA today?

            Year               Primary Metals

                                    Employment

                                    In thousands

            1990              689

            1995              642

            2000              622

            2005              466

            2010              362

            2015              392

            2017              372

https://data.bls.gov/pdq/SurveyOutputServlet

Out of the Economic Wilderness

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

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

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

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

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

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

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

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

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

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

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

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

Economic Growth Confusion

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

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

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

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

  Long-term Economic Growth Rate = 

  Growth Rate of the Labor Force

                         

  + Growth Rate of Labor Productivity

Don’t you just love equations?

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

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

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

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

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

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

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

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

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

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

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

Confessions of a Two-Handed Economist

President Truman is famous, among other things, for saying he wanted a one-handed economist who would not say “on the one hand this, but on the other hand, that.” In other words, he didn’t always want a complete and balanced analysis – he wanted to know where things were headed. No hemming and hawing!

Truman would have hated me. I love to tell the whole story no matter how much my audience falls asleep.  I am probably a nine-handed economist. So today I am stopping all that. Today, I am one-handed, and today I will tell you what I really think. Today is the day I am part of a panel at Big Arts on Sanibel Island. So I am killing two birds with one stone – writing this blog and using this lunacy as my presentation to the grey-haired audience at Big Arts.

Sanibel Island is an absolutely wonderful place. Thanks to Chuck and Nancy Bonser, who will remain unnamed, we were introduced to this paradise located off the coast of Fort Myers, Florida. We have been going there off and on for the last 30+ years. It not only has wonderful birds to watch, shells to collect, and seafood to eat, Sanibel has a warm and wonderful group of locals who always make us feel incredibly welcome whether we are bellying up to the bar at the “office” (Sanibel Grill) or arguing politics and economics at the Sanibel Café or listening to incredible music at George & Wendy’s Restaurant and the Keylime Bistro.

Thanks to Chuckie B, I have been teaching a course and also participating in panel presentations at a place called Big Arts. I will be teaching again at Big Arts in 2018 but before that class begins, I am part of a panel today! I am supposed to talk about the future of the US economy and think I have 15 minutes to deliver a totally persuasive forecast.

So here goes. My forecast is that the US economy will grow faster in 2018 than it did in 2017. That means a growth rate in the range of 3.5% to 4.5%. All you Never-Trumpers can hang up on me now. You have better things to do than to read or listen to this. I know you were hoping for a feeble growth forecast but I am not a politician, and I am trying to be a one-handed economist today. It’s all about the economy, and as usual, you can take it or leave it.

Below are my bets that underlie this forecast. But first are the risks. Just kidding. I am not going to discuss the risks. I have only one hand today and even though there are trends that argue against me, I am going to ignore them. Take that President Truman!

First is brother Mo. Mo is short for momentum. Most of the time forecasters bet on Mo. It’s like knowing that Uncle Jason always stops at the local grocery store on his way home from work and buys one can of Rainier. He never deviates. But sometimes unexpected factors cause him to alter his pattern. Ashley might want him to stop at the Whole Foods. Whatever. On a given day it makes sense to bet on Jason's Rainier and on the economy pretty much performing like it has for the last few years. Go Mo!

Second is gathering confidence. Each year in which the economy does not fall into a recession and employment rises and inflation seems a little less likely to fall creates a floor of confidence that allows the economy to not only continue growing but to grow even faster. Confident consumers are more willing to buy and firms are more willing to produce.

Third is what is happening in the rest of the world. The US led much of the world out of the last recession and is now ready to step back and let some of the other countries pull the wagon. As many of the hardest hit countries recover and as Europe and Japan strengthen, it creates a global environment of growth to which the US benefits.

Fourth is interest rates. Many people worry that rising interest rates will nip my last three points in the bud. But I doubt that will happen. The interest rates we know and love are not controlled by the Fed. The Fed may plan to raise interest rates but that doesn’t mean that rates will behave. Telling your child that you are going to cut his allowance does not always elicit the desired change in behavior. As in the case of the errant child, interest rates are impacted by many things. While the world is getting stronger, it is still typified by an overcapacity in which supply is greater than demand. Output can expand greatly without the usual cyclical factors that raise prices, price expectations, wages, and interest rates. The data supports this view. Last week I showed a graph that questions if and when a new Fed policy to raise interests will actually lead to that result. It's definitely not a slam dunk.

Fifth is geopolitical. My observation as a kid was that bullies loved to harass kids who would not fight back. Bullies often stay away from kids who will dish out at least a little punishment. The US is saying some tough things to the world’s bullies – I don’t need to name them since it is pretty obvious who these bullies are. Some of you worry that this will lead to war and some really horrible consequences. I don’t. I don’t think our government wants war any more than previous governments did. But our government is doing some things that make us less easy to bully. So I am betting that there will be a lot of noise about US defense and security and very little negative reaction that might put my growth forecast in jeopardy.

Sixth is "da Market". The past changes in stock market indexes cannot be ignored. A lot of wealth has been created. While uncertainty about the future means we won't go on a spending spree, it is hard to ignore those trillions of dollars accumulating in our financial statements. Spending some of those wealth increases will add to the party. Another aspect of rising stock prices is the falling cost of capital. The higher are stock prices the lower is the cost of raising a given amount of capital. With interest rates stalling and stock prices rising, it will be a great time to buy plant and equipment. 

Finally, I like that the pendulum is swinging. Government financial regulation, climate change policy, other EPA rules, and other government regulations on business can move a wee bit away from where they were heading in the past eight years without causing the world to explode. I know some of you want ever more progress on various social policies and government regulation. You have good hearts and smart minds. But I don’t think you know enough about the effects of economic growth on all the things you cherish. I am, therefore, happy to see the pendulum swing back a bit with the hope it will generate growth without harming the future of the US and the planet.

Notice I didn’t say much about tax reform. In my humble opinion it might be eighth in the list of seven I just discussed. It should help economic growth but it is such a hodgepodge of good things and gimmicks, I am not ready to pronounce the tax reform as the greatest thing since sliced bread. No, I am not crazy about its implications for the national debt. 

I stuck my neck out. You are invited to chop away. Hope you have a wonderful 2018!

Economic Growth Anemia

Many of my friends cannot remember which one was Laurel and which one was Hardy. I do remember which one was Sonny and which one was Cher. And so it goes with economic growth and business cycles. In truth, growth and cycles are as different as Simon and Garfunkel but you would never know it.

Economic growth has become the Cinderella of macro. Pushed into the back room and assigned to the lowliest cleaning duties, economic growth is hardly heard of in favor of business cycles. The Fed has never been more neurotic. Are we at full employment today? Are we too strong? Is inflation too low? Should I drink JD or Scotch?

Whew. I feel a lot better now. Let’s start at the beginning. Macro has two main areas – growth and cycles. Growth is a long-run concept. It is all about how the capacity to produce changes over time. Imagine the economy as one big factory. What makes the factory able to produce more (or less) as a long-term or permanent outcome? You can imagine the kinds of things that affect the capacity to produce – better equipment, new structures, a more efficient layout, better training of the workforce, are just some of them.

The second part of macro – cycle theory – is very short-run-oriented and poses questions about why the nation’s output deviates from the capacity to produce. That is where things like recessions come into play. Most recessions are over in a matter of months. Their impacts can go on for a while, but the large and sometimes sharp turns in output are usually limited to half a year, plus or minus. Policies designed to reduce these cyclical changes are very different from those that augment long-run capacity changes. Typically the causes of such short-term cyclical events have something to do with the ever-fickle desire to buy – or what we refer to as demand changes. Suffice it to say, the things that cause short-term changes in demand are very different from the things that impact long-run capacity – and so too are the policies different.

With all that behind us, let’s think more about Cinderella -- i.e., long-term or capacity growth. While capacity growth sounds like engineering, the reason we emphasize it is that capacity growth is the key to improving both the standard and the cost of living. The evidence is around us. Whether it is a rich country like the USA or a dramatically growing country like China or Vietnam, the evidence is that producing a larger pile of goods brings permanently higher incomes and lower poverty incidence to the citizens of those countries. With those higher incomes come safer and more environmentally friendly production. While there are some who would argue against growth, most of those people are on the fringe.

We usually use sustained real GDP growth to measure capacity changes. Not focusing on short-term changes, I present some figures for the time period from 1955 to 2016 – 61 years.

Average Annual Growth in U.S. Real GDP

1955 to 1970           4.8%

1970 to 1985           4.1%

1985 to 2000           4.4%

2000 to 2016           2.0%

The US economy expanded at an annual rate of over 4% for about 45 years from 1955 to 2000. After that we saw a pronounced slowing to 2% per year. It is true that we had a major recession in 2008 and part of 2009, but it is also true there were many recessions between 1955 and 2000. If we look at shorter time periods after 2000, we see 2.7% annual growth from 2000 to 2005, slower growth of 0.7% per year in 2005 to 2010, and then 1.9% per year in the six expansion years from 2010 to 2016.

While anything is arguable, the data seem clear that something changed to permanently alter the growth rate of the US economy after the turn of the century. Left to its own course, this slowdown threatens our ability to increase our standard of living and reduce poverty.

What causes economic growth to slow? To answer that question, economists use growth models. These models ignore many things that cause short-term deviations in demand and output to instead focus on capacity-altering events. Growth models boil down to two sets of factors – those that impact the supply of labor and those that impact the productivity of labor. A retiring baby boom, global competition, government regulation, tax rates and other policies towards business are often discussed in the context of waning capacity.

The surprising thing is that most legislators ignore the bull in the china shop. Maybe it is too complicated for them. Instead they would rather spend their precious few working hours heatedly debating social policy. Policies relating to regulation and tax reform are a case in point. Such policies have the potential to raise the growth of output yet few of the public discussions focus on output, instead pointing fingers about how they might harm social goals and income distribution.

Social goals are critical to a nation. But so is growth. If we continue to relegate serious growth discussion to the background, we will suffer the consequences as we become a stagnant economy with few resources for much of anything including solving difficult social problems.

Medical Care Costs

(I apologize for the formatting this time. This one looks pretty bad. This blogspot is not user friendly when it comes to formatting and formatting is not my thing.)
On July 18 and 25 I wrote blogs that  focused on government spending on healthcare. I got some questions and decided to look a little further into medical costs. 

Below are words I lifted from the Bureau of Labor Statistics which define the two medical price components found in the US Consumer Price Index. Medical Care relates mostly to Commodities like pharmaceuticals and medical devices. The larger of the two components measures the prices of Medical Care Services from regular doctor's office visits to hospital services to buying a pair of glasses.

Medical care in the CPI is broken down into medical care commodities (mostly prescription and non-prescription drugs) and medical care services.

Medical care services is the larger of the two components, representing over three-fourths of the medical care weight and about 6 percent of the entire CPI market basket.

Exactly what does the CPI price in medical care services? The largest components are hospital services and physicians’ services. Also included are dental services, services by other medical professionals, eyeglasses and eye care, and nursing homes.

In other words, the medical care services index in the CPI reflects the cost to consumers not only of trips to the doctor’s office or to the hospital, but also of trips to the dentist, psychologist or chiropractor, or even buying a new pair of glasses or staying in a nursing home.

The goal today is to compare the long-term behavior of these two medical price series to the performance of the overall Consumer Price Index which includes everything purchased by typical US urban consumers. 

The first table below presents the inflation rates for five decades beginning in 1966 and ending in 2016.  You can see, for example, that the CPI rose 8% per year from 1966 to 1976. In the next decade it rose by 9% per year. Since then inflation has been falling to where it grew by a mere 2% per year from 2006 to 2016. In each of those decades the price of medical care rose faster than the CPI. For example, in the decade from 1976 to 1986 Medical Care Commodities was increasing by 13% per year while the CPI rose by 9% per year. Medical Care Services rose even faster than Medical Care Commodities in three of the five decades. It rose, for example, by 14% per year from 1976 to 1986. 

The second table lets you see more directly how Medical Care Commodities and Medical Care Services were changing relative to the overall CPI. For example, from 1966 to 1976 Medical Care Services rose by 12% per year relative to the CPI at 8% per year. That implies that Medical Care Services were rising 50% faster than the CPI. Did that relative performance change? As you read down the last column of the second table you see the numbers 50, 56, 125, 67, and 100. The general trend has been upward for 50 years. Medical Care Services from 2006 to 2016 rose twice as fast as all goods and services. 

For the last 50 years Medical Care Commodities and Medical Care Services have grown much faster than overall prices of consumer goods and services. There is reason to believe from these numbers that the gap has increased over time and while the gap has been larger (1986 to 1996) it was very high from 2006 to 2016. 

The obvious next question is to ask is why. But answering that is no easy task. The provision of healthcare has changed much since 1966 and again since 2006. Medicaid and Medicare made for major changes and more recently Obamacare added new layers of delivery and payment. Today we nail down one point -- the medical sector has been and continues to be highly inflationary when we compare it to the other things we buy. 

The CPI attempts to make adjustments so that we compare apples with apples over time. Therefore, a rise in price should not indicate an increase in quality -- it should be a rise in price for a like or similar good or service. But we know that technology in medicine has been very important and while the Bureau of Labor Statistics may try to adjust for quality, I am guessing these adjustments are not perfect. Healthcare is both better and more expensive. I fear much of what the numbers show is that we are paying more to stay healthy and alive. 

One upshot of today's data. If government is spending more for healthcare today it is not just because of Obamacare. Healthcare prices have overshot just about everything for half a century. If we want to control how much we pay either through or without government, we need to better understand pricing of healthcare goods and services. 

Annual Inflation Rate Per Decade

1966 to 2016, in Percent

CPI All items, Medical Care Commodities, 
and Medical Care Services

			Medical
		Medical	Care
	All	Comm	Services
66 to 76	8	10	12
76 to 86	9	13	14
86 to 96	4	8	9
96 to 06	3	5	5
06 to 16	2	4	4

Relative Annual Inflation Rate Per Decade

1966 to 2016, in Percent

CPI All items, Medical Care Commodities, 
and Medical Care Services

			Medical
		Medical	Care
	All	Comm	Services
66 to 76		25	50
76 to 86		44	56
86 to 96		100	125
96 to 06		67	67
06 to 16		100	100