Thursday, August 12, 2010

Is current unemployment structural?

Mark Thoma, writing for Money Watch, identifies the three basic types of unemployment. Frictional unemployment arises mainly from the combined movements of a free people. Cyclical unemployment, what most economists believed was the cause of the current recession, is the normal ups and downs of the business cycle. There is a growing body of evidence that the persistent unemployment we are experiencing may be structural:

…defined as unemployment arising from technical change such as automation, or from changes in the composition of output due to variations in the types of products people demand.

In a letter published on the Federal Reserve Bank of San Francisco‘s website, authors Mary Daly and Bart Hobijn find evidence of structural unemployment in a divergence in Okun’s Law, a law that has remained true for 60 years, until now.

In 1962 Arthur Okun, then a Yale University professor, had been tracking GDP and unemployment statistics dating back to 1949. He found that for every 2% that real GDP fell below its trend, there was a 1% increase in the unemployment rate. As time passed and the ratio held, this became known as Okun’s Law.

As seen by the red boxes in the chart below, Okun’s Law has remained consistent up until 2009.

FRBSF figure 1
By permission of FRBSF

As Daly and Hobijn point out:

Since real GDP was almost flat in 2009 while its trend level increased by 3%, the unemployment rate under Okun’s law should have increased by 1½ percentage points. Instead it rose by 3 percentage points, more than twice the predicted increase.*

Evidence suggests that the reason for this was an unusually rapid rise in worker productivity. Output remained stable while businesses shed excess labor, as shown by GDP per hour in the chart below.

FRBSF figure 3
By permission of FRBSF

It should be remembered, however, that GDP is mostly measured on the buy side, not the sell side. In 1949 there was no such thing as a Japanese import. 1949 was the year of the communist take-over in China. In 1949, products stamped “Made in USA” were commonplace throughout the world. Measuring what was bought in America would produce a nearly identical statistic as measuring what was made in America. To put it mildly, things are a little different now.

Whether you’re buying a shirt made in Mexico, a coffee maker from China, or an automobile made in parts unknown around the world and assembled here, it all gets counted as domestic product. The growing body of evidence for structural unemployment, is matched by a growing body of evidence that GDP has become an archaic metric.

There is also the difference between the industrial economy of 1949, and the service economy of today. It is much easier to lay-off a service worker and still maintain a reasonable amount of service, than to lay-off a manufacturer and maintain output. This could help account for the rise in GDP per hour.

In any case, economists are still sifting through the rubble of the recession that began in 2008 to understand what happened. Any decisions made by politicians now, will be based on incomplete evidence.

*Reprinted from the Federal Reserve Bank of San Francisco Economic Letter 2010-07. The opinions expressed in this article do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System.

Saturday, August 7, 2010

The specter of “Somethingflation”

There is a moment in every horror movie between the first appearance of a ghost and the pretty lady’s scream. It begins with an unrecognizable shape, a strange color, or the glimpse of a sudden unexpected movement on the periphery of vision. The heart leaps, the adrenaline flows, and the brain begins a wild search for pattern recognition. Our nation’s economy has been stuck in this moment for the better part of two years. (Think Vincent Price on valium). Hollywood will never produce an economic horror movie.

The general public is skittish, as are the markets, and understandably so. The emerging shapes and colors of our present difficulties are vague and mysterious. Like synapses firing, the deflation/inflation debate in the financial opinion pages offer patterns at random, that never quite explain what we are facing. Paul La Monica, of CNN Money, has coined a name for this apparition, “Somethingflation.”

The barrage of conflicting patterns we’ve been subject to, can be lessened by a few rational observations. The increasing or decreasing prices on common items, such as a gallon of gas, a loaf of bread, or a pair of basic shoes can be used to determine inflation or deflation. Note: Any American female, from pre-teen to grandma, is a good source of information on these things.

In his book, The Return of the Great Depression, author Vox Day identifies a more nuanced way to determine what Somethingflation might be:

Econometric Uncertainty Principle… the inevitable pressure on the measuring agency and subsequent bureaucratic manipulation of any statistic identified as a politically significant macroeconomic measure.

Priceless. But, separating politics from political economy is more an art than a science. Of the six possible scenario’s in Day’s book, two of which are relevant here, inflation can be determined by the spot prices of commodities. Gold provides a good benchmark of inflation.

spot gold ytd

The deflation scenario states that the rising supply of debt will be met with a dwindling demand from buyers. The Greek near-default earlier this year is an example, only in our case, there’s no group large enough to save the U.S. The yield on Treasury Bills is a good indication of demand. With the Fed Funds rate already at zero, the 10 Year T-Bill is our next best option.

10yr T-Bill YTD
Source: Dept of the Treasury

So there is our outline of Somethingflation; a slightly rising gold price indicating inflation, and a slightly falling Treasury yield indicating deflation. These two trends cannot continue together. One must inevitably give way to the other. Whatever this ghost turns out to be, friendly or otherwise, screaming is optional.

Sunday, August 1, 2010

The beauty of bad credit

A few weeks ago, a Chart of the Day showed the rise of consumer credit in America since the end of World War II. The hook at the end is the beginning of the housing market collapse and cut-backs in credit card purchasing.

consumer debt 1945-present

What are the ramifications of this major trend reversal? Certainly the banks and credit companies will be struggling well into the future, more bailouts not withstanding. Mark Whitehouse writing in the Wall Street Journal points out a related trend:

As of April, 25% of Americans had fallen into the least-creditworthy category, garnering a rating of less than 600 from FICO, the main arbiter of consumer credit in the U.S. That compares to only 15% before the recession, according to data compiled by Deutsche Bank.

Mr. Whitehouse goes on to explain how the time element involved in one in four Americans re-establishing credit will be a drag on any recovery. But, Barry Ritholtz, of The Big Picture sees a silver lining:

…I am going to posture that easy credit allowed some people borrow to maintain a lifestyle, rather than earning to maintain a lifestyle.

I wonder: Will the lack of credit spark a revival of creativity and industriousness amongst those that want to maintain their spending habits? Asked another way, could bad credit spark more economic activity?

The answer, I believe, is yes. It will just be different economic activity. Living without credit, whether by choice or necessity, focuses the mind on long term value.

Walk into any retail store, or any mall complex, and note how much space is dedicated to impulse buying. Note also, the space dedicated to items whose only appeal is to young mothers and teenagers. Once you start looking for it, you can’t help but notice how these spaces overlap. To one without a credit card, these spaces are a swamp of useless social decorations- something to be waded through on your way to somewhere else.

For decades, every teenager has been told of the importance of establishing good credit. This usually takes the form of a credit card. “Use it and pay it off”, they are told, “it shows responsibility.” But, is that really true?

Taken by itself, paying off credit is certainly responsible. Its antithesis, not paying off credit is not responsible. But, in order for buying on credit to be responsible, its antithesis, buying with available cash, living within one’s means, would have to be irresponsible.

The spending habits of the American consumer are certainly changing. Whether that leads to a revival towards quality and long term utility remains to be seen. One can always hope. In any case, retailers beware.