consumption

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Catching Up: Grab Bag

First of all an apology to you all: I haven’t posted anything for a few days. While I’d like to say that was because I was on vacation, the real reason was a mysterious technical outage. Apparently Time Warner Cable decided to take some time off. That’s a monopoly for you. Leisurely system upgrades during peak hours. Ugh.

Meanwhile back to work:

This week will see some interesting statistics released, starting with retail sales tomorrow. I think we are headed into a ‘make or break’ period for the administration. There are several signs accumulating that the economy’s recovery is not far off, but like a very tired runner covering those last few yards is getting very difficult.

For instance, last week’s consumer confidence data was quite disappointing. The index fell sharply after having registered four straight months of increase. While there is no direct correlation between consumer confidence and consumption at the aggregate economic level, any decline in confidence at this point in the cycle must be cause for concern. The hope has been that as job layoffs start to decline, and as home prices reach the bottom, consumers will start to venture out of their foxholes and begin to spend once more. There had been tentative signs of that happening – one of those signs being the steady increase in confidence registered since earlier this year. A sustained about-face by consumers would open up a wide hole in the recovery strategy.

The obvious reason for the drop in confidence is the continued poor employment situation. Jobs are simply very hard to find at the moment and there are no signs that employers are about to shift back towards hiring. The numbers of people who have now been unemployed long term is rapidly growing and that is surely eating away at the public’s mood.

Which brings us to the stimulus debate.

As you all know I have been an advocate of much larger stimulus from the beginning. For whatever reason – and frankly I haven’t heard a good one yet – the administration low-balled the amount of effort that we put into the recovery. I have a suspicion that the powers that be thought that once the financial sector was stabilized the economy would right itself fairly quickly. Where they got that reasoning from I don’t know, but it was bogus all along. History tells us clearly that recessions and depressions caused by a collapse in finance are much more severe and need much more stimulus to correct. Add in the devastation caused by unwinding the real estate bubble and the downward spiral was bound to be dramatic.

What we got was a bureaucratic response rather than leadership.

Now we have to dig our way out of two problems: the economy is still stuttering, and the political backlash against stimulus has gathered steam making it difficult to fix the original error. We may be condemned to allow things to get worse again before the political winds changed sufficiently for further stimulus.

Note to self: in a crisis such as this, bold leadership is preferable to calm calculation. I suppose it would be better to combine both, but that would take the presence of a truly historic leader, and the current administration is resolute in not rising to that level of performance.

Too bad.

Meanwhile the opponents of massive fiscal spending haven’t had a good time of it either. A couple of weeks ago the media was full of bombast about the horrendous and impending inflationary impact that the stimulus and loose monetary policies were having. One sure sign of disaster we were told was the run up in long term US government bond yields. Since then those yields have eased off considerably. As a result the opposition has had its main counter stimulus argument neutralized.

Clearly we all need to be very concerned about the long term fiscal balance of the Federal budget. It was the prospect of perpetual deficits that was supposed to be the cause of the sudden spike in rates since earlier this year.

I acknowledge that in an economy operating close to capacity excessive monetary expansion ‘should’ show up as price inflation. But we are nowhere near capacity: the Congressional Budget Office – the politically neutral scorekeeper Congress uses to analyze policies – estimates we are as much as 8% from capacity. So all that money being pumped into the economy ‘should’ flow into propping up demand rather than merely raising the prices of existing demand.

I think a more plausible cause of the rise in rates was simply that the bond and other credit markets were adjusting back to more normal levels after months of traumatized and excessive caution. Such an adjustment would mean a flow of cash from US bonds into competing private uses. The result would be a natural bidding up of bond prices as the government was forced to pay more to keep the flow of bond sales satisfactory.

Confirming this explanation is the fact that bond sales have settled back down. When the first stories started to appear about the glut of US bonds on the market the government faced some stiff market conditions: buyers were reluctant to buy bonds and T-Bills because a glut would reduce their future value. Those difficulties have faded, and for now at least, the government doesn’t appear to be having any difficulty raising the cash it needs to keep the stimulus going.

But a word of caution: there is no doubt at all that we are entering a period of higher taxes. The whole Reagan/Bush era was predicated on tax reduction which was supposed to provide stimulus to the private sector and thus drive wealth creation. If we look back over the entire period the policy failed. The only element in the economy that prospered at an above average rate was corporate profits. Apparently tax reduction had no enduring effect elsewhere – wages are certainly a very weak spot in the Reagan/Bush record books. One thing they did leave us with are massive deficit problems that are now impeding our ability to correct the economic downturn. Even if this was the only imbalance we needed to fix, taxes would need to rise. But the recession has blown a hole in Federal revenues, and the political agenda now includes fixing our broken health care system. That will cost money.

So taxes will tend to rise over the next few years. There is no alternative: the public does not seem to have the stomach for the huge service cuts that would be implied by sticking to current Federal revenue levels and then trying to balance the budget. Neither does it seem possible to rein in defense spending. Something has to give. The Republican dream of dismantling the New Deal has been thoroughly shattered every time they mention it to the voters. Yet they have been very successful in selling the ‘trickle down’ snake oil. So the general public is now inured to the notion that taxes can stay low, yet services remain high.

Only in dreamland is such folly possible.

So, I repeat: taxes are set to rise.

In that context an obvious target would be the corporate tax deduction for health care expenses. This deduction costs us $250 billion a year in lost revenues. Its elimination would more than cover the cost of the health care plans now being debated in Congress. It survives because the unions see it as a employee benefit, and are fearful that its loss would force companies to stop offering health benefits. Ironically that is exactly what I would want to happen: business shouldn’t be the source of health care for the simple reason that a rational business sees the cost of workers as a total cost, inclusive of wages and health care. In that scenario a business is legitimate in cutting wages in order to keep offering health care benefits. All the evidence supports this notion: studies indicate that wages in the US as a whole are about 6% less than they would otherwise be were health care not offered through employers. So American workers are paying a significant, but hidden, price for the ‘benefit’ of health care.

Finally, as I catch up ahead of this week’s news, for those economics geeks out there: I read with amusement an article in the Financial Times on Friday that US oil prices were dropping in reaction to news of a rapid build up in inventories. Those of you who follow text book theory will immediately see the oddity of this news. One of the central assumptions of the text book theory is that prices already embody all the news people need in order to buy and sell goods and services. Ergo, there should be no adjustment: the effect of inventory increases should already be built into the oil price. One would think that the economics theorists who defend that notion of prices are currently scurrying about trying to square away the FT’s comment with their theory. But no. One of the most unfortunate aspects of the current crisis is that it has exposed just how oblivious and indifferent those theorists are both to the damage their ideas have wrought, and to the inherent stupidity of them.

As you all know I try to pour as much contempt on the standard economics theory as I can. So spare me this small moment of triumph!

Meanwhile: that increase in oil inventories is occurring especially in the kinds of oil that farming and industry use for fuel. So a back up in inventory could be a sign that usage is not as high as anticipated. In turn, that means the economy may be slowing its improvement.

That gets us back to the stimulus.

More please!

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Unemployment: The Key to Our Future

This morning’s release of the monthly ADP Employment Report adds some fuel to the green shoots argument. The story is the same as that we’ve been following for a couple of months now: things are getting worse less slowly. I suppose that means things are getting better in a perverse kind of way.

According to ADP the economy is still shedding jobs at a prodigious rate: we lost another 473,000 in June. The good news in this is that the monthly losses are significantly smaller than those we saw at the end of last year and the beginning of this. The average monthly loss during the second quarter was 492,000 compared with an average of 691,000 during the first quarter.

So that’s the good news: we lost under half a million jobs! Whoopee.

“Unemployment will be the key to our return to economic health, and the prospects are mediocre at best.”

I have tried to emphasize all along that the real issue is not the recession itself, we have the policies to halt the onset of depression, but the recovery. Unemployment will be the key to our return to economic health, and the prospects are mediocre at best.

We will learn later this week what the unemployment figure has grown to. Many analysts are thinking it will hit 9.6% or even slightly higher. Given that we are still losing jobs at a steady rate, and that there seems to be no re-hiring en masse on the horizon, the unemployment rate is almost certainly going to peak at about 10.5% by late this year or early next. Remember: unemployment lags behind the economy as a whole. Employers fire workers after a recession has started and re-hire after a recovery is well under way. So the drag effect of those lost jobs tends to hang around even after there are plenty of other signs of recovery: business investment usually picks up as firms retool for an uptick in sales, but the try to retool with a shrunken workforce rather than take on the expense of hiring more workers.

When we delve into the consequences of this drag effect it becomes obvious why this particular recession and recovery represents a challenge.

The bulk of our economy’s purchasing power comes from salaries and wages. This is reported through the personal income data. Last month, as I discussed at the time, most of increase in personal incomes came from the arrival of the stimulus checks. Wages contributed a decline. This was because unemployment reduced the number of workers receiving wages, not because the average wage fell dramatically, although there are signs that average wages are now beginning to fall.

Economic theory argues that wages should fall in line with a decline in overall activity because workers should prefer to receive a lower wage rather than none at all. Obviously this doesn’t reflect the real world: unemployment insurance mitigates job loss, at least for a while, and so reduces the incentive workers have to accept lower wages; union restrictions on wage changes also slow the process down; and earlier on in a downturn workers seem more willing to gamble on getting a new job at the old wage rate rather than accept a pay cut. For all these reasons wages are notoriously ‘sticky’. This stickiness invalidates much of the analysis that flows from standard economic modeling.

Nonetheless, the flow of wages will ultimately determine the tone of the recovery.

This is not good news.

As workers contemplate their financial situations they will have to decide how much to spend and how much to save. That balance is always a critical factor in the economy. The less savings the more consumption, and thus growth is faster. One component in this equation is the level of indebtedness. If workers are secure in their prospective employment they tend to be willing to take on debt in order to supplement wages as a source of cash for consumption. Furthermore, as long as paper sources of wealth such as house and stock price inflation, are rising, people feel that they can absorb the cost of debt because they have a ‘backup’ way to liquidate the debt in emergencies. The destruction of paper wealth over the past two years has been catastrophic for most consumers. It has eliminated their sense of security and has pushed them into a shift towards higher savings. In other words the unwinding of the housing bubble is contributing to surge in thriftiness.

Couple this effect with a massive run up in unemployment which, as I mentioned above, sucks out incomes from the economy, and the outlook for a strong rebound in consumption is very dim.

This is why high unemployment levels become so critical. The associated loss of spending power cripples the economy’s chances of entering the much hoped for ‘V’ shaped recovery – a rapid decline followed by a rapid recovery.

But then we have to confront a self-fulfilling prophecy: lower consumption resulting from high unemployment will prolong the period of high unemployment. Because wages are sticky and do not fall to help the job market correct itself the way the textbooks argue, an economy can easily get stuck in a self reinforcing cycle of low growth associated with relatively high unemployment. The only way to break out of this rather depressing cycle is more government stimulus. The argument is already being joined. Unfortunately the administration seems not to have the necessary nerve to press for it. That’s too bad since it is are only ‘escape card’.

So the longer we shed jobs, even at the diminished rate that now seems to pervade, the more sure we can be that the recovery will be a longer and slower one.

We are already breaking through the ‘worst case’ levels of unemployment that many analysts foresaw at the onset of recession and are likely to keep on going. This can only be bad news.

Which is why today’s ADP report, while good in some ways, was nowhere near good enough.

Dig in. The road ahead is long and arduous.

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Who Cares What the Public Says?

Unless we want to replicate the disaster that is the Californian budget on a national scale we should pay no heed at all to the views of the general public when it comes to fiscal policy. That’s harsh. But true. California, you will recall, messed its budget up by incessantly adopting the fiscal consequences of all those infamous propositions. Its constitution forced its budget to behave the way the public wanted. The consequence has been disaster.

There are a number of polls now floating about at the moment saying that the public is leery of the administration’s willingness to add to the federal deficit as it bails out banks, auto and insurance companies, and spends on its stimulus plan. The news media have begun to fill columns with all sorts of dire statements about the national debt rising uncontrollably, the bond market’s hysterical reaction, and the massive prospective cost of the health care reform now being debated. The public’s reaction is predictable enough already! The public wants balanced books: that’s the safe way to household survival after all.

Add in the pot stirring partisan sniping from the Republicans and the scene is set for a backlash against the entire array of government policies now underway. I can only imagine the additional fury were the general public more aware of the fairly well hidden costs of the Federal Reserve Board’s unconventional monetarypolicy.

Yes this is an expensive process. And yes the deficit is growing at a rapid pace. The future holds some daunting problems as a result.

But.

We only have one choice.

Cutting back on the federal deficit now, or even in the next year or so, in order simply to get our books in order would be catastrophic. We already have an example of what the result would be: the Great Depression.

One of the key lessons learned from the 1930’s is that balancing the budget is exactly what we should not be doing. The Japanese learned that the hard way back in the 1990’s. A key problem the US encountered back in the early years of the Great Depression was that as the economy appeared to improve policy makers tightened things up far too rapidly and far too much. The result was to plunge the economy back down again. A recovery only became permanent as European defense spending caused by the war created huge demand here. Without the war the recovery would have been much weaker and more tortuous.

This seems counter-intuitive to many, hence the poll numbers.

The issue is this: the economy lacks sufficient demand to keep its resources active. This results in factories being idled and rising unemployment. Normally the ‘shock’ that causes the drop in demand comes from outside: e.g. oil prices spiking in the late 1970’s. The textbook policy response is to lower interest rates and thereby stimulate activity. Both the shock and the response in these circumstances are confined to the private sector. Usually the Federal Reserve Board succeeds in fending off or reversing a recession simply by easing monetary policy: increasing liquidity in the economy and lowering interest rates.

But in extraordinary moments like the current crisis that policy won’t work.

Interest rates are already at zero. There is no way rates can go down further. This is not a normal recession either: the shock came from within the system itself. It was self-inflicted. The collapse of the financial system and the bursting of the house price inflation bubble stunned consumers into a sudden burst of savings. The wipe-out of wealthcaused bybanking folly made us all too cautious. So the private sector started to shrink as spending dried up.

I have thrown the phrases ‘liquidity trap’ and ‘paradox of thrift’ around before. Both describe our circumstances accurately.

A liquidity trap exists any time an economy has low interest rates but no desire to invest or spend. People save instead. Fear grips society as unemployment rises. Rates decreases are not possible so policy makers hands are tied. A paradox of thrift is simply the situation where people start to save more than usual, that lowers their consumption, which lowers sales and hence causes businesses to contract by firing workers, which makes everyone else save even more. All that savings effort becomes self-defeating for the society as a whole. And the gap between actual demand, and potential demand widens inexorably. Remember that the whole objective of public economic policy is to keep things humming along at or near potential capacity since that where we experience full employment.

But we have fallen far from capacity: maybe as much as 9% below, balanced right on a knife edge with depression on one side and a very slow recovery on the other.

When the private sector contracts in this way, and normal monetary policy is rendered useless, we have no option other than to resort to huge deficits. Governments have to print and spend money to offset the huge drop in the private sector. If they don’t do this then the decline accelerates out of control until it reaches a logical conclusion. That conclusion is reached when consumption can no longer be postponed. Even the most thrifty have to spend occasionally, and even those who are trying to save need to re-stock used up assets and supplies. In the days before modern economics gave us the way with which to avoid these massive declines, depressions ended only when demand reappeared in this ‘natural’ way. It is in this way that we can speak of markets being ‘self correcting’. If we are happy to endure the implied collapse and the long term nature of the decline along with the human and economic cost, then by all means balance the budget and keep government out of the process.

That all this is unknown to the general public is not at all a surprise. Why would it be?

But it is well known to all policy makers, even those who abhor Keynes and all he taught.

And it is why we should carry on with big spending and huge deficits until we are sure the recovery can sustain itself. That will be sometime next year.Then we can focus on getting the imbalances that threaten to throw us off course eliminated. In particular we can then address the deficit.

Until then: who cares what the public says?

I hope Obama doesn’t.

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Unemployment: Worse, But Better?

We have reached that part of the recession that confuses everyone. The data seems to signal a change, but getting the right words to describe that change can prove elusive. Furthermore getting a good interpretation of the message contained in the data is incredibly difficult. Separating the ‘noise’ from the information often proves well nigh impossible, so most analysts resort to their natural instincts. In other words they guess.

This morning’s unemployment data from ADP the big payroll processing firm is a good example.

Clearly the data is horrible: the economy shed 532,000 jobs in May. By any measure that’s an awful figure and should portend all sorts of grief for the economy as a whole later in the year. Especially since it follows hard on April’s figure which was just as bad.

But these are not normal times.

If we put the May data in the context of the three months of the first quarter this year it represents a noticeable improvement. The average job loss for those months was about 690,000 a month.

So should we cringe or should we celebrate?

Neither.

Obviously the economy is not shedding jobs as quickly as it was. That’s good news. But losing another half million jobs is nothing to write home about. It is simply awful.

So how do we pick apart these contradictory messages?

Well: things are not as terrible as they were. The economy seems to be approaching a point at which it will stop contracting. Employment is one of those measures that lags the overall economy: it gets worse only after the economy has started to shrink, and it improves only after a recovery has begun. That makes intuitive sense because businesses always adopt a ‘wait and see’ approach to emerging trends before they commit to making changes to the size of their workforces. And it is borne out by data stretching back through all, our previous business cycles.

So the slowing rate of growth in unemployment is a hint, but only a hint, that firms have done the majority of their workforce reductions. There will be bumps: GM’s bankruptcy may skew the June figure. Plus if the business climate doesn’t improve we may need another wave of cuts.

Take a look at some of the sectors of the economy: manufacturing has now shed jobs for thirty-nine straight months. And it clearly hasn’t finished. Likewise construction has reduced for twenty-eight months in a row and finance for eighteen. These are very long strings of continuous job losses by any stretch of the imagination.

And we still lost well over half a million jobs last month. We are nowhere near a job market turn around.

It looks as if unemployment will keep climbing right through this year. I doubt whether we will see a month of job gains until next spring. Hopefully, though the losses will fade to a minimal levels before then.

Which brings us to the larger point: what does the job situation tell us about the economy as a whole? After all that’s what we are trying to understand.

Things are not as bad as they were. But they remain precarious. We are still teetering on the edge of crisis, but we are not getting much worse.

Look at it this way: we are still digging a hole from which we will have to escape. Perhaps now we can start to see how big the hole will eventually turn out to be. The best way to measure that is to compare the shrunken economy with where it would have been had it been humming along nicely. This comparison gives us an idea of the gap we have to make up. In fact it is this measure of ‘under-utilization’ of our resources like labor and factories that is a major factor in driving Federal Reserve Board policy.

So what does the comparison tell us?

The good news is that we seem to be approaching the maximum point of the downturn. In truth no one knows where or when the bottom is. But most likely the contraction will end later this year, let’s say that’s a 60% probability. So there remains a very strong probability, 40%, that the contraction lasts into next year. Either way it appears that we will need two or three years to get back to full capacity. Some estimates have the actual-to-potential GDP gap stuck as high as 5% even during 2011. In turn, that implies the job market will remain fairly rotten for several years, with unemployment stuck between 7% and 10% throughout 2009, 2010, and 2011.

That means we have no room for easing up on any of our policy measures. It also suggests we may need another dose of stimulus. Don’t forget that the objective of the stimulus is to plug that gap between actual and potential GDP. The size of the gap gives us a rough and ready measure of the size of the needed stimulus. So far we have had a stimulus of only about half the gap. And much of that will take a couple of years to take effect: the Congressional Budget Office [‘CBO’] reported this week that only about 25% of the stimulus package will be effective this year, and even by the end of 2010 only 75% will be in effect. Unfortunately the components that will take effect first, things like tax cuts and transfer payments, have the least impact on unemployment.

Finally: I remain very skeptical of any analysis that argues for strong recovery. This employment data shows we have a very long and hard road ahead. There has been no change in the big structural problems to be overcome:

  • we still have very weak banks so the supply of credit is insufficient to fuel strong growth
  • household wealth has been hammered by the combination of the collapse in home prices and the stock market
  • jobs are scarce and likely to remain that way
  • this implies a continued debt reduction by households which will inhibit spending
  • there is no obvious non-personal consumption ‘engine’ to pull us out of the hole: exports are weak, investment is will be poor because of debt reduction by firms and the lack of credit, housing is devastated and needs years to recover [if it ever will], and state governments are in panic over their own budgets, so there’s no spending coming from that quarter.

This leaves the Federal government as our primary source of growth. Since the stimulus package was both too small and too skewed towards least effective actions, even this is a weak source of support.

In other words: nothing much has changed to persuade me that growth this year, if it occurs at all, will be anything other than miniscule, and that next year will be very weak.

Still, we should look on the bright side: at least this wasn’t a Depression.

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Stock Market Illiteracy

Sometimes my total disrespect for the stock market leaps to the fore. It is an extraordinarily skittish place and seems to be full of the most short sighted and most easily swayed folks on earth. Analytically? Don’t even go there. Let’s just say that dunderhead isn’t close to the mark. They can’t read too well either. Take today’s data on incomes from the Bureau of Economic Analysis.

It shows that personal incomes rose in April by a ‘surprising’ 0.5%. I put surprising in quote marks because it appears that the market reacts more to the level of expectation than to the news itself. I too am surprised. Will I be doing back flips? No. Will I declare the recession over and the returns to the glory days upon us no? The stock market will and has. Dumb. Very dumb.

The data also shows that disposable incomes rose even more: by 1.1%. For those of you new to this, disposable incomes gives us an after tax view of how wages and incomes flow through to the point at which they can be spent or saved. The market loves that jump in disposable incomes. Presumably the market view is that we are on the cusp of a good old all-American buying binge. Which will drive consumption up, boost profits and hence drive the stock values higher.

Ummm. I wonder if they read line three of the report: personal consumption expenditures, [‘PCE’]. Had they read that far they might have noticed that PCE fell in April by 0.1% A small fall I admit. Almost insignificant. Except that it continues a trend we all, well I did anyway, noticed last month: the strong upturn in PCE of January and February has been followed by two weak months. That upturn was one of Bernanke’s original ‘green shoots’. It has withered entirely away.

This is not good news.

Look deeper into the data:

Most of the rise in incomes comes from obscure things. Wages fell. Rental incomes and transfer payments went up and produced the rise. Not many average Americans get rental income, so even if that continues I doubt it will lead us to the promised land of consumption growth. And ‘transfer payments’? As its name implies that’s income that is being shuffled around the board, it isn’t new. Think: ‘ American Recovery and Reinvestment Act of 2009’. Sound familiar? How about ‘stimulus package’? That’s right the most important factor pushing up PCE was the stimulus package. Hardly a long term improvement.

And how about the upturn in disposable incomes. Same thing. The stimulus package sucked out taxes. Hence ‘after tax income’ shot up. ‘After tax’ equals ‘disposable’. Duh.

Now keep looking at that data: the personal savings rate rose strongly fro 4.5% to 5.7%. Terrific. That’s the highest rate for fourteen years. We need to become more thrifty. We need to return to the savings rates of the 1960’s when families routinely socked away 10% of their incomes for a rainy day.

But not just yet.

First we need to spend every penny we have to get the engine running smoothly again. Then, once we are all back working we can start to save.

So here’s my, apparently contrarian, view: this data makes me a little queasy. Wages are weak and falling. The stimulus had far too much tax rebate in it, $300 billion of the roughly $800 billion, and what there was is now being saved. Just as I predicted. That means the stimulus will have less effect than it ought to have had. In jargon: its multiplier is too low. Just as Keynes would have argued.

The economy’s problem right now is not savings, nor is it incomes – especially when incomes are temporarily distorted by transfer payments and tax rebates. The problem is spending. In the jargon: final demand is too low compared with the economy’s capacity to produce. We have idle resources: closed factories and unemployed workers. We need to get that capacity back in use. Savings don’t help. Nor do lower taxes.

There is nothing new at all in any of this.

It’s just that the stock market suffers from attention deficit disorder and seems to have forgotten. Don’t worry though: there’ll be a new report soon that will send the market careening off in a negative sense. Probably for the wrong reasons.

And that’s why none of us should pay too much attention to the stock market. They can’t read down there.

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