Living In a Hypothesis

In a recent speech at the National Association for Business Economics Annual Conference, Washington, D.C. March 26, 2012, Fed Chairman Ben Bernanke talked about the US job situation and monetary policy designed to rectify the problem. That Fed policy is consistent with central bank policy worldwide makes this speech worthy of study. The frightening aspects are that this policy represents untried economic theory – a “hypothesis”, the results to date are a failure, the future impact is unknown beyond some theoretical speculation, and central banks will continue to implement it magnifying future effects.

Excerpts from the Speech

Note: click on graphs to enlarge them. Bold text in quotes is our emphasis.

Bernanke:

At the same time, some key questions are unresolved.  For example, the better jobs numbers seem somewhat out of sync with the overall pace of economic expansion.  What explains this apparent discrepancy and what implications does it have for the future course of the labor market and the economy?

Translation: The data linking jobs and the economy are inconsistent and we don’t know why.

Comment: If your data is inconsistent and therefore unreliable, how can you construct meaningful labour market monetary policy and implement it, particularly if you can’t measure the effects reliably?

Bernanke:

Importantly, despite the recent improvement, the job market remains far from normal; for example, the number of people working and total hours worked are still significantly below pre-crisis peaks, while the unemployment rate remains well above what most economists judge to be its long-run sustainable level.

Translation: All the data on jobs remain well below pre-crisis (2007) levels.

Comment: It’s interesting that you can measure “improvement” when you’ve just admitted your data is unreliable. Also, if the job metrics are “below pre-crisis peaks” then the job situation is still possibly in crisis territory. We note that assuming the factors that create the data inconsistencies are among themselves consistent, you should be able to reliably measure the relative positioning of jobs in terms of pre- and post-crisis levels.

Bernanke:

I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor.  Consequently, the Federal Reserve’s accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well.

Translation: Long-term unemployment has resulted from the periodic downturn in the business cycle plus factors other than the normal business cycle that in themselves are long-term or structural. The Fed’s policy of introducing massive liquidity into the market to stimulate demand should fix the problem.

Comment: Where to begin? According to the NBER, we may be about 3/4 of the way through the current business cycle from the Dec. 2007 peak and based on average cycle length. The high level of unemployment suggests that either this is an abnormal business cycle in terms of recovery and job creation or there are significant structural effects in operation or both.

It is commonly accepted that personal consumption or demand accounts for about 70% of GDP or aggregate demand in the US. Although per capita personal indebtedness has declined from its peak at the beginning of the recession in 2007, it remains high and may be leveling off as seen in Figure 1 and the data behind it.

Figure 1. Total per capita Liabilities – Balance Sheet of Households and Nonprofit Organizations.

Planet earth to Ben: people have about as much debt as they can manage. They can’t  and/or won’t take on more. Companies, lacking a stable of academic economists, unfortunately read this as no great increase in demand in sight and therefore no need to make capital investments except where the investment can improve productivity by reducing operating costs, notably the labour force.

We would argue that monetary data shows in fact that economic activity and hence aggregate demand, has declined despite quantitative easing (QE) and is still on a downward trajectory. This is shown in Figure 2 by the velocity of all measures of the money supply. Where in this data do we see signs of “support for demand and for the recovery”?

Figure 2. Velocity of the M1, M2 and MZM money stock.

The next observation is that a $2 trillion injection of liquidity to date has done little for creating employment. If we consider that we are moving through the business cycle to where jobs should be created, QE may have contributed nothing. Other commentators have suggested QE2 was almost totally ineffective. It’s up to Ben to show us how effective QE has been in terms of both job creation and its ongoing effectiveness over time. We just don’t see it in Figure 3.

Further, if we look at the behavior of unemployment after previous recessions as shown in this graph, we see that recovery from this recession is similar in appearance to the others. Unemployment peaks at the end or just after the end of a recession and drops, in some cases almost as fast as it rose from the cycle trough just before the recession’s start (eg. 2002). The major difference this time is in the depth of the recession or the height of unemployment.

Figure 3. The size of the Fed’s balance sheet against unemployment.

What is glaringly obvious is that the huge Fed stimulus has had no discernible effect on unemployment. In fact, if one does a rough estimate of the growth in unemployment from the previous low to the midpoint in past recessions, roughly half the increase has already happened. The most recent recession is different in that a stimulus spike around the midpoint coincided with an elevated 2nd half increase in unemployment. However, we are not positing a direct connection between the two but rather a policy disconnect.

Bernanke:

The recent history of these flows suggests that further improvement in the labor market will likely need to come from a shift to a more robust pace of hiring.  As figure 7 [our Figure 4] shows, the declines in aggregate payrolls during the recession stemmed from both a reduction in hiring and a large increase in layoffs.  In contrast, the increase in employment since the end of 2009 has been due to a significant decline in layoffs but only a moderate improvement in hiring.  To achieve a more rapid recovery in the job market, hiring rates will need to return to more normal levels.

Figure 4. The flow of jobs in the last and current business cycles.

Translation: We’re pinning our hopes on a pickup in the rate of hiring.

Comment: Let’s start by analyzing the job flow data from the start of the 2002 recession to the start of the 2007 recession. We see these stages:

  1. In the recession stage, hires declined throughout and were lower than separations, particularly near the end of this stage and continued lower for a quarter after the recession ended.
  2. Hires and separations then moved close together into the midpoint of the business cycle.
  3. In the latter half of the business cycle, hires outpaced separations by a modest amount, right up to the start of the next recession.

Now let’s compare the past recession and recovery:

  • Hires and separations performed in a manner similar to the previous recession. The only difference was the separation between the two increased notably in the second half of the recession and into the first quarter after.
  • Hires and separations then moved close together with hires slightly above separations unlike in the previous recession. In his speech, Ben suggests an explanation for this: [what] we may be seeing now is the flip side of the fear-driven layoffs [implying a higher rate of layoffs than in a normal recession] that occurred during the worst part of the recession, as firms have become sufficiently confident to move their workforces into closer alignment with the expected demand for their products.
  • We can’t know where we are in this cycle until the NBER has told us where the cycle ends and the next recession begins, but the pattern of the post recession recovery is similar to the pattern after the previous recession which would place us near the 2005-2006 peak.

From this graph, if “more normal” hiring levels are represented by the 2002 recovery, then we require a decrease in the current rate of hiring! Indeed, in point 3 above, Ben is anticipating this. So where will the higher rate of hiring come from? Hope lies eternal, even – or especially – at the Fed.

Bernanke:

However, although structural shifts are no doubt important in the longer term, my reading of the research is that, at most, a modest portion of the recent sharp increase in long-term unemployment is due to persistent structural factors.

Translation: I’m pretty sure that the sharp increase in long-term unemployment is due only modestly to structural changes in the workforce. [It’s really the fault of those consumers who aren’t consuming.]

Comment: It is curious that in his speech he examines in some detail, the possibility of structural changes in the workforce that would lead to high unemployment. He discounts them as being a major contributor and we would concur. In so doing, he leaves cyclical factors as the primary cause, and the lack of aggregate demand as the single most important one. What he has totally ignored are the structural changes in the economy which the Fed has created over the last two decades, first with their creation of artificially low interest rates ending in the current zero interest rate policy (ZIRP) and lately with a flood of excess liquidity into the economy through QE. As we argue in our final comment below, these have caused enormous distortions and it would be surprising if employment rates were not materially affected by them.

Bernanke:

If this hypothesis [that cyclical rather than structural factors are likely the primary source of its substantial increase during the recession] is wrong and structural factors are in fact explaining much of the increase in long-term unemployment, then the scope for countercyclical policies to address this problem will be more limited.

Translation: We think that the high unemployment rate this late in the business cycle is due to cyclical problems, primarily the lack of “aggregate demand”. If the real problems are structural, then first of all we can’t see them and second, there’s not much we know how do about them.

Comment: We know the Fed cannot see a bubble even when it trips over one – witness the stock market in the 1990s and the housing market after that bubble broke. We suggest that the level of personal indebtedness, the size of national debt and deficits, the tripling of the Fed’s balance sheet,  the enormous sequestered reserves of the TBTF Banks, historically low interest rates projected well into the future – all represent structural distortions of the economy and capital markets. Since no market today functions in anyway like a traditional market, why should the labour market be different?

As one last point, how would we represent “aggregate demand”? It is defined as the sum of consumption expenditure by consumers, business and government, with the balance of trade added in. We see by the graph in Figure 5 that personal consumption has resumed after a contraction during the recession. Given our earlier comments on personal indebtedness, it is hard to see how additional consumption can be squeezed out of consumers beyond the current rate. Government can increase its expenditures but the impact on its sovereign debt rating would likely be negative and counterproductive. Business has no incentive to invest massively. And don’t forget, interest rates have been at or near historic lows for some time; and that that hasn’t encouraged borrowing to spend.

Figure 5. GDP and PCE growth.

Bernanke’s hypothesis that we are suffering through, namely that high unemployment is primarily the effect of insufficient aggregate demand that can be fixed with policies designed to stimulate that demand, must be declared to be false. All policy tools used to date, ZIRP and QE have failed. Figure 3 shows that QE failed to affect unemployment to any measurable degree. As for ZIRP, Figure 6 shows that it is also a total failure.

It is interesting to see the impact of the Federal Funds Rate on unemployment. According to this Figure, it would appear to lead unemployment by about 3 years. This means that changes in the rate effect the economy in a way that takes about three years to reflect in unemployment. It would appear to be quite a powerful tool.

If the Fed wants to slow the economy, it raises the rate. This creates higher unemployment as the economy responds. Going the other way, if the Fed wants to stimulate the economy and reduce unemployment, it simply lowers the rate.

But if we look carefully at the graph we see a problem beginning to develop in the 1980s. Each time the Fed lowered rates to stimulate the economy, it had to lower them further to get the same economic impact. Finally, in the middle of the last recession rates effectively reached what is called the zero bound; hence, ZIRP. At this point the tool broke. The Fed can raise rates to contract the economy, but it cannot lower rates further to stimulate the economy.

In theory, the Fed could take rates negative, but this would create a massive move out of debt instruments into cash, stocks and commodities creating massive inflation.

Figure 6. The Effective Federal Funds Rate against unemployment.

What has become clear to us as the root cause is the structural distortion of virtually all markets in today’s world by central bank activity. And no central banker that we know of is close to understanding that he is the problem and not the solution, even though he must be painfully aware that all his tools are broken.

As an afterthought, we recalled Operation Twist that is set to expire in a couple of months. Its effect has been to lower longer-term interest rates. If it does have a lagged effect we may not see it reflected in unemployment for some time. Where we would expect to see a positive effect would be in the housing market where lower mortgage rates should encourage buying, raising prices and driving new construction. The latest Case-Shiller data shows a consecutive decline in house prices for the last several months leading to the graph in Figure 7.

Figure 7. The 10- and 20-city composite Case-Shiller indices, year-over-year change.

The February data shows home buying and mortgage application rose in January but fell slightly in Feb. If lower long-term rates are to affect housing it should appear in the data but is reflected as a short-term buying blip at best. More disturbing are the percentages of people that plan to buy a house within 6 months. The rates are well below last year’s and falling. This year is also experiencing an abnormally benign weather pattern that may have moved traditional spring buying, forward.

The housing industry has been an important source of employment in the past. If its improvement is anemic or non-existent in a market in which Operation Twist is operating, then another Fed tool is ineffective in influencing the unemployment rate suggesting that the problems are almost wholly structural rather than cyclical.

For additional comments from Mike Shedlock, read Bernanke Puzzled Over Jobs, Cites Okun’s Law; Six Things Bernanke is Clueless About.

Non Sequitur – Sort Of

We add this simply as a point of interest. Following our appending of the Case-Shiller report that showed US mortgage applications and house prices down in February, we read in Reuters today that in the UK:

This is consistent with other economic data we are seeing out of the EU (see Tracking the Next Recession). This in turn argues for decreased US exports to the EU and a reduction in aggregate demand – the balance of trade part that the Fed can only influence by forcing the economy to contract and import less. As we said, hope …

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