January Employment Muddle

According to the Bureau of Labor Statistics, there was a significant drop in the unemployment rate, from 9.4% to 9.0%, in January while payrolls increased by a meager 34,000.

The two figures sometimes give conflicting indications because they are drawn from different data: the unemployment rate is calculated from a survey of households, while the payroll number comes from a survey of firms.

The interpretation is further complicated this month by several other factors, including a revised estimate of the population, and the possible impact of unusually severe January weather.  Calculated Risk, the Times' David Leonhardt, the Economist's Greg Ip, John Hilsenrath of the WSJ, and Real Time Economics' round-up of assorted pundits provide some guidance in sorting out the numbers.

Overall, it looks like the news is consistent with a picture of a recovery gaining momentum, but with a long way to go.  Hopefully the February report, which is due on March 4, will give a clearer picture.

Rebalancing Watch

International trade fell sharply during the worst days of 2008-09, and this was reflected in a sharp decline in the US trade deficit.  One of the big questions in the recovery is whether the trade deficit (or, more broadly, the current account deficit) will return to its pre-crisis level.  That is, was the reduction in the deficit temporary, or have we achieved some "rebalancing"?

Friday's advance estimate of GDP provides some encouragement in this regard.  The US economy still has a long way to go, but it is now at least back to its pre-recession level of output.  The trade deficit remains smaller than it was before the recession - it was 3.3% of GDP in the 4th quarter of 2010, versus 4.9% in the last quarter of 2007.

The widening trend that began in mid-2009 appears to have leveled off or reversed.  Menzie Chinn James Hamilton suspects that the decline in the trade deficit in the quarter was tied to the decline in inventory accumulation:

But the fact that a huge negative contribution of inventories coincided with a huge positive contribution of imports does not seem to be a coincidence. There's a clear pattern in the recent data that when one of these makes a positive contribution to GDP growth, the other makes an offsetting negative contribution. Although we often think of inventories as a substitute for production (you could either produce a good or sell it out of inventories), in the current environment inventories seem to act more as a substitute for imports (you could either import the good, or sell it out of inventories).

Nonetheless, it looks like the trade deficit may not headed back to where it was. What happens going forward depends in large part on what happens with the US' trading partners.  Faster growth in the rest of the world should reduce the trade deficit.  We're seeing this in much of the developing world, which is recovering more quickly (indeed many emerging markets now face a danger of inflationary overheating).

At Project Syndicate, Martin Feldstein argues that one of the major surpluses, China's, will come to an end because its astronomical saving rate is headed down:

China’s national saving rate – including household saving and business saving – is now about 45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan will cause the saving rate to decline, as China seeks to increase consumer spending and therefore the standard of living of the average Chinese.

The plan calls for a shift to higher real wages so that household income will rise as a share of GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their earnings as dividends. And the government will increase its spending on consumption services like health care, education, and housing.

These policies are motivated by domestic considerations, as the Chinese government seeks to raise living standards more rapidly than the moderating growth rate of GDP. Their net effect will be to raise consumption as a share of GDP and to reduce the national saving rate. And with that lower saving rate will come a smaller current-account surplus.

Of course, declining savings only reduces the current account if investment doesn't also fall with it.

Real exchange rates play a role, too, and in this regard, inflation in China is causing its exports to become more expensive, its intervention to hold down the nominal exchange rate notwithstanding.  The Times' Keith Bradsher reports:

Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific...

Already, the slowdown in American orders has forced some container shipping lines to cancel up to a quarter of their trips to the United States this spring from Hong Kong and other Chinese ports. 

See also this recent post.  Whether it comes by inflation or a movement in nominal exchange rates, a Chinese real appreciation would take some pressure off other developing countries which are shadowing China in holding down their currencies.

3.2

That's a B+ grade point average; its the limit imposed by several western states on the alcohol content on the beer that can be sold in grocery stores; and its the BEA's advance estimate of 4th quarter 2010 real GDP growth.  3.2 is hard to get excited about (though it could be worse).

Real GDP is finally back above its pre-recession (Q4 2007) peak.  However, while growth has accelerated from the 2nd and 3rd quarters, is still not fast enough to close the "output gap" anytime soon.  The red line below is real GDP (quarterly, at annual rates) and the blue line represents what would have happened if the economy continued to grow at 2.5% (roughly the average rate for 2002-07) after the end of 2007.

If real GDP grows at 3.2%, the red line catches up to the blue line in about 10 years.

Consumption grew at a 4.4% pace, and the rate of increase for durable goods purchases was 21.6%.   Exports increased at a rate of 8.5% and imports fell 13.6%, bringing the trade deficit down to 3.3% of GDP.

The main source of disappointment would be investment: nonresidential fixed investment increased at a 4.4% rate.  Since investment is the most volatile component of GDP, one would expect it to grow rapidly during the recovery (just as it shrank rapidly during the recession).  This is particularly true given how well corporate profits are doing. 

The overall investment component shrank at a 22.5% rate, because inventory accumulation slowed dramatically (from a $138.6bn rate in the third quarter to $5.2bn in the fourth). That means that growth is no longer dependent on inventory restocking.  This had a fairly big effect on the overall number - if inventory accumulation had stayed the same, growth would have been 6.9%.  So one could argue that things are perhaps a little better than the headline number suggests.

Government was also a drag on growth as decreases in state and local government and federal defense purchases outweighed a federal non-defense increase.

For the full year 2010, real GDP growth was 2.9% (after falling 2.6% in 2009).  The GDP deflator rose by 1%.

In the first quarter of 2011, disposable income will get a boost from the temporary payroll tax cut agreed to in December, which should help.
 
That's just the first of several estimates - the updated "second estimate" is due Feb. 25.

SOTU

A couple of thoughts on the "State of the Union" -

As an economist, I don't find the rhetoric of "competitiveness" very appealing (see Paul Krugman's classic on this).  International trade is mutually beneficial* - not a zero sum struggle to beat other countries to the "good jobs."  From an economist's point of view, the rapid growth in China is a great story about an dramatic increase in human welfare.  However, while competitiveness rhetoric can be used to justify bad policies like subsidies and tariffs, Obama is employing it to promote policies like investment in infrastructure, basic research and education that are beneficial regardless of what is going on in other countries.  Though it is a mistake to feel threatened by the success of other countries, Obama seems to be exploiting this sentiment to embarrass us into getting our act together, which isn't entirely a bad thing.  He's like our national "Tiger mother."

Unfortunately, President Obama appears to have conceded the rhetorical war on two important fronts: global warming and the budget deficit.

On global warming, which is the most important policy issue we face, the President chose not to even mention it directly.  So much for having "adult conversations" in our politics...  Even if the towel has been thrown in on cap-and-trade, the administration does appear to be trying to confront the problem, sotto voce, in other, less efficient ways.  At least, that is how I interpret the call that 80% of energy should come from "clean sources" by 2035.

As for the deficit, the idea that the government is like a family that needs to "tighten its belt" seems to have won out.  That's simple, intuitive and wrong.  The basic principle of countercyclical fiscal policy - that when households are cutting back, government needs to step in and make up for it with offsetting spending increases or tax cuts - also seems simple and intuitive.  But apparently not enough so.  President Obama is a very good speech-maker, but has proven not to be enough of a great communicator to get the public thinking correctly about this.

It looks like we'll get some "cuts" and "freezes."  These may manage to be a drag on the recovery and damage some important government functions without making much of a dent in the real long run problem because domestic discretionary spending is a fairly small part of the overall budget (as Howard Gleckman says: "that makes Obama the anti-Willie Sutton. He is going whether the money isn’t").  It seems that we're done with counter-cyclical fiscal policy and its all up to the Fed now.  With 14.5 million still unemployed, that is a mistake, and a real shame.  While I hope (and believe) the President is correct in presuming the recovery will continue, it still could benefit from a fiscal push.

See also: Paul Krugman, Mark Thoma and Ezra Klein.

*There are number of possible caveats on that, including that while a country as a whole benefits, some within it are hurt (Stolper-Samuelson theorem) and that a trade deficit can reduce aggregate demand which is bad for employment in the short-run.

Residential Investment vs Construction Payrolls

There's some disagreement out there between those who see the recession as a "reallocation" shock resulting from a change in the composition of output (with the implication that a significant proportion of unemployment is "structural," because workers have the wrong skills and are in the wrong locations), and those who see it as primarily a phenomenon of aggregate demand (AD).  The two stories are not mutually exclusive, but I'm with those who would put more weight on the AD side.  After all, the economy is continually reallocating resources, creating and destroying firms and jobs, and usually manages this without an aggregate downturn; as Brad DeLong puts it:

"Reallocation" occurs when people are pulled out of unemployment or jobs in which their marginal product is low by opportunities in expanding businesses. "Reallocation" does not occur when people lose their jobs and pile up as unemployed. "Reallocation" occurs not in depressions but in booms.

Arguing against the reallocation story, Scott Sumner points out that most of the decline in housing occurred prior to the recession:

Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:
January 2006 — housing starts = 2.303 million, unemployment = 4.7%
April 2008 — housing starts = 1.008 million, unemployment = 4.9%
October 2009 — housing starts = 527,000, unemployment = 10.1%
So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs...

You can see this in a graph of real residential investment (red), which falls from nearly $800bn to $500bn (in 2005$, at annual rates) from the beginning of 2006 through the end of 2007.  Most of the increase in the unemployment rate (green) occurs later, in 2008 and early 2009.

That seems to suggest that the economy was smoothly managing a significant reallocation of resources out of construction until the end of 2007.  However, while residential investment was falling like a rock in 2006-07, the decline in construction payrolls comes later, and really gets going in 2008-09.

My hunch is that what is going on here is an example of "labor hoarding" - the tendency of firms not to adjust inputs immediately when output changes, because it is costly to do so.  Initially, construction companies may not have been sure whether the decline was temporary or permanent; it may therefore have made sense to keep people on the payroll so that they would be ready to respond if business picked up.

That doesn't validate the reallocation hypothesis, but it is true that there were alot of construction workers among those losing their jobs in 2008 (but there were job losses throughout the economy, not just construction, of course, as an AD decline implies).

Inflation (or Lack Thereof)

According to the BLS, inflation blipped up in December:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in December on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 1.5 percent before seasonal adjustment.

Much of that increase was due to the cost of energy, which rose 7.7% in December (gasoline prices were up 13.8%).  The "core" CPI, which excludes food and energy prices, was up 0.1% in the month, and 0.8% for the year. 

While there was some energy-induced inflation in the month, the annual rates of change in both overall (red) and core (blue) inflation remain subdued:

Those rates remain well-below the Fed's informal 2% target. The traditional inflation-unemployment dilemma of monetary policy just isn't an issue for the Fed right now.

The increase in energy prices is a sign of a recovering global economy, but it has a negative impact on the trade balance (the NX component of GDP).

Kittens are Cute

In chapter 12 of The General Theory, Keynes made a famous analogy:

[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

NPR's Planet Money decided to put this to a test.  They posted three cute animal videos - a loris, a kitten and a baby polar bear - on their website (videos here).  One group of people was asked to vote on which was the cutest (i.e., to make a judgment about "fundamentals"), while the other voted on which was most likely to be voted cutest (to be the "speculators" in the market). The first group voted for the kitten, which received 50% (vs. 27% for the loris and 23% for the bear), and the second group also favored the kitten, by 76%.

That's a clever test, but if prices in financial markets played out like this example, then there wouldn't be a problem - the speculators are moving the market towards the correct fundamental value (that kittens are cutest).  Indeed, the speculators get it right more decisively than the fundamental investors.

That's not the point Keynes was trying to make.  He was very skeptical of the workings of financial markets.  In the same chapter, Keynes wrote:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.

I think that indicates a weakness of the experiment - there really is no uncertainty that kittens are cute, or that kittens will be cute in the future, so the market can get that one right pretty easily.

Personally, though, I liked the polar bear.

Real Appreication of Chinese Inflation

The Times' Keith Bradsher reports on inflation in China:

In China, consumer prices were 5.1 percent higher in November than a year earlier, according to official government data. And many economists say the official figures actually understate the rate of inflation, which might in reality be twice as high.

“Four percent, China can bear it — beyond 5 percent, people will complain a lot,” said Huo Jianguo, president of the Chinese Academy of International Trade and Economic Cooperation here.

Higher global commodity prices, as well as rising wages in China, play roles in the increasing cost of Chinese goods. But economists say the main reason for the inflation now is China’s foreign exchange reserves, which surged by a record amount in the fourth quarter.

The central bank has been pumping out currency at an ever-accelerating pace over the past decade to limit the renminbi’s appreciation against the dollar. That strategy has helped preserve a competitive advantage of Chinese exporters by keeping their prices relatively low on global markets — while also protecting the jobs of tens of millions of Chinese workers in export factories.

Now, though, that cheap currency policy seems to be reaching its limits. The extra renminbi are feeding inflation. That is starting to undermine exporters’ price competitiveness — just as a stronger renminbi would do if Beijing was not intervening to begin with. 

That is, there are two ways for a real exchange rate to appreciate: through changes in (i) nominal exchange rates and (ii) relative prices (i.e., inflation).  The real exchange rate is defined as the nominal exchange rate, e, (e.g., the dollar price of renminbi) times the ratio of the two countries' price levels:

real exchange rate = e x P(China) / P(US)

While China intervenes heavily by selling renminbi for dollars to keep e from rising (and piles up massive "reserves" of dollars in the process), faster inflation in China - the increase in P(China)/P(US) - means that Americans must give up more stuff to get a unit of Chinese stuff.  That is, the relative price of Chinese goods is rising.

China is intervening as hard as ever in the foreign exchange market, according to Bradsher's article:

China’s foreign reserves leaped by $199 billion in the fourth quarter. The increase was much larger than economists had expected, and they suggested that China had roughly doubled its intervention in currency markets to around $2 billion a day. 

But the policy only works to the extent that China can offset the inflationary effects of the extra renminbi - for example by raising bank reserve requirements - and it appears they're no longer effectively able to do so.

The real increase in the price of Chinese goods will show up in US prices, but only modestly due to limited "exchange rate pass through".  In part, this is because consumer prices we pay reflect not only the price of the Chinese goods, but also the local retail and distribution costs, which are often a large portion of the retail price and not affected by the real exchange rate.  Of course, that means to effectively shift demand away from Chinese goods, the movements in the real exchange rate need to be even larger (somebody wrote a dissertation about this...).

A more important margin of adjustment may be substitution away from Chinese goods to those produced in other developing countries (i.e., this is great news for Mexico).  This Financial Times article by James Mackintosh discusses the problems created by the efforts other countries feel obligated to make in order to hold their own currencies down because of China.  Secretary Geithner raised this issue in a speech:

The undervaluation of the Chinese currency, the renminbi, and restrictions on capital flows in and out of China gave Chinese companies “a competitive advantage” and “impose substantial costs on other emerging economies that run more flexible exchange rates,” Mr. Geithner said.

“This is not a tenable policy for China or for the world economy,” he added. 

Politically, its sensible strategy for the US to try to frame China's currency policy as one that mainly hurts other developing countries rather than the US - it lets them be the bully, not us (as The Onion reported, China's closing the gap here, too). But the real appreciation also helps in terms of easing the pressure on the other countries that compete with China in export markets.

As David Leonhardt writes in his Times column:

Without taking inflation into account, the renminbi has risen 3 percent against the dollar since last summer, when China began letting it rise. Once inflation is accounted for, the real increase has been about 5 percent. At that pace, the renminbi could erase its artificial undervaluation — as some economists estimate it — in less than two years. 

Will this ease tension between the US and China?  Perhaps, but Leonhardt argues that there are bigger things to argue about:

For the United States, the No. 1 problem with China’s economy is probably intellectual property theft. Technology companies, for example, continue to notice Chinese government agencies downloading software updates for programs they have never bought, at least not legally.

No wonder China has become the world’s second-largest market for computer hardware sales — but is only the eighth-largest for software sales.

Next on the list, say people who work in China or do business there, is the myriad protectionist barriers China has put up. These barriers make this country’s recent efforts at “buy American” protectionism look minor league. In some cases, Beijing has insisted that products sold in China must not only be made there but be conceived and designed there.

Hmm....

There has been more interesting stuff written recently on the issue of "rebalancing" the current account relationship between the US and China - see Martin Feldstein, David Altig, Paul Krugman and Free Exchange.

Eichengreen on the Dollar

At Project Syndicate, Barry Eichengreen sees some interesting similarities between today's debates over the dollar's global role and those of the 1960's, when the Bretton Woods system was nearing its collapse:

In 1964, it was the rapidly growing economies of Europe, still catching up to the US, that were howling about the Federal Reserve. As a result of a recklessly expansionary American policy, they argued, they were being flooded with imported finance. The US was “exporting inflation.”

American officials countered that the financial inflows reflected Europe’s underdeveloped capital markets. Europe’s inflation problem was a byproduct of its central banks’ reluctance to tighten policy more aggressively, and European countries’ hesitancy to let their currencies rise, reflecting their long-standing commitment to export-led growth.

The effort to replace the dollar with IMF "Special Drawing Rights" (SDRs) ultimately failed, and no agreement was reached on achieving greater flexibility within the context of the Bretton Woods system:

The other focus of negotiations in the 1960’s was an effort to enhance exchange-rate flexibility. Proposals to this effect – a response to the emergence of chronic surpluses in Germany and Italy, and chronic deficits in the US – attracted growing attention once the SDR negotiations sputtered to a close in 1968.

But, with other countries having enjoyed two decades of export-led growth as a result of pegging their currencies to the dollar, there was a reluctance to mess with success. While the IMF, in a high-profile report on exchange rates in mid-1970, endorsed the principle of greater flexibility, it offered no new ideas for getting countries to move in this direction and proposed no new sanctions against countries that resisted. International imbalances continued to mount until the system came crashing down in 1971-1973.

A crucial difference between then and today's informal "Bretton Woods II" system is that the dollar is no longer linked to gold, and, therefore the US no longer has to worry about a drain on its gold reserves.  President Nixon ended the original Bretton Woods system in August 1971 with the announcement that the US would no longer redeem dollars for gold at the request of foreign governments (US citizens had lost their ability to exchange dollars for gold in 1933).

This means the "system" doesn't come to an end when the US pulls the plug, but when the surplus countries decide to stop holding and accumulating dollars.  There are really two issues: (i) the composition of official reserves - i.e., what currency they are denominated in (ii) and the level of reserves - whether surplus countries continue to intervene sell their own currencies in exchange for reserves to prevent appreciation.

In terms of the composition of reserves, writing at Vox, the prolific Prof. Eichengreen explains that there is no plausible alternative to the dollar.  The euro isn't looking so great right now, of course, and, as for the others:

There are of course a variety of smaller economies whose currencies are likely to be attractive to foreign investors, both public and private, from the Canadian loonie and Australian dollar to the Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are too small for their currencies to ever play more than a modest role in international portfolios.

Brazilian and Indian markets are potentially larger. But these countries worry about what significant foreign purchases of their securities would mean for their export competitiveness. They worry about the implications of foreign capital inflows for inflation and asset bubbles. India therefore retains capital controls which limit the access of foreign investors to its markets, in turn limiting the attractiveness of its currency for international use. Brazil meanwhile has tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have moved in the same direction.

China is in the same boat. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. Yet this has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. Nor has it prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use.

So the dollar is here to stay, more likely than not, if only for want of an alternative.

Flawed as they are, Eichengreen notes, the alternatives will look more attractive if US policies severely undermine confidence in the dollar.  Not raising the debt ceiling, for example, would do the trick (and it appears the Republicans' business backers may be forcing some sense into them on this one).  As Eichengreen has it, a form of Spiderman's motto applies: "with exorbitant priviledge comes exorbitant responsibility."

Cowen on Finance and Inequality

In his American Interest essay, "The Inequality That Matters," Tyler Cowen offers a number of reasons not to be too troubled by the general rise in income inequality over the last 30 years (not surprising given his generally libertarian-ish outlook).  As he notes, much of the increase in inequality is really occuring within the top 1% of incomes, and much of that is driven by the financial sector.  That, according to Cowen, is where the real problem lies. Along the way he also offers one of the best nutshell explanations for why financial sector incomes exploded to such monsterous proportions:

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed. 

Furthermore,

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks. 

Like Keynes said:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

Back to Cowen:

In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.