What drives mortgage rates?
What are fixed income securities?
What is mortgage securitization?
What Caused the Mortgage Mess?
The Economy. What is it and what drives it?
What part does the government play regarding the economy: fiscal policy vs. monetary policy?
What is the Federal Reserve?
What is the FOMC?
Demand, Supply, Elasticity
What The Fed Funds Rate Should Be - Taylor's Rule
Money Supply & Monetary Base
The Changing Nature of Work
Credit Default Swaps
The Economics of Unemployment
What drives mortgage rates?
Mortgage interest rates move in response to the supply and demand for mortgage debt. Mortgage debt is pooled into securities. You can read about mortgage securitization here.
At the start of each business day FNMA sets a Required Net Yield for its various programs (30 year fixed, 15 year, 7/1 ARM and 5/1 ARM). This sets the market for retail mortgage rates. FNMA is not unilaterally setting rates but making a best guess each morning as to what price it can sell to investors mortgages of a given note rate. It is only by putting oneself into the place of these investors that we can see what moves rates.
Mortgage debt competes with government debt (U.S. Treasury debt, foreign government debt, state and local debt) and corporate debt in the world of "fixed income securities." The reason that this part of the economy is not duly reported is that most economic reporting is geared to the individual investor. Few individuals purchase fixed income securities. Most are held by mutual and pension funds.
Imagine that you are worth $100,000,000 and all of your wealth is in cash. Let us also assume that you are content with this $100,000,000 and feel that you have enough money to live for the rest of your life. The problem is that you cannot go out and buy today everything that you will need in the future. Things such as food are perishable. Gasoline is bulky and explosive. Some things - next year's fashionable clothing and electronic gadgets do not yet exist. What you really want is a way to preserve, as far into the future as possible, the present purchasing power of that $100,000,000. You want to be able to buy as much stuff 30 years from now as that $100,000,000 can buy today.
Your only enemy is inflation. If the prices of things increase and your $100,000,000 is sitting in a mattress, your money will be able to buy less stuff. How do you prevent this? You lend your money to an entity which you believe is sure to pay it back and is willing to pay you an interest rate which at least matches inflation. You can lend your money to various entities and get a higher reward (interest rate) for a higher risk (chance of getting stiffed) but let's merely look at FNMA mortgage debt which, at least for the present, is guaranteed by the Treasury Department.
If we regard Treasury debt and the Treasury guaranteed mortgage debt as 100% safe then the only issue is inflation. Mortgage rates will rise as inflation increases. Actually that is not quite accurate. We need to add one word here. Mortgage rates will rise as the perception of inflation increases. Investors don't wait for inflation to readjust their expectations. They look at data and formulate expectations as to what inflation will be in the future. They base this on "fundamentals." "Fundamentals" are the hard bits of data which tell us how the economy is doing. Some key ones are: CPI (Consumer Price Index) and PPI (Producer Price Index), GDP, and the BLS Employment Situation Report. Before each of these is released Wall Street analysts release their expectation as to what the data will say and, before the data is actually released, investors react to those expectations. If the released data matches expectations closely then the market barely moves. Dramatic moves occur to the extent that the data varies significantly from expectation.
Back to Top
What are fixed income securities?
While this is not discussed often, it is necessary to understand that investors in fixed income securities are not looking for the same thing as investors in equities. Understanding the concerns of investors in fixed income securities is necessary for understanding what drives mortgage rates.
Back to Top
What is mortgage securitization?
Mortgage debt is pooled into securities. At present this securitization is done by entities such as FNMA and FHLMC. The fact that FHLMC and FNMA are now owned by the Treasury Department does not affect the way mortgage debt flows. Before the mortgage mess, jumbo mortgages were secured by Wall Street investments banks. No matter who is doing the securitization, the notion is similar. Take, for example, 200 loans which all meet FNMA underwriting guidelines and have the same interest rate and term and toss then into one big pot. Let's say that the average loan size is $250,000. We now have a $50,000,000 pot. Divide the ownership of that pot into 50 pieces of equal size each worth $1,000,000. What we then sell to investors is those piece each with a face value of $1,000,000. Each $1,000,000 piece represents a 1/50'th interest in each of the 200 loans. As money from the loans comes in each month the cash flows from the borrower to the loan servicer to FNMA to the owners of the pieces.
This securitization is part of the "secondary market." Banks make money by originating mortgages and selling them in this market. There are two substantial advantages from securitization. First, bank capital does not get tied up on mortgages in the long-term. Banks profit from repeated use of capital making money each time they turn whatever capital is used to fund and then sell loans. Second, the risk associated with having loans which are geographically concentrated is mitigated. Since the product held is fungible it can readily be resold. The liquidity added by the securitization of mortgages makes the product more valuable. Liquidity almost always adds value.
Mortgage back securities were created Salmon Brothers and Bank of America in 1977. Originally they faced legal and tax barriers. Substantial enough lobbying ended that.
Mortgage securitization was used to perversely obfuscate the risks associated with subprime mortgages. The debt rating firms ignored their obligation to investors and went along with investment banks and made it look as if pools of mortgages were investment grade.
A lesson from the mortgage mess is that mortgage securitization is dangerous if misrepresented and misused.
Back to Top
The Mortgage Mess
In 2008 the U.S. faced a massive liquidity crisis. The cause was bad mortgages. Lots of bad mortgages.
The mortgage mess had four distinct threads:
1) HUD mandated that FNMA and FHLMC loosen their underwriting guidelines. This was the largest single cause of the demise of FNMA and FHLMC. HUD demanded this for reasons which it saw as social. Their thinking was something like: "It is not fair that these entities only make loans to people with prime credit." The mortgage lending with a social purpose has been going on for many years. CRA (Community Redevelopment Act) mortgage loans were a quid pro quo for any bank wanting to expand through acquisition. No one at HUD saw the consequences of this.
2) Wall Street investment banks and debt rating firms enabled the securitization of subprime lending that was not done through FNMA and FHLMC by deceptively mixing subprime and prime loans to make all of the resulting securities investment grade.
3) The Federal Reserve's lower interest rates post 9/11 encouraged banks to make two other types of bad mortgages. One was the Option ARMs which led to the demise of WAMU and Wachovia (after it acquired World Savings).
4) low interest rates also encouraged bad commercial lending on apartment and office buildings. This accounted to the demise of many of the banks which have been taked over by FDIC. For the most part these were a lot of small-medium size banks.
The untold part of this story is that is was not simply banks which did this. HUD was the party most responsible for the demise of FNMA and FHLMC. Instead of stopping the large investments banks from securitizing bad loans the SEC compounded the problem by halving their capital requirements.
The mortgage mess was a team effort: government agencies, commercial banks and S&Ls, Wall Street investment banks, debt rating firms and every mortgage agent who got people a mortgage they could never afford all contributed.
Back to Top
The Economy. What is it and what drives it?
The Economy. What is it and what drives it.
If you watched Star Trek: The Next Generation you recall thay while those folks were always looking for trouble in space, life on earth was, by our present standards, utopian. A great synopsis is on this You Tube clip. In that episode Picard and company have awakened a group of 20th Century folks who were "frozen" and he explains to then that no one any longer has material needs. Until we achieve this we are stuck with the economy.
The expression "the economy" refers to an economic system in place at a given time. Since I live in San Francisco I can think of the world economy, the U.S. economy, the California economy or the local economy. For the purpose of containing this to something which can be discussed in a reasonable amount of time, "the economy" here will refer to the economy of the United States.
National economies depend on laror, captial and physical resources. Resourses can be land, minerals, oil, natural gas. Economic actrivity consists in producing, exchanging, distributing and consuming goods and services.
The U.S. economy is primarialy about businesses. This is where entreprenuers, labor and capital come together. Businesses require some measure of regulation from goverment. On a national level there are two important manners in which government interacts with the economy. These are fiscal policy and monetary policy. (See piece on these.)
One big problem is that the U.S. ecomony changed so much in the period from the end of World War II to the mid-1970s that the way we talk about it and the fundamental bits of data we hear reported simply have not kept pace with change. The U.S. economy is still framed as if we are still in the Industrial Era. We talk about Capacity Utilization and Industrial Production even thought these represent less than a quarter of the economy. Think of it this way: how much do you spend each month on cable TV, cell phone service, internet access. Do economists realize that people now buy music on iTunes and books can now be delivered to Kindles and iPads? Is the economy of the future U.S. going to revert to industrial or agrarian?
The economy is the buying and selling of goods and services. The core variables in the economy are consumption, investment and savings. Business, government and individuals are all consumers. The focal elements of the economy is business. Businesses are where capital and labor come together to produce goods and services. The owners of the company do this for a profit. The employees exchange their time and skill for wages. Jobs are created when someone thinks that they can make more money by hiring more people. One continuous and massive obfuscation is that politicians play a significant role in job creation. This, while perpetuated by politicicians and the media, is simply not true.
While the consumption part of the U.S. economy takes place locally perhaps the most significant change to the economy started in earnest the the 1970s with the encouragment of the world economy. While this has been a disaster for U.S. manufacturing it has provided products to consumers which could not be delivered at such low prices if things were all made domestically. The U.S. has still not fully adjusted to the world economy. The loss of manufacturing jobs has morphed industries in ways that folks are not yet fully aware of. In 2000 the 10 top selling lines of cars and trucks in the U.S. were all manufactured in the U.S. Most of them by companies we think of as Japanese.
A major part of why we are not properly informed regarding the economy is that such a vast portion of financial news concentrates on the stock markets. Stocks are not a good leading economic indicator lately and equities are but a part of the economy.
The most impoirtant thing to realize about the economy is that it is a vastly complex system. It involves decisions by consumers, business and investors. While we should seek constantly to understand it better we should not be surprised that we seem to be so poorly able to forecast what happens.
Back to Top
What part does the government play regarding the economy: fiscal policy vs. monetary policy?
While the engines of economic growth are business, labor and capital the federal government plays several important roles. One is regulatory but the important two are fiscal policy and monetary policy. Fiscal policy is about spending and taxes and this is in the hands of Congress and the President. Fiscal policy suffers from its nexus with politics and elections.
Monetary policy is about setting short-term interest rates and money supply and this is controlled by the Federal Reserve. When the economy stalls the Fed usually lowers interest rates. Access to lower interest rates decreases the long term cost of buying something with borrowed money and this stimulates consumer spending. On metric of future economy activity (GDP) is called Leading Economic Indicators (LEI). The largest weighted component of LEI is M2 a part of money supply. Experience has been that increasing money supply stimulates GDP. Interestingly this has failed miserably of late. A gigantic spike in monetary base (see this chart from the St. Louis Fed) had no lasting effect on GDP.
When lower interest rates do nothing to spur the economy the Fed can try quantitative easing (QE). With QE the Fed creates money, buys assets (treasury and mortgage debt) and hopes that the added liquidity will trickle down and get spent. The problem is that the Fed tends to take its foot off the accelerator too late and the results are as bad as the initial problem. These can be asset bubbles or inflation.
Back to Top
What is the Federal Reserve?
Is the Fed the 4th Branch?
The folks who framed the Constitution drew on the experiences of European governments and formulated a three part federal government: the president, Congress and the courts. A system of "checks and balances" among the three branches is supposed to prevent any one of them from becoming too powerful.
In many countries the military has the real power. This seems to work in smaller countries but in the U.S. the military wields no substantial domestic political power.
Like it or not, there is one pervasive power in the U.S. - money. Money is brought to you by the Federal Reserve.
Briefly, the Federal Reserve was created in 1913 to provide, well, a Federal Reserve - a way for banks to share each others reserves if a "run" was created on one. After the Depression, Congress, in 1935, created the system whereby the Fed was able to create money by purchasing government securities.
The Fed affects business and the economy by controlling the money supply and by its ability to control interest rates by buying and selling government securities on the open market. More impressively, the Fed can send shock waves through the economy by merely talking about raising rates.The threat of raising rates has as much effect as actually raising rates.
What Powers Does the Fed Have?
The Fed has 2 main sources of power:
1) the power to diddle with rates both by resetting the actual Fed Funds target or by merely talking about it and
2) the "magic checkbook" whereby the Fed can create money out of nowhere and buy bonds on the open market. The power to create money out of nowhere (so called, "fiat money") is impressive. I'd like to be able to do that.
Let's for the moment grant that the very ability to create money makes the Federal Reserve a separate branch of the government. (Of course it is not, it is still part of the Treasury Department.)
Someone recognized that it was imperative that the Fed buy debt on the open market and not directly from the Treasury Department. This idea of "open market" is extremely important. The Fed can open up its checkbook (the magic one with the infinite overdraft protection) and inject money into the economy by buying government notes and bonds. But, it must do so on the open market. Congress' sovereignty over expenditure is maintained by forcing the Fed to buy from private holders of government debt. If the Treasury Department ran the show, Congress would have succumbed its budget powers to the executive branch.
The Federal Reserve has very significant control over the economy, but it does not "make or break" the economy. It smoothes out the sizes of the economic cycles by avoiding potholes. In response to the 2007-2008 liquidity crisis the Fed created Commercial Paper Funding Facility which was a way of guaranteeing short-term loans to businesses and state and local governments. History may point out that this was the single biggest thing which contained the effects of the liquidity crisis.
Before the 2007-2008 thing the Fed had long seen its primary role as containing inflation. With inflation contained, the Fed has the ability to "fine tune" rates and look great. Contained inflation is like driving down the highway on a clear, sunny day with dry pavement and little traffic.Everyone drives well. If inflation is out of control, the correcting forces of the Fed are like someone trying to avoid other cars on a wet road, at night with a 45 mile an hour crosswind. There will be some wrecks.
The success of the 1990s economy was not due to politicians or even the Fed. It was due to the combined sanity of workers, businessmen, investors and the Fed. It is very easy for bankers to make a lot of money and the Fed to look great in this environment. Perhaps the very weakness of politicians this decade helped. Everyone else can just do their job. The Fed has power in its ability to create money. But it has not created wealth and prosperity. Wealth is the product of hard work, a healthy measure of greed and a good bit of luck.
The Real Power of the Fed
I think that, in final analysis, the Fed is one big bank with a gigantic amount of special rights and privileges. It can create money but unlike other banks it operates with almost no control from other parts of the government. It is not subject to the audits that other banks are. (The Fed is audited by the GAO and the district branches are subject to outside audits but the audits do not look into the policy making, open market operations, or discount window operations.) It is relatively free to buy and sell gold and U.S. and foreign bonds and currencies. It is the lack of intervention from politicians that enables the Fed to work and gives it power. The Fed has served itself well by not causing any scandals. No Michael Milkens, no Espys, no coke busts, no Chappaquiddick, no Oliver Norths.
The Fed is not a 4th branch of the government. It is a very powerful bank which draws its power from the quiet anonymity of doing a job with almost no supervision from the other branches of the government.
Back to Top
What is the FOMC?
The FOMC (Federal Open Market Committee) is part of the Federal Reserve. There are three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve controls the discount rate and reserve requirements. The FOMC controls Open Market Operations. Open market operations are an indirect method of controlling interest rates. In essence, open market operations direct the Fed to buy or sell 1-year Treasuries to keep the yield at the value set by the FOMC.
The FOMC meets 8 times a year. Its members are comprised of the Fed Board of Governors, the President of the New York Fereral Reserve Bank and a rotating group from the other Federal Reserve banks. The FOMC has clout. It directs open market operations but it also is part of the voice of the Fed. Their opinions about the state of the economy move markets.
The Treasury Department is mandated to buy all newly issued debt on the open market. Treasury sells new debt through primary dealers. They are not allowed to sell debt directly to the Federal Reserve. The FOMC sets a target for open market debt after issuance and it actively buys and sells already issued debt to keep yields where it wants them.
Back to Top
And when I get the paper
I read it through and through
And my girl never fails to say
If there is any work for me,
And when I go back to the house
I hear the woman's mouth
Preaching and a crying,
Tell me that I'm lying 'bout a job
That I never could find.
- lyrics to "Get a Job" by the Silhouettes 1957
The hard truth is that some of the jobs that have been lost in the auto industry and elsewhere won't be coming back. They are casualties of a changing economy. And that only underscores the importance of generating new businesses and industries to replace the ones we've lost, and of preparing our workers to fill the jobs they create.
- President Barack Obama July 2009
In 2001 we had a mild recession. In fact that was a very mild recession. What was strange was that job recovery was weak even as the recession (a dip in GDP) ended. The loss of jobs became a political issue which obfuscated the underlying realities.
A Keynesian-inspired stimulus bill in 2008 created a brief spike in GDP but little growth in jobs. If we had a recovery it was another jobless recovery. This is where the political view of the economy becomes useless or worse.
Presidents tend to pitch economic policies as creating jobs. That is politics much more so that it is economics. In reality job creation is little influenced by the President or Congress. Jobs are, in essence, like any other commodity. There is a supply - the work force - and a demand. The demand for jobs varies according to the demand for the products and services of businesses. Businesses and, consequently, job creation run in cycles. These cycles are not some unseen or metaphysical force. They are a result of the nature of the way businesses work. Opportunity knocks, business builds, jobs get created, supply exceeds demand, business contracts, jobs are lost. It's that simple.
Business opportunities are seen by a number of different companies and individuals who devote time and capital to business creation and expansion and the cycle always results in an oversupply. The consequence is recession.
This cycle was particularly nefarious because what was in oversupply was bad mortgage loans which undermined the banking system and created a liquidity crisis which cascaded to other businesses. Some jobs will come back apart from whatever the government does. Construction jobs will return when there are signs that the current oversupply of housing has diminished. There may be some reticence because of tougher lending standards and the perception that construction is less likely to be profitable if values are flat. Some retail jobs will come back as people start spending more. Significant jobs growth will occur as the result of new technological breakthroughs which create new industries and the jobs which go with them. The problem is that this happens on its own schedule. The jobs expansion which went with the growth of the Internet was not a planned event. It also was not accident. The works of a lot of individuals came together and created opportunities. President Obama's appeal about jobs is timely but then fact is that there is little which the government can do to create these new industries because, in fact, we do not know what they are. The President accurately states that these jobs will require more education that the old jobs. We may well find that our inability to educate our citizens for the jobs of the future is our most serious economic problem.
The role of the government in the creation of the jobs of the future may well be in investment tax credits for certain industries. The government has spent a lot of money to keep the auto industries going but these are not the industries where the jobs of the future are. One of the structural problems is that the industries of the future, by their nature, do not have large numbers of lobbyists. It is the entrenched industries and the labor unions associate therewith which do the lobbying.
On thing is sure about jobs. When companies think that hiring someone will produce more profit they hire people It's that simple.
Back to Top
Demand, Supply, Elasticity
"Demand" is the amount of stuff that consumers are willing and able to buy at a given price. Many folks would like a 6 bedroom home with a great kitchen, a pool, a wine cellar, and entertainment center with a 6 foot HDTV and a 6 car garage. The prices of such homes being what they are, few people are willing and able to buy at these prices.
"Utility" is the satisfaction people get from consuming (using) a good or a service. Utility varies from person to person. It varies by taste. It also varies by circumstances. Some people get more satisfaction from wine than others. Unless I am trying to impress someone, it is unlikely that I will spend $100 on a bottle of wine unless I can appreciate its value. The same person may get less satisfaction by drinking a bottle of Chateau Lafite Rothschild once he is too drunk to distinguish it from Ripple.
The amount of a stuff demanded depends on:
- the price of the good
- the income of the would-be buyer
- whether the buyer likes it (consumer taste)
- the demand for alternative goods which could be used (substitutes)
- the demand for goods used at the same time (complements)
Complements are like pickles. If McDonalds sells fewer quarter-pounders the demand for pickles goes down. If people eat fewer hot dogs they will buy fewer hot dog buns. As an extreme, people are unlikely to buy hot dog buns for hamburgers (substitutes) even if the price of hot dog buns is halved. They may buy more hot dog buns if the price of hot dogs is halved.
Supply is the amount of a good producers are willing and able to sell at a given price. The amount of stuff supplied depends on:
- the market price of the good
- the cost of producing the good
- the supply of alternative goods the producer could make with the same raw materials, plants, equipment and labor force
- the supply of goods produced at the same time (joint supply)
- unexpected events (i.e. "disasters") that affect supply.
The Law of Supply & Demand
In 1776 Adam Smith in "The Wealth of Nations" explained the law of supply and demand as: "The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labor, and profit, which must be paid in order to bring it thither."
And Then What?
So the "law of supply and demand" tends to set a "natural price" for stuff. The problem is that none of us are ever happy with the way things are. Companies want to do more business and, thus, are willing to "diddle" with the price of things in order to seek a greater market share and (perhaps) greater profits.
The price elasticity of demand measures how much the quantity demanded responds to a change in price.
Elasticity can be defined numerically as the change in demand divided by the change in price. (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)
Elasticity greater than one means demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There’s no change in quantity demanded when there’s a change in price.
Supply also has elasticity. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price. It measures how much the quantity supplied responds to changes in the price.
By the differences in nature between supply and demand (by that I mean that demand can change in a very short period of time) the price elasticity of supply is usually larger in the long run than it is in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price - in the long run.
One thing that we have seen lately is that some commodities, such as crude oil, have relatively inelastic supplies. The lack of supply elasticity translates into too small an increase in supply with rising price which has sent prices spiraling upwards.
For an economy to function well elasticity or inelasticity is not a neutral proposition. Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, jobs, taxes when the economy is languishing. Elasticity is good; inelasticity is bad.
Money Also Has a Price - Its Name is Interest Rate
While these rules pertain to most all commodities, we want to note that they also pertain to our favorite commodity - money. Money has a price. The price is the interest rate.
Interest elasticity of supply represents a change in the quantity of lendable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of lendable funds demanded in response to a change in interest rates.
Lurking behind interest elasticity is the willingness of banks to lend. They may, in fact, have a ton of lendable funds but are in fear of losing it to bad loans. Ultimately there is a loan to be made. The risk must be factored in and the borrower and lender strike a deal which they each feels to be beneficial to them.
So What's Wrong?
Rate lowering alone does not lead to significant long-term economic growth. It merely helps to create an environment in which it can happen. Existing businesses and entrepreneurs will make investments and create jobs when the reward from those investments outweighs the risks.
The are other actions that the Fed might undertake to jump-start business activity. The problem may be in the yield curve itself. The Fed dictates the short end (the overnight rate) and, to the extent that the short end dictates Prime it also dictates the Prime rate. But this is still short-term money. In terms of our mortgage world, businesses that get Prime based loan are getting volatile ARMs If I am a businessman wanting to make a capital investment I would be much more interested in what I could borrow money for at a fixed rate for 10 or more years. This is the corporate bond market.
The "Liquidity Trap"
An extreme case of interest inelasticity could be a prelude the "liquidity trap." The expression "liquidity trap" is one of those things that economists like to argue about - as in "does it really exist?" Keynes used the expression to describe a situation where interest rates were so low that wealth holders chose to hold cash i.e. remain liquid rather than invest it or even put it in the bank.
So What Has Been Happening?
What happened in 2009-2010 was that demand became inelastic. Lowering interest rates did not lead to increased demand for borrowing.
Back to Top
What The Fed Funds Rate Should Be - Taylor's Rule
What The Fed Funds Rate Should Be - Taylor's Rule
If you pay attention to well-know monetary economists with an academic leaning they believe the the Federal Reserve sometimes creates problems by being too aggressive in lower interest rates and too late in taking their foot off the gas.
One commonly used model for what the Fed Funds rate should be is Taylor's Rule. This is named for Dr. John B. Taylor a professor of economics at Stanford. The Taylor rule is an attempt to formalize how the Fed moves the overnight rate in response to the measurement of two key things 1) inflation and 2) GDP growth. Recall that the assignment given to the Fed is: Keep the economy growing at a moderate pace while keeping inflation low. A scholarly presentation of this is available in Acrobat format at http://www.frbsf.org/econrsrch/econrev/98-3/3-16.pdf
A somewhat more readable version is at http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-38.html
The Taylor rule is best regarded as a scientific explanation attempting to quantify the behavior of the Fed by postulating a mathematical equation of the Fed's "reaction function". That is, if one analyzes the data: interest rates, inflation and GDP can one determine a rule that describes the Fed's behavior.
The specific and simple rule is based on the following
r = the equilibrium real fed funds rate (the "natural" rate that is consistent with full-employment)
I = the average inflation rate for the past 4 quarters
(note here that inflation is not CPI but the GDP Deflator)
I* = the target inflation rate
y = the output gap (100*(real GDP - potential GDP)/potential GDP)
The equation is Fed Funds Rate = r + I +0.5(I-I*) +0.5y
If, for example, the target inflation rate was 2% and inflation (as measured by GDP deflator is 3%) then the Fed funds rate should be 2 + 3 + 0.5(3-2) = 5.5%.
In addition, if there is an output gap i.e. a difference between real GDP growth and "potential" GDP growth (a somewhat elusive concept) rates must be adjusted accordingly. If GDP growth exceeds "potential" then rates must be increased.
In practice there are several major considerations. The Fed would like to react to the data slowly by adjusting the overnight rate slowly. The goal is the goal legislated for our monetary policy - stable prices and full employment.
The global economy may have made Taylor's rule less relevant than it once was. Markets are now influenced by global output gaps and global unemployment. While some are working to integrate the world's economies others are resisting. We have folks protesting at G8 and WTO meetings. Politicians in the U.S. make the pitch of protecting jobs at home when, in fact, they have near zero ability to do so.
Back to Top
Money Supply & Monetary Base
Every Thursday the Federal Reserve releases a report on the money supply. You can find this here: http://www.federalreserve.gov/releases/h6/current/ There are two money supplies: M1, M2, and another measure called monetary base.
M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) travelers checks of non-bank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. Government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions.
M1 is money ready to be spent. It buys groceries and gas for the car and pays the rent or mortgage.
M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.
M2 buys groceries and gas for the car and pays the rent or mortgage plus it buys the car and makes a down-payment for the house. It also is a source of capital investment.
There is also a measure which is no longer reported weekly called M3.
M3 consists of M2 plus (1) balances in institutional money market mutual funds; (2) large-denomination time deposits (time deposits in amounts of $100,000 or more); (3) repurchase agreement (RP) liabilities of depository institutions, in denominations of $100,000 or more, on U.S. Government and federal agency securities; and (4) Eurodollars held by U.S. addresses at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada. Large-denomination time deposits, RP's, and Eurodollars exclude those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and money market mutual funds.
M3 consists of M2 - the money in play in the U.S. economy and two other big ticket items: Eurodollars, which are not in play and RP's which are in play, theoretically, only in the short term. Much of M3 is not "money in play" in the economy. Eurodollars are not and large-denomination time deposits are held by folks with wealth who have no intention to spend those dollars any time soon. RP's are more difficult to get a handle on. These are short-term borrowings but if they keep getting loaned out they are in play. In fact, the entire purpose of RP's is to put dollars in play.
In March 2006 the Federal Reserve announced that it leave M3 out of its biweekly reporting of money supply. That produced hundreds of Internet articles speculating the the Fed was holding back information and on a new plan of disinformation. The people who wrote those articles had probably watched X-Files too often and though that the Cancer Man was behind this. The point is that M2 is what is important. It is the most commonly watched part of money supply..
Eurodollar are dollar denominated assets held at financial institutions outside the United States and, consequently, not under any regulation by the Federal Reserve. Subsequent to World War II the U.S. started pouring money into Europe for rebuilding. That money was in the form of dollars and those dollars stayed in Europe. During the 1960's the Soviet Union became a holder of dollars and feared seizure of those dollars if they were kept in US banks. British banks agreed to hold those dollars for the Soviets and make deposits in U.S. banks in dollars. In essence the Soviets were able to hold dollar based assets satisfied of their safety.
The popularity of such transactions has expanded vastly. The expression "eurodollar" is now used to refer to any currency held outside its native country and banking system.
When the Federal Reserve uses the term "eurodollars" they refer to U.S dollars held outside their control. That could be dollars held in foreign countries including dollars held by U.S banks in branches outside the U.S.
The next two paragraphs are from the web site for the Federal Reserve Bank of New York:
Among the tools used by the Federal Reserve System to achieve its monetary objectives is the temporary purchase and sale of United States Government securities and federal agency obligations in the open market.
In conducting these operations, the System uses "repurchase agreements" ("RP's" or "repos") and "reverse repurchase agreements" transactions which have a short-term, self-reversing effect on bank reserves.
Such repurchase agreements are instigated by the Fed's trading desk for the purpose of controlling money supply. In theory, they are used to offset day-to-day fluctuations in bank reserves. In would seem to me that repos should be included in regarding the money supply and regularly reported. Nevertheless more attention has always been paid to M2 than M3 so dropping the regular reporting of M3 is not exactly drastic. The Fed has not used money supply but rather interest rates to spearhead monetary policy for the past 20 years. The fact that M2 and M3 have increased so dramatically with modest inflation speaks volumes to this disconnect.
In addition to money supply there is another very important datum called monetary base. Monetary base is cash in circulation (total cash minus cash held in bank vaults) plus bank reserves held in Fed Reserve Banks. This is regarded as "high-powered" money. The fact that the massive increase in monetary base in 2009 resulted in no substantial increase in GDP simply indicated that we were is an anomalous period where not even "high powered" money did much talking. Banks felt safer with their cash sitting at the Fed than they did putting it into play.
Back to Top
The Changing Nature of Work in the U.S.
Every month we look at the BLS Employment Situation Report. It is one of the most important pieces of economic data issued each month.
Underlying the numbers is a larger picture of the changing nature of the U.S. economy. The source for data for the American workforce is the Bureau of Labor Statistics. One may go to:
http://stats.bls.gov/webapps/legacy/cesbtab1.htm and retrieve some interesting data series on the changing nature of the workforce.
There are many things that can be derived from such data but I would suggest that there are 2 big points:
1) 81% of the workforce is in service producing jobs and
2) almost all new job growth is in service-producing jobs.
Indeed, none of this is "news" but I think that it requires perspective. We are not on the Enterprise where the Captain says, "replicate some blankets, clothing and food for these people," and the "replicator" makes it. Stuff is made abroad. This is done because economics dictates it. It can be made less expensively there and, thus, there is no good reason to make it here.
Americans of my generation and younger folks have been through a period where we are trying to seek a greater social consciousness. The very reports that the BLS publishes describe our concerns regarding the differences in employment rates between various ethnic and age groups. It identifies groups that have higher unemployment, presumably so that something may be done about it.
As the economy is becoming more of a "world economy" where "stuff" is made in other countries this concern is diffused. Should we be concerned about how much money people who work in factories in Asia make? Maybe, at some time in the future, our concerns will translate into better lives for people there. For now, stuff will be made abroad and wages will be determined by the market there. We might be horrified at the low wages being paid to seamstresses in factories there but the real question might be: what were these people doing before they took those jobs? In the "world economy" the United States will be:
a) a supplier of capital
b) a supplier of technology and ideas
c) as stable economy providing a stable currency and
d) a consumer.
Is This Work?
At some time in the past, a large sector of the economy was agrarian. The Industrial Revolution came along and we became a nation of factories. Perhaps the folks who operated the machines felt that they were not really working. "The machine is doing all the work. I'm only turning the controls." Even though operating a back hoe might not seem like as much work as digging a hole by hand, the fact is: it accomplishes the task at a much lower cost. I don't think that there are many successful excavating contractors who use shovels exclusively. The important thing is not getting calluses but getting the hole dug. The contract to dig the hole will go to whomever can do it at the lowest cost.
We are in the second iteration of the Industrial Revolution. The machines are now computers. Our jobs are service jobs. They are made to somehow seem less "real" or less important. A commonly held belief is that "service producing" jobs pay less than "goods producing" jobs and that, by not making goods we are becoming a nation that cannot compete in the world economy. Our merchandise trade deficit is viewed as a symptom of malaise.
This is nonsense. There are several serious problems with the notion of service jobs as not being a viable basis for a healthy economy for the 21st century:
1) the concept is imbued into the fabric of American Protestant ethos. Work is good. Work should be hard. Real Americans are Masons not lawyers. This is absurd. I am (by education) a physicist. Work is measured in foot-pounds. Pick a 10 pound object up one foot and you have done 10 foot-pounds of work. Pick a 1 pound object up 10 feet and you have done the same amount of work. You can use a pulley to pick up a very heavy object and you are doing no less work than if you had busted your ass picking it up without one. Work is measured by accomplishment - not perspiration.
2) the government-defined concepts of goods producing and service producing are fuzzy.
If I buy a frozen hamburger at Safeway it is a good. If I buy it cooked at McDonalds - it is a service.
If I am a trucker who works for a manufacturing company and move parts around for them I am a goods producer. If I own the truck and am contracted to do the exact same work, I am a service producer.
Is a computer program a good or a service?
Is assembling a computer by attaching chips to a board that much different than assembling something such as a loan file and delivering it to a lender? The neat standardization of loan files makes them commodities tradable on markets as if they were bushels of wheat.
3) the changing nature of work is a derivative of the extent of technology. The average product has a lot less "stuff" in it and a lot more intellect. The computer that I am typing this on was produced with a lot less effort by "goods producing" workers than the first Univac 1107 that I used. Its ability to accomplish tasks is largely the result of a lot of work by service producers: programmers, circuit designers, electronics engineers and physicists.
Is someone worse off because less physical work has been done to build my computer?
4) as union-dominated manufacturing jobs: producing steel, cars, and television sets, have vanished to appear in other countries there is a political-social concern that this represents a failure to the people in these industries - the real workers for who the labor movement fought so hard in the first half of the 20th century.
The perception is that the loss of these union jobs is not socially beneficial, that those hard-fought gains of workers are being lost to service-producing jobs at lower wages with less benefits. Perhaps labor unions have lost power but their workers are getting more done.
Expansion in service producing has not resulted in a reduction in the number of people producing goods. It has made them more productive. America is not de-industrializing. It is getting more done with fewer workers. The important point here is that this expansion in productivity has required not more work, not more raw material but more capital. I want to repeat that last item for emphasis. The requisite for higher productivity is capital, lots of capital.
But What About the Big Layoffs?
Among the many things that drive me nuts about the media is the presentation that since big companies lay off large numbers of workers, the economy must be going into the tank. This is addle-patted. That is like saying: since old people die and people are born at an early age the average age of the population must be decreasing. I don't think so. Everyone gets a day older each day. In a similar manner: big companies have big layoffs, little companies start every day and the small and medium sized companies are the ones that add jobs.
Back to Top
The Measures of Inflation
By "inflation" we are almost always talking about CPI. But, there are other measures of inflation. Some of these are more forward looking than the backward looking, "this is what happened last month" nature of CPI.
Consumer Price Index (CPI)
CPI is a measure of the average level of prices of a fixed "market basket" of goods and services purchased by consumers (food, clothing, utilities etc.). CPI is an indicator of inflation on the retail level.
This is calculated every month by the Bureau of Labor Statistics and available online at http://stats.bls.gov/cpihome.htm.
The are 2 major CPI's:
CPI-U (U is for Urban) which represents about 80 percent of the total U.S. population. It is based on the expenditures reported by almost all urban residents, including professional employees, the self-employed, the poor, the unemployed, and retired persons as well as urban wage earners and clerical workers.
CPI-W is based on the expenditures of urban households that meet additional requirements: More than one-half of the household's income must come from clerical or wage occupations and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months. CPI-W represents about 37% of the population.
It is the CPI-U which everyone calls "CPI."
Food and beverages (cookies, cereals, cheese, coffee, chicken, beer and ale, restaurant meals)
Housing (residential rent, homeowners' costs, fuel oil, soaps and detergents)
Apparel and its upkeep (men's shirts, women's dresses, jewelry)
Transportation (airline fares, new and used cars, gasoline, car insurance)
Medical care (prescription drugs, eye care, physicians' services, hospital rooms)
Recreation (newspapers, toys, musical instruments, admissions);
Education and communication (tuition, postage, telephone services, computers), and
Other goods and services (haircuts, cosmetics, bank fees).
CPI is seasonally adjusted to cull apart the changes that are seasonal from the underlying economic changes. Seasonal changes are fluctuations in prices which occur at the same time every year. They might be due to: automobile model changeovers, weather and holidays. For example, gasoline costs more in the summer, tomatoes cost more in the winter.
The unadjusted data is what people actually pay. The adjusted data is what is reported in the media. CPI is a number that reflects prices with 1982-1984 averages as 100.0. The adjusted index was 162.5 for April 1998 as compared to 162.2 for March so we say "CPI is +0.3%." CPI is based on a very large sample of goods in a very large sample of places. The one criticism that can be made is that it takes no account for what people actually buy. If, because of El Nino, tomatoes which cost $1.39 a pound in March now cost $4.59 a pound, people will diminish their purchases. Because of this, CPI may, in terms of what people actually buy, be slightly overstated.
CPI is reported as core and overall. Core eliminates food and energy. The issue is that food and energy have very month-tomonth large variances. Overall is the best measure of what people really pay but, because it filters out large swings in food and energy prices, core is the real indicator of where inflation is going in the longer run.
PPI is the Producer Price Index - this measures the average change over time in the selling prices received by domestic producers of goods and services. PPI's measure price change from the perspective of the seller. This varies from CPI which is a measure of price change from the buyer's perspective. Sellers' and buyers' prices may differ due to subsidies, taxes, and the dynamics of distribution costs.
Implicit Price Deflator
While CPI might be the "Dow" of Inflation it is, in essence, a measure of the price that people pay for things and services. The economy, however consists of a bit more than individuals.
A broad measure of economic activity is GDP (Gross Domestic Product). The GDP Implicit Price Deflator or IPD is based on the Gross Domestic Product and therefore reflects price changes in all goods and services transactions in the United States, including the consumer, producer, investment, government, and international sectors. The IPD for GDP takes into account the price changes of the goods and services that actually happened. The IPD for the GDP is, thus, a more meaningful measure of inflation than either CPI or PPI.
IPD might, for example, be used to adjust the cost of a long term projects such as Civil Engineering projects. The EPA, for example, writes it into the bids for toxic cleanup projects. If one wanted to compare the economic impact of natural disasters from different periods, it would be appropriate to normalize the dollar losses at the time that the occurred using IPD's.
ECI is the Employment Cost Index. When we were hearing about a tight labor market this might be where inflation would first show. ECI is the cost of labor on a fixed basket of occupations. This eliminates the effect of the influence of employment shifts among occupations. While the average hourly earnings data would be affected by a shift in the occupational composition of the workforce and would appear as a wage gains, ECI would not be affected. Wages & salaries account for about 72% of the ECI. The rest is benefit costs. ECI data is available from BLS at: http://stats.bls.gov/news.release/eci.t01.htm.
FIG is a product of Economic Cycle Research Institute, Inc. This is a construct that is forward looking. It is a way to predict future inflation. The previously discussed indices take note of inflation that has already occurred. ECRI has a website at http://www.businesscycle.com This site is a, sort of, Bible on inflation. FIG is reputed to be able to predict inflation up to a year ahead.
Back to Top
Since 1983 or so attention has been on inflation and its evil effects but the opposite of inflation is also a problem.
Disinflation is a decrease in the rate of inflation. The rate of inflation decreases but its actual value is still positive. If we uses CPI to measure inflation, then we have been in a disinflationary environment since the early 80's.
The attention to disinflation is directed to the fact that as the increase in CPI continues to fall it might hit and pass through zero and we would then have deflation.
Credence was added when Greenspan suggested that deflation is a potential threat. (Note: he also brought this up in October 1998.) The risk, at present, is "too much stuff." When there is too much stuff, the price of stuff falls.
The Asian Currency Crisis resulted, in part, from an unwise and too large infusion of capital into plants to make more stuff. There was plenty of fault to spread around. Companies, Asian governments, banks and investors all had a hand. When Asia was unable to consume these goods, there was excess capacity. That glut may have been exported to the U.S. resulting in disinflation and, if the problem is not confinable, deflation.
Our focus for so long has been on preventing inflation that, even though outright deflation is a somewhat far-fetched scenario it is good that we are becoming aware of it.
What Happens in Deflation?
Just how close to deflation is the U.S. economy? Inflation (which hit a post-World War II high of 13 percent in 1979) is running at a 34-year low of around 2.5 percent. So, it wouldn't take much to transform disinflation - progressively smaller price increases - into declining prices.
Deflation might be a nightmare because we are not prepared for it. Deflation is the opposite of inflation. Prices of goods and services would fall over time. Cash would increase in value. Debt, which was no big thing in times of inflation, might prove fatal to municipalities, companies and individuals. The effective interest rate would rise and defaults might result. This could lead to chaos in banking. Debt heavy companies would feel pressure to cut wages and salaries. Folks with mortgages might not have any income as their jobs disappeared. In deflation, debt is a curse. A retiree on a fixed income would find himself richer each month. One might curse the mortgage broker who got them a 5% fixed rate mortgage. Aarrgh!! My payments are fixed. I have fewer dollars of income. Each month the value of that fixed number of dollars would increase. The value of my home would decrease. Why should I make my mortgage payment? In the first four years of the Great Depression, prices fell an average of 8% per year and big chunks of the economy went down with them.
In deflation there is little incentive to invest in plants and equipment. Why invest today if the expense of doing so will be less next year?
An example of deflation killing an industry was Telecom in the year 2000. Large capital investments in bandwidth were made – some of it with borrowed funds – and the price of bandwidth collapsed. The telecom industry was hurt by its own competitiveness, a side effect of a free-market economy. Karl Marx snickered in his grave.
Inflation and deflation can be viewed in a historical perspective. In the book "The Death of Inflation," British economist Roger Bootle points out that inflation has been the exception throughout history, not the rule. British studies show that in 1932, prices were slightly lower than they were in 1795. And, according to Bootle, when one looks at prices dating back to the year 1264, 97 percent of all the price inflation in the last 700 years has occurred since 1940. (I am not sure what this implies but it sounds "cool".)
But really. It seems far-fetched that any nightmare deflation scenario could occur soon.
What I see as more likely is the following:
1) inflation is (for the time) under control.
2) Americans, unlike Japanese, are spenders. We are unlikely to stop spending for an extended period. That is downright un-American. The Japanese are savers. They actually think about the future. Look where it has gotten them.
3) The global economy has served to temper U.S. inflation. There is not a worldwide environment of deflation which would necessitate lowering prices and wages here. Tempering - yes; lowering - I think not.
4) We now know that we can have very low unemployment (it was as low as 4.5%) and yet very low inflation. The root of inflation is not what it was once thought to be.
5) Computer prices continue to drop and are now available to most anyone. The Internet promotes price competition. The cost of transactions, such as processing an online application, are decreasing. People are trading stocks at rock-bottom fees using the web. Again, this is a price-tempering force, not a source of deflation.
6) the fact that the Chairman of the Federal Reserve would even mention deflation indicates that we are aware, at an early enough stage, that it is a serious threat. This alone might keep deflation from becoming a problem.
7) Deflation - the dangerous Japan-like deflation - would occur (to repeat paragraph II) as a parallel to a lengthy period of recession. Could that happen? Yes. Is it likely? No.
Back to Top
Credit Default Swaps
In all of the post-bubble analysis of what went wrong a share of the blame is often placed on credit default swaps.
Credit default swaps (CDS) are fairly new having not existed before 1994. Inauspiciously enough, CDS stemmed from a disaster. On March 24, 1989 the Exxon Valdez, an oil tanker headed to Long Beach, CA hit a reef in Prince William Sound, Alaska and spilled somewhere between 260,000 and 750,000 barrels of crude oil. In 1994 a jury awarded the plaintiffs (there were 38,000 litigants) $287 million in compensatory damages and $5 billion in punitive damages. The defendant was Exxon. Exxon appealed the case (this was not settled until 2009) but did not want to tie up $5 billion in capital. Exxon went to J.P. Morgan and got a $4.8 billion credit line in case it lost the appeal. J. P. Morgan was (and still is) a bit of an "old school" company. Exxon was a big client and an old client of J. P Morgan so they said "yes" to the loan.
If you recall last week's newsletter wherein I discussed the Basel capital accords you will remember that the Basel accords call for such a commercial loan (the one JP Morgan made to Chase) to be a 100% risk loan. That means that this loan tied up a minimum of $4.8 billion x 0.08 or $384 million of J. P. Morgan's capital. Blythe Masters who was then a member of J. P. Morgan's swaps team (I have added a piece at the end on swaps) and is now the head of commodities for J. P. Morgan Chase had the idea of selling off the risk associated in the event that Exxon defaulted on that $4.8 billion credit line. The deal was made in 1994 and CDS (which did not even have a name at the time) were born. J. P. Morgan had its capital freed, the insurer got a premium, Exxon had its credit line, the plaintiffs had a guarantee of payment, and Exxon and J. P, Morgan preserved their relationship.
Subsequently CDS became the way that holders of debt purchased insurance in the case that the party owing the money defaulted. They were a form of credit insurance.
CDS started as insurance for corporate debt but what may have happened is that with the economy being healthy and very few corporations defaulting on debt, folks started to think of CDS as a cash cow and aggressively expanded the concept to include other debt including mortgages. With the help of HUD mandated subprime and other subprime non-GSE mortgage debt the prescription for a firestorm was created: 1) bad mortgages 2) expanded money supply and low Fed rates and 3) CDS Since then credit default swaps have grown gigantically. There is a web site which has outstanding CDS. By the end of 2007 the outstanding notional amount of CDS was $62.2 trillion. One year later it was $38.6 trillion. The web site above show it currently at $24.2 trillion.
There is nothing inherently wrong with CDS What should be considered for regulation is 1) should CDS be traded on a open market and 2) should naked CDS be allowed. Naked CDS are those wherein the buyer of the CDS has no underlying stake. Think of this as buying fire insurance on someone else's house because you notice that he does not take good care of it. While this could be a motivation for arson it could also serve as a red-flag to an insurance company that the market is telling them that one of their policy holders is not taking adequate care of the insured property.
The mortgage mess/Great Recession has provided a very large dose of reality to those who gambled with CDS After the Lehman BK there was a total of $400 billion (notional) in CDS Most of the $400 billion involved entities that had money both coming and going on Lehman CDS so that the total net amount after balancing funds coming and going was about $7.2 billion. The big loser from CDS was AIG which had unwisely held an unbalanced portfolio.
Interest Rate Swaps
Before there were credit swaps the common swap of concern to the mortgage industry was the interest rate swap. An interest rate swap is the exchange of a fixed rate loan for an adjustable rate loan. If I hold assets such as fixed rate mortgages but my liabilities are of much shorter duration than the weighted average maturity of those mortgages they I may want to buy a swap to protect against a rising cost of funds.
Back to Top
The Economics of Unemployment
A lot has been said and will likely continue to be said about the fact that as the recession ended unemployment has remained high. As employment starts to pick up it would serve well to try to understand the economics of unemployment.
In 2009 we had a stimulus bill - The American Recovery and Reinvestment Act - which was intended to increase GDP and lower unemployment. The results were, at best, mixed. The only certainty is the increase in the national debt. At the end of 2010 we had an extension of the "Bush era tax cuts" which was touted as more stimulus.
Why is there so much unemployment at present? In general this is due to the recession which resulted from the liquidity crisis of 2007. As GDP fell companies needed fewer workers because there was less demand. Current workers were laid off and new workers were not hired. Okun's Law states that for every 2% drop in GDP , unemployment increases by 1%. This (like just about everything in economics) is not really a law but a rough approximation or rule of thumb. Keynesians see increased government spending as a solution. The notion is that if the government makes up the output gap by spending then the rest of the economy will start growing and the seeds planted by deficit spending will grow into mighty oaks which will mean increased GDP, spending, jobs and tax revenue. Of course this is not what happened.
What really causes unemployment and how is it remedied?
Economists generally break unemployment into three categories: cyclical, structural, and frictional.
Cyclical unemployment is a consequence of business cycles: opportunity knocks, companies create jobs because they believe they can turn opportunity into jobs and profits, and eventually supply exceeds demand. Once there is not enough economic demand to create a job for everyone seeking employment, layoffs occur.
Frictional unemployment or equilibrium unemployment occurs voluntarily when people move from job to job or into and out of the labor force. Some of this is "take this job and shove it" unemployment where folks are seeking a better job. This can also result when people graduate from college and enter the labor market. The fact that they are looking for a job adds them to the employment force. A woman who has a child may take unpaid time off from the labor force. Frictional unemployment arises from the length of time required for the employer and the employee to connect. This same sore of "search friction" occurs in the housing market. When there are positive signs for hiring, more people may reenter the work force and actually increase the unemployment rate. The "work force" includes those working and those looking for work.
Structural unemployment is a bit more sinister. This has to do with the changing nature of the labor market and the potential mismatch between those seeking jobs and the skills which go with the available jobs. With the collapse of the housing bubble the demand for jobs associated with home construction dropped dramatically. From its peak in August 2006 more than 2 million construction jobs were lost. There are substantial job openings in health care and education but carpenters and plumbers may not be prepared for those jobs. This is structural unemployment.
This can be seen in the monthly Bureau of Labor Statistics report on job openings.
Structural unemployment would also include people left behind because they cannot sell their underwater home and move to a place where there may be job openings for someone with their skills. This is more complicated in the present day when most families have need two paychecks and two job openings in order to relocate even if their home had equity.
Keynesian economics and the suggested deficits which go with it address only cyclical unemployment. Perhaps cyclical unemployment eventually takes care of itself even without added deficits and the only economic advantage is that deficit spending may clear recessions sooner. In reality, Keynesian notions may have stopped working in the early 1970's. This is a topic which is so polarized politically that a rational discussion is almost impossible.
There are other issues beyond these textbook descriptions regarding unemployment. One is the extension of unemployment benefits (which used to go to 26 weeks) to 99 weeks. The work (on frictional unemployment) of the winners of the 2010 Nobel Prize in Economic Sciences concludes that more generous unemployment benefits give rise to a higher unemployment rate and longer search times. In a job market with substantial structural unemployment the seeming social benefit of extended unemployment insurance may turn into a kiss of death as the gap between the skills of those unemployed and the skills required for job openings widens. This is not about carpenters becoming teachers but about service sector job-seekers keeping up with rapidly changing software systems.
There is an important difference between the labor market and other markets. Unlike the prices of commodities wages tend to be sticky. They do not in any sense quickly adjust downward when there is sharp unemployment. While no one really knows why wages are sticky it seems to be the case that when recessions occur wages do not really fall but simply grow more slowly. Economists may suffer from having too little experience with managing. The best explanation for sticky wages may simply be that if I am an employer with 100 employees and because of reduced demand need to cut my labor costs by 10% I have two simple choices: 1) cut everyone's pay 10% and keep all 100 employees or 2) lay off 10 employees and keep wages flat for the remaining 90. If I choose #2 the laid off people are gone and not around to complain and those remaining may feel lucky and average morale may be high. If I cut everyone's wages all I may have is 100 unhappy employees and declining morale and productivity.
What Should the Government Do About Unemployment?
My belief is that there is little positive that the government can do about unemployment. Businesses and workers come together and create jobs. The weight of government regulation is so large that the net effect that the government has on creating jobs is negative. The goal of government should be to minimize the damage that it does to the job market.
At present there is a gigantic mountain of cash in commercial banks and investment banks waiting to be invested or loaned. The unemployment rate will fall only after that gigantic mountain of cash is deployed to start new companies. One of the issues may be that capital deployment has recently tended to look only for "hot" sectors. We had bioscience and then the dot-com boom/bust. There may be an underlying problem with the way we deploy capital but that is a discussion for some other time.
Back to Top