It's the Unemployment Rate Stupid

The recent labor market data was abysmal; 38,000 new jobs created against an expectation of 150,000 or more. Unemployment fell slightly to 4.7%, in part because the labor force continued to shrink. A lower unemployment rate is good news and, historically, 5% unemployment has been considered close to full employment. But is that the whole picture?

Chart 1: The Employment to Population Ratio

Some have claimed that we should be looking at the employment to population ratio instead of the unemployment rate. The performance of that statistic is not encouraging as is evident from Chart 1 which shows that the current employment to population ratio is 59.7%, a value that we last saw in May of 2009. That looks bad. But should we be worried? 

In the dim distant past, economists focused on the unemployment rate as a measure of labor market strength. In the 1970s, a group of economists from the real business cycle school persuaded us that unemployment is the wrong measure and that we should look instead, at the hours workers by a representative person. That measure varies for three reasons. Changes in the length of the work week, changes in the  labor force participation rate, and changes in the unemployment rate. The length of the work week for the average person has fallen steadily since WWII and although it goes up and down over the business cycle, the variation in average weekly hours in not the major reason for recessions. What about the labor force participation rates? 

Chart 2: Unemployment and Labor Force Participation

According to a popular narrative, labor force participation is low because of 'discouraged workers'. These are people who would really like to be working but who have dropped out the labor force because they cannot find a job. What is the evidence for the 'discouraged worker'? In my view; not much.

Chart 2 shows male and female labor force participation rates alongside the unemployment rate. Try as I may, I cannot get excited about the changes in the labor force participation rates. They display secular trends that are largely explained by the aging population and by the sociology of an increase in female labor participation in the 1950s and 1960s.

Recessions are not, as some economists have argued, times when workers choose to voluntarily enjoy additional leisure.  They are times when it is hard to find a job because not enough people are choosing to spend their income as opposed to saving it. If the discouraged worker effect were an important explanation of the slow recovery from the Great Recession, we would expect to see significant variation in labor force participation rates at business cycle frequencies. The fact that we don't suggests, to me, that the dismal employment to population ratio is caused by the end of the baby boom. As I argue in my forthcoming book, Prosperity for All: How to Prevent Financial Crises, this is not something that monetary or fiscal policy can, or should, be used to 'cure'. 

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The first version of this post incorrectly posted the employment to population ratio for 25-54 year olds. I have updated it with the civilian employment-population ratio.

Kitten on the Keys

In my misspent youth, I considered a career as a ragtime guitar player.  Two of my idols were David Laibman and Eric Schoenberg who transcribed Scott Joplin for guitar. I sold all my vinyl many years ago (big mistake) and have slowly been replacing it with Amazon digital downloads.

Laibman and Schoenberg have only one album of note, the New Ragtime Guitar. But what an album! One of my favorite pieces is Kitten on the Keys and at one point, I learned how to play the Laibman-Schoenberg transcription of Dill Pickles Rag. 

Why, I hear you ask, would I post this on an economics blog. Because, in googling Laibman and Schoenberg to find out what had happened to them, I learned for the first time, that David Laibman is an economist who retired a few years ago from CUNY in New York. Here is a  link to his page. 

Eric Schoenberg turns out to be his cousin and he sells high end guitars in Tiburon, near San Francisco. Next time I'm in the Bay Area I plan to check out the store. Who knows, maybe I'll get a discount on the $76,000 1938 Martin in exchange for the publicity. 😎

The China Syndrome

I feel a little like Rip Van-Winkle. The consensus amongst economists in the 1980s was that trade is always and everywhere good for everyone.  After attending a UCLA workshop on trade a couple of weeks ago, I learned that all that has changed. There is a new consensus, summarized in two papers, "The China Syndrome", published in the American Economic Review, and "the China Shock", a new working paper,  by David Autor, David Dorn and Gordon Hanson (ADH). According to their research, the effects of trade with China have been truly catastrophic for the average American worker. Over to ADH --

Our analysis finds that exposure to Chinese import competition affects local labor markets not just through manufacturing employment, which unsurprisingly is  adversely affected, but also along numerous other margins. Import shocks trigger a decline in wages that is primarily observed outside of the manufacturing sector.

Sound familiar? This is a case of academic economists catching up with what the median blue-collar worker has known for a long time. The U.S. lost jobs to China and the average American worker was not compensated by the winners. And there were winners.

China's economic growth has lifted hundreds of millions of individuals out of poverty. The resulting positive impacts on the material well-being of Chinese citizens are abundantly evident. Beijing's seven ring roads, Shanghai's sparkling skyline, and Guangzhou's multitude of export factories none of which existed in 1980 are testimony to China's success.

Nor were the winners only Chinese workers. If your income is primarily generated by ownership of human or physical capital; you have benefited enormously from the chance to combine your talents, in the case of human capital, and your wealth, in the case of physical capital, with a vast pool of unskilled labor. But those benefits were never passed on to American workers and American workers are now voicing their collective displeasure at the ballot box.

Prosperity for All: Coming Soon to a Bookstore Near You

This is my first post for a while: so, sorry if you missed me. I've been busy writing books and papers. I received the final galley proofs this week for my new book, Prosperity for All: How to Prevent Financial Crises. You can pre-order it from OUP or Amazon and it will ship on September 1st.

I also finished three new working papers that I will say more about in future posts.

I've been consistent in my criticisms on this blog of attempts by Paul Krugman to revive the IS-LM framework. That's not because I'm opposed to IS-LM as it appeared in its earliest incarnations; the papers by John Hicks and Alvin Hansen. It's because of the bastardization of the Keynesian agenda by what my friend and teacher David Laidler referred to as North American Keynesianism. In my view, articulated in Prosperity for All, macroeconomics went off the rails in 1955 when Samuelson introduced the neoclassical synthesis in the third edition of his textbook, Economics: An Introductory Analysis. (See Pearce and Hoover for a great discussion of the influence of Samuelson's text and my book How the Economy Works).

The IS-LM model is an effective way of capturing some empirical regularities in a graphical apparatus. But it is not a complete theory of macroeconomics in the sense that we mean by that term today. When Hicks wrote the famous paper that became IS-LM, he had already written a pathbreaking book, Value and Capital, that is, in many ways, a much much better book than Keynes’ General Theory. Value and Capital used a technique, temporary equilibrium theory, that presents a complete dynamic model of the macroeconomy.

In Value and Capital, time proceeds in a series of “weeks”. Each week, people meet in a market. An auctioneer calls out prices and only stops when the demands and supplies of all commodities are equal. At that point trade takes place and people trot off home to the family farm to produce goods for the next week’s meeting. At each market meeting, the demands and supplies that people announce are functions of their beliefs about future prices. And those beliefs may or may not turn out to be correct.

When Hicks read the first draft of the General Theory, he had a crisis of confidence and figured that everything he'd spent his life working on was wrong (see Michel De Vroey's piece on this point). He seized on Keynes’ idea that, at each market meeting, people trade with each other before the auctioneer has finished his job. The result is involuntary unemployment and he formalized that idea by developing what we later came to call the IS-LM model.

The Keynesian economics of the General Theory is static. It purports to explain how employment, GDP and the interest rate are determined at one weekly meeting, taking the price level as fixed. Modern macroeconomics is dynamic. It purports to explain how employment, GDP, the interest rate and the price level are determined in a sequence of weekly meetings. To knit together the temporary one-week Keynesian equilibria, Samuelson, in the new-classical synthesis, used the Phillips curve, which he saw as a price adjustment mechanism in which the wage adjusts in response to an excess demand or supply of labor. This was the biggest mistake in the history of macroeconomic thought and we are still suffering the consequences as central banks work with false ideas and broken models.

In Prosperity for All I articulate the evolution of an alternative research agenda. I argue that it is beliefs that are sticky: not prices. At each weekly meeting, the auctioneer finishes his job. The demands and supplies of all goods are equal and all markets clear; including the labor market. But the labor market is a search market, not an auction market, and there are many different ways in which it can clear (see my EJ piece on how this works). Labor market equilibrium is pinned down by beliefs about future prices and, for every belief, there is a different Pareto inefficient market-clearing unemployment rate.

The differences of this theory from all of modern macro, both classical and New-Keynesian, are profound. In my view, high involuntary unemployment is an equilibrium phenomenon. A market economy can get stuck in a Pareto inefficient equilibrium with high unemployment forever. It is the job of government to design political institutions that provide the equilibrating mechanisms that are missing from laissez-faire market economies.

You might think that the above paragraphs would make me an uber-Keynesian. Surely I should be riding in on my white horse unfurling the banner of fiscal intervention to save capitalism from itself. Not so fast. Although my work provides a foundation to the Keynesian theory of aggregate supply: I am skeptical of Keynes' views on aggregate demand. Much more on this in a future post.

Idiopathic Tardus Augmenti

There are religious nonconformists. There are climate change deniers. And there is now a new class of political agnostic: the secular stagnation skeptic. According to a piece in Time magazine this week, Barry Eichengreen finds the issue of secular stagnation so divisive amongst academic economists that he has coined a new term to help us sort ourselves into believers and non believers: the 

Steam Boat off Harbour's Mouth: J.M. Turner

 secular stagnation Rorschach Test. I like that term. And as I look at the ink blot of incoherent theory and misinterpreted facts that is presented to us for interpretation I find myself peering at a late Turner painting. I am straining to see the ship in the blizzard.

The Time piece is supposed to explain, to the layperson, what economists mean by secular stagnation. It serves only to spread the confusion that was laid by Larry Summer’s original article in which he resuscitated the term ‘secular stagnation’, originally coined by the American economist Alvin Hansen.

The confusion that originates in Larry’s article is between economic theories of unemployment and economic theories of growth. On unemployment, economists can at least agree to disagree.

For the thirty years leading up to the Great Recession, most economists built economic models where there is never any unemployment and the quantity of labor demanded is always equal to the quantity of labor supplied. Although there are still a few rosy tinted true believers who think that this makes sense; for the most part, the breed is dying out. It has been replaced by a new religion that genuflects to the altar of the sticky price. These ‘New Keynesian’ economists agree that, in the long-run, the quantity of labor demanded will equal the quantity of labor supplied. But, in the short-run, high unemployment persists because wages and prices are ‘sticky’.

Larry is not in either of these camps. Nor am I. I have spoken at length with him about this. Larry sees high involuntary unemployment as an equilibrium situation. I have modeled that idea in my own work where I use the theory of labor market search to explain why high involuntary unemployment may persist. And Larry has written papers with Olivier Blanchard where low involuntary employment may persist as workers become discouraged and remain out of the labor force. The exact formulation of this idea is unimportant. Larry and I are on the same page. Market economies are not self-stabilizing and they do not quickly adjust to find the socially optimal employment rate in the absence of active stabilization policies.

That brings me to the theory of economic growth. On this topic, despite more than twenty-five years of intense and active research, there is little or no consensus. The dominant way that macroeconomists model economic growth was developed by Robert Solow in the 1960s. Growth, in the Solow model, is caused by an exogenous increase in an unexplained factor called technological progress.

We produce goods by combining capital, land and labor using blueprints that represent the state of knowledge. If we had combined one acre of land with twenty-five machines and one hundred people in 2000 we might have produced (by way of an example) one hundred units of output. If we had combined one acre of land with twenty-five machines and one hundred people in 2001, we might have produced one hundred and three units of output. In this example, the economy grew by three percent between 2000 and 2001. But why did this happen?

According to the Solow model, the economy did not produce three percent more output in 2001 because we used more land, more labor, or more machines (although these may also have increased). It produced three percent more output because entrepreneurs used better blueprints. And according to the economic theory that is fed into almost all macroeconomic forecasting models, the reason for the improvement in those blueprints has nothing to do with economic policy and it has nothing to do with population growth, with investment spending or with changes in the unemployment rate. It is a black box we call technological progress.

There has, of course, been a great deal of work on theories of endogenous growth. Paul Romer and Robert Lucas have both produced seminal pieces on that topic that led to reams of economic research papers that try to understand Solow’s black box. To a macroeconomist who is interested in secular stagnation, these theories are a big disappointment.

I do not know why growth is low. There are a number of promising candidate theories. My own favorite explanation is that the Fed has lost control of inflation and that firms are not creating new technologies, at a pace that is fast enough to generate high growth, because uncertainty has increased. But I do not have a good economic model that links that idea in a coherent way with economic data. When it comes to economic growth; I have very little to say about why growth is currently slow. I am not unusual in that regard. Beware of economists bearing confident assertions about the best way to increase productivity growth. This is simply an area that we know very little about.

So what do I see in Turner’s painting? If secular stagnation means that unemployment can be permanently high if we don’t do something about it: I see secular stagnation. If secular stagnation means that we will be in trouble when the next recession hits because the Fed will not be able to lower interest rates further: I see secular stagnation. But if secular stagnation means that a massive bout of government investment in roads and infrastructure will cause firms to start producing better blueprints, I say; show me the theory and the evidence that leads you to believe that that is so.

Ignorance is not a reason for embarrassment. When medical doctors do not understand the cause of a disease, they cloak their ignorance with Latin. An illness of unknown origin is ‘idiopathic’. Economists should adopt the same strategy. When growth is slow and we don't know why, the economy is not experiencing secular stagnation. We are afflicted with a bout of idiopathic tardus augmenti.