Its the wiggles not the trend

Chart 1: Number of unemployed people and number of people in the labor force. Both series normalized to December 2007=100.

A commentator on my blog asks if the reason that unemployment appears to be more important than labor force participation as a cause of recessions is that the scales are different on Chart 2 from my previous blog post. I don't think that's it.

Chart 1 (left) shows the data in a different way. The red series is the civilian labor force. The blue line is the number of unemployed people. Both series were originally measured in thousands of people. The data on the graph have been normalized by constructing index numbers.  In each case I normalized the series in December 2007 (the start of the Great Recession) to 100.

Both series have un upward trend. That's because of population growth: there are more people in the labor force each year and there are more unemployed people each year. My point has nothing to do with the trends. Its about the wiggles. 

Look at it another way. If I gave you the red series and asked you to predict the number of people in the US labor force in 2015, using data through 1990, you'd probably do a pretty good job using lagged values of the labor force, lagged values the US population, and a quadratic time trend. If I also told you there was going to be a major recession lasting from December of 2007 through June of 2009, it wouldn't have helped you much, if at all, in your prediction. Recessions are all about the wiggles. Participation is all about the trend.

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.