The 1.6 Percent GDP + 9.5 Percent Unemployment = Second Stimulus

On Friday, the Commerce Department revised its estimate for 2Q10 US gross domestic product (GDP). Unfortunately, the revision was a downward revision. According to the Commerce Department, the US economy grew at a 1.6 percent pace in the second quarter, less than the original 2.4 percent estimate. The number represents a sharp decline in the speed of economic recovery compared to the first quarter, when GDP grew at a more robust 3.7 percent clip. There's little question that the 1.6 percent figure is tepid, worrisome and certainly not sufficient reignite job growth.

If there is a bright spot in the Commerce Department report, it is that consumer spending, which represents the core of the economy accounting for nearly two-thirds of all economic activity, has risen at least modestly for four straight quarters. Still the pace of growth remains slower than normal in an economic recovery.

The US labor market remains abysmally soft. The unemployment rate in the United States was 9.5 percent and the broader U6 rate stood at 16.5 percent in July. The BLS August 2010 report will be released this Friday. I suspect the report will disappoint with the unemployment rate creeping up to 9.6 percent. My contention that our unemployment problem isn't just cyclical but structural got a boost from David Altig, research director at the Atlanta Fed. Writing in Macroblog, Altig takes us through the Beveridge Curve.

"The disconnect between the supply of and demand for workers that is reflected in statistics such as the unemployment rate, the hiring rate, and the layoff rate can be dynamically expressed by the Beveridge curve. Named after British economist William Beveridge, the curve is a graphical representation of the relationship between unemployment (from the BLS's household survey) and job vacancies, reflected here through the JOLTS (Job Openings and Labor Turnover Survey)."

The most tempting explanation for the seeming shift in the Beveridge curve relationship according to Altig is "is a problem with the mismatch between skills required in the jobs that are available and skills possessed by the pool of workers available to take those jobs." Another who thinks our unemployment problem has a structural component is Brad DeLong of the University of California at Berkeley who's been swayed by Altig's analysis. DeLong writes:

Given the large recent increase in vacancies in the past two quarters, the U.S. unemployment rate ought to have started to fall. It did not. That means that the chances are now very high that our cyclical unemployment is starting to turn into structural unemployment, as businesses that seek to hire and have the cash flow to hire still find that the currently-unemployed applying for jobs don't fit inside their comfort zones.

Taken together our tepid 1.9 percent 'recovery' plus our still torrid 9.5 percent unemployment rate call for decisive action. Perhaps it is a measure of the Administration's thinking but this weekend, Laura Tyson, a member of President Obama’s Economic Recovery Advisory Board, has an op-ed in the New York Times making the case for a second round of a fiscal stimulus.

The primary cause of the labor market crisis is a collapse in private demand — the same problem that bedeviled the economy in the 1930s. In the wake of the financial shocks at the end of 2008, spending by American households and businesses plummeted, and companies responded by curbing production and shedding workers. By late 2009, in response to unprecedented fiscal and monetary stimulus, household and business spending began to recover. But by the second quarter of this year, economic growth had slowed to 1.6 percent, according to a government estimate issued Friday. Clearly, the pace of recovery is far slower than what is needed to restore the millions of jobs that have been lost.

Households and businesses are on a saving spree to rebuild their balance sheets. Their spending relative to income has fallen more than at any time since the end of World War II. So there is now a substantial gap between the supply of goods and services the economy is capable of producing and the demand for them. This gap is starkly reflected by the 23 million Americans who are looking for full-time jobs and the millions more who have left the labor force because they could not find one.

The situation would be even worse without the $787 billion fiscal stimulus package passed in 2009. The conventional wisdom about the stimulus package is wrong: it has not failed. It is working as intended. Its spending increases and tax cuts have boosted demand and added about three million more jobs than the economy otherwise would have. Without it, the unemployment rate would be about 11.5 percent. Because about 36 percent of the money remains to be spent, more jobs will be created — about 500,000 by the end of the year.

But by next year, the stimulus will end, and the flip from fiscal support to fiscal contraction could shave one to two percentage points off the growth rate at a time when the unemployment rate is still well above 9 percent. Under these circumstances, the economic case for additional government spending and tax relief is compelling. Sadly, polls indicate that the political case is not.

The President needs to make the economic case directly to the American people and the politics be damned. Enough of this sitting in the White House and trying to be above the political fray. It's time to get down and dirty and rough up the GOP.

Mark Zandi on Unemployment

Mark Zandi, chief economist of Moody's Analytics and co-founder of Economy.com, sits down for a conversation with attendees of the Monitor Breakfast about the state of the economy, including the recent plunge in U.S. housing sales and rise in unemployment. While he is optimistic about the economy's long-term chances to rebound, the national unemployment rate will likely continue to rise through the November 2010 elections. "If it's 10 percent come Election Day, I'm not sure I'd be surprised," says Zandi. "It's going to be in that kind of ballpark."

Beyond the Efficient Market Hypothesis

I've got to run because I'm volunteering on two political campaigns. The thought of Barbara Boxer losing her Senate seat drives me to despair and I'm also volunteering for a local candidate for the Board of Supervisors.

A quick post on the efficient market hypothesis or EMH. “The Efficient Market Hypothesis is not only dead,” noted the financial blog Minyanville on July 29, 2010. “It’s really, most sincerely dead.” Perhaps, first, a quick definition is in order. From Investopedia:

The Efficient Market Hypothesis (EMH) is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

The EMH is at cornerstone of our economic model because it lies at the Greenspanian (and conservative) notion that financial markets can be self-regulated, even though financial markets operate very distinctly from normal supply and demand economic principles. As The Economist has noted that “Financial markets do not operate the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the prices of a financial asset rises, demand generally rises.”

Financial markets are too often guided by a herd mentality that leads to financial asset bubbles. This was true in the Tulip Mania of the early 17th century in Holland and it was true in the more recent Dot Com Stock Market Crash and US housing bubbles. Irrational exuberance trumps information. The EMH is built on the assumptions of investor rationality. 

John Maynard Keynes, however, argued that the stock market should be seen as a "casino" guided by an "animal spirit". Keynes held that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.

Today, Joseph Stiglitz in the Financial Times writes on the need for a new economic paradigm of moving beyond the efficient market hypothesis.

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply – and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used “representative agent models” – all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favoured assumptions, full rationality.

Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles. After all, their models said that financial markets were always efficient. Remarkably, standard macroeconomic models did not even incorporate adequate analyses of banks. No wonder former Federal Reserve chairman Alan Greenspan, in his famous mea culpa, could express his surprise that banks did not do a better job at risk management. The real surprise was his surprise: even a cursory look at the perverse incentives confronting banks and their managers would have predicted short-sighted behaviour with excessive risk-taking.

Stiglitz also points to the work at the George Soros funded Institute for New Economic Thinking (INET) that was founded in October 2009. Its mission is to create an environment nourished by open discourse and critical thinking where the next generation of scholars has the support to go beyond our prevailing economic paradigms and advance the culture of change. Two of my favorite economists are associated with the Institute: Simon Johnson of MIT and Richard Koo of Nomura Securities whose book on Japan's lost decade The Balance Sheet Recession has been my guide for looking at our economic situation.

Here's a short video on the INET:

There's more...

The D-Word

For some time now, the US economy has had all the ingredients—soft, anemic labour markets and wage growth, slack consumer demand, a real estate sector that has to revive after a three year downturn—for a deflationary cycle. Deflation was last seen in the US in the 1930s and in Japan in the 1990s, when the inflation rate fell to zero and then turned negative for several years. But now the Federal Reserve is increasingly concerned that we may be on the cusp of a deflationary asset spiral.

From the New York Times:

On Thursday, James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed’s current policies were putting the American economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”

The warning by Mr. Bullard, who is a voting member of the Fed committee that determines interest rates, comes days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed, though it had no immediate plans to do so.

Mr. Bullard had been viewed as a centrist and associated with the camp that sees inflation, the Fed’s traditional enemy, as a greater threat than deflation.

But with inflation now very low, about half of the Fed’s unofficial target of 2 percent, and with the European debt crisis having roiled the markets, even self-described inflation hawks like Mr. Bullard have gotten worried that growth has slowed so much that the economy is at risk of a dangerous cycle of falling prices and wages.

Among those seen as already sympathetic to the view that the damage from long-term unemployment and the threat of deflation are among the greatest challenges facing the economy, are three other Fed bank presidents: Eric S. Rosengren of Boston, Janet L. Yellen of San Francisco and William C. Dudley of New York.

Deflation is a particularly vexing economic problem because as prices fall, people who already owe money have to pay back loans in dollars that will buy more goods than the dollars they borrowed. Assets are worth less than the amount owed. For new loans, it raises the real, or inflation-adjusted, cost of credit, the opposite of what monetary policy needs to do to combat falling demand. Plus, in the effort to boost spending, policymakers cannot cut the target rate below zero. At that point, negative inflation can keep the real rate high enough to restrict economic growth.

Here's a recent note from the Federal Reserve Bank of San Francisco on the Risks of Deflation.

A Dark Beige Report

Commonly known as the Beige Book, this report produced by the nation's central bank  covers economic conditions in all 12 Districts that are part of the Federal Reserve system. It is published eight times per year. The latest report, published on Wednesday, describes the economy as struggling under the weight of a depressed real estate market, continued high unemployment with consumers largely wary and lacking confidence with many consumers still reluctant to spend because of worries about the job market.

Two of the Federal Reserve 12 districts — Atlanta and Chicago — reported that "the pace of economic activity had slowed recently," while the Cleveland and Kansas City districts said that "activity generally held steady."

The other eight districts — including San Francisco, which covers California and other Western states — reported "improvements in economic activity" from the spring, the Fed said. But it added that "a number of them noted that the increases were modest."

More from the New York Times:

The manufacturing sector especially appears to be losing steam. The Federal Reserve regional report, said manufacturing activity in most of the 12 districts experienced some growth since the last report in early June.

But the pace of activity “slowed” or “leveled off” in half of them, including Cleveland and Chicago. In both cities, automobile manufacturing grew, while steel manufacturing declined.

Business contacts in Atlanta and Chicago said economic activity slowed in June and July, with significant worries in Atlanta related to the Gulf Coast oil spill.

Analysts say the book offers a qualitative, rather than quantitative, general overview of various sectors and regions across the country.

The report said the retailing and transportation service sectors showed signs of solid growth. Several districts reported that apparel, food and other necessities were strong sellers. However, consumer spending on big-ticket items was weak, reflected in the decline in auto sales in New York, Philadelphia, Cleveland, Richmond, Chicago and San Francisco. The report also said consumers remained price conscious as they continued to reduce their debts.

Almost all districts reported that they had “sluggish” housing markets as a result of the April expiration of the government’s homebuyer credit. Commercial and residential construction activity was weak in almost all districts. Cleveland, in particular, said it did not expect an improvement in new home construction this year.

The Beige Book report also noted that labor market conditions “improved gradually” in New York, Chicago, Minneapolis, Richmond, and Atlanta, but that San Francisco reported high levels of unemployment. California remains the state with the third-highest unemployment rate in June at 12.3 percent seasonally adjusted. Nevada had the highest rate, with 14.2 percent, followed by Michigan at 13.2 percent. Not surprisingly, wage pressures remained largely contained across most Districts.

Retail sales, the largest component of the US economy, were higher than year-earlier sales in the New York, Philadelphia, Minneapolis, and Kansas City Districts,  while Dallas reported solid gains. But sales in the Boston District were mixed compared with the previous year. Recent sales increased slightly in the Cleveland, Atlanta, Chicago, and San Francisco Districts; sales in the Richmond District weakened; and sales in the Kansas City District were flat compared with the previous report. Several Districts cited apparel, food, and other necessities as recent strong sellers, while big-ticket items were weak sellers.

The report is likely to give credence to those have been arguing that US economy faces continued weakness and that efforts to rein in the deficit may further undercut the economic recovery which remains tepid and jobless.

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