Comments & Context

Mismatching the facts

In a speech delivered on August 17, Minneapolis Fed president Narayana Kocherlakota claimed that there’s been a major breakdown between the relationship between the unemployment rate and the number of job vacancies reported in the BLS’s Job Openings and Labor Turnover Survey (JOLTS). According to Kocherlakota, the breakdown began in mid-2008 as the unemployment rate rose more rapidly than the JOLTS openings data suggest—a breakdown that intensified in mid-2009, as the unemployment rate continued to rise and then failed to decline significantly as the number of openings rose by nearly 20%. Kocherlakota explains this by asserting that there’s a mismatch between the skills, geography, and demography of available workers and unfilled openings. And that’s not anything that monetary policy can change: “the Fed does not have a means to transform construction workers into manufacturing workers.”

There are many things wrong with Kocherlakota’s argument. While he’s right that a regression that forecasts unemployment based on the JOLTS openings rate says that the jobless rate should have been 7.7% in June, not 9.5%, the number of unemployed fell by over a quarter-million more than the number of openings rose during the first half of 2010.

Despite that, there are still almost 5 unemployed for every opening—down from over 6 at the end of 2009, but still enormously high. Also, as the graphs below show, the major problem with the labor market is that the recession was harsh and the recovery so far has been weak. The gap between GDP growth and employment growth, though wider than it was in the recessions of the early 1990s and early 2000s, isn’t out of line with earlier downturns, like those of the early 1980s, mid-1970s, and the 1950s. Since the JOLTS data that Kocherlakota bases his mismatch thesis on only begins in December 2000, he’s missing a lot of important history.


And, the share of permanent job losers, as opposed to those on temporary layoff, hit a record high in over 40 years of data at the end of 2009, and has come down only slightly since. By contrast, the share on temporary layoff is at a record low. Clearly, that composition makes re-employment a lot harder.

In a paper prepared for a Brookings Institution panel in March, Michael Elsby, Bart Hobijn, and Aysegul Sahin review the grim pathologies of the labor market in the Great Recession. In almost every aspect, the downturn was the worst since the 1930s. Among their specific points:

  • While inflows into unemployment in the early part of the recession were dominated by the weaker demographics—the young, the less educated, the nonwhite—the rate of exit has been broadly similar for all subgroups.
  • Since the workforce is now older than it was in earlier recessions, the rise in the unemployment rate is actually sharper than it appears, since older workers are less likely to be disemployed than younger ones. Adjusting historical unemployment figures for the labor force’s changing age composition shows that this recession’s unemployment rate is a record by a significant margin.
  • Specifically addressing the mismatch argument, Elsby et al. find that instead of finding a divergence in outflows from unemployment between industries in structural decline and those not in decline, the rates of sectoral outflow have converged. (Outflow rates in the financial, durable goods and information sectors were all lagging the total when Elsby et al. published.) As with demographics, then, the problem is largely an aggregate one.
  • The dominance of long-term unemployment among the jobless in this cycle is disturbing, since the longer people are unemployed, the less likely they are to find new employment. Based on historical relations, Elsby & Co. project that the decline in unemployment could be half as rapid as it was in the mid-1980s. (Of course, if GDP growth remains weak, then that recovery would be even slower.)
  • Another factor likely to contribute to a slow decline in the unemployment rate: the high share of the employed working part-time for economic reasons. In July, they were 6.0% of the total employed, well over two standard deviations above the series’ 55-year average, and not far below last December’s record of 6.6%. And it’s likely that they’ll find full-time work before the currently unemployed do.
  • Some analysts have pointed to the extension of unemployment benefits over the last couple of years as keeping the jobless rate higher than it would otherwise be. Based on other studies, Elsby et al. estimate that emergency benefits have contributed between 0.7 and 1.8 points of the 5.5 point rise in unemployment in the recession, with the lower end far more likely than the upper. (One reason: the statistical estimates are largely based on periods when temporary layoffs rather than permanent losses were more common.)
  • Finally, the JOLTS data show that the quit rate was remarkably low during the recent recession. It’s picked up a bit since but remains lower than at any time before late 2008. This suggests that employed workers, who presumably have the qualifications that employers desire, remain remarkably skeptical about the possibility of finding fresh work. If it were easier than it looks for the qualified to find a job—as the mismatch theory suggests—then the quit rate would be higher.
by Philippa Dunne· · 0 comments · Comments & Context

Where we are?

Here’s an updated guide to “where we are”—how the U.S. economy is faring relative to the average of previous financial crises around the world. Though individual details vary, we’re following the script pretty well.

In the graphs of four major indicators that below, the lines marked “average” are the averages of fifteen financial crises in thirteen rich countries since the early 1970s, as identified by the IMF. GDP isn’t shown because the experiences were so varied that the averages were meaningless. But for the indicators shown, the averages do illustrate some tendencies worth taking seriously.


Though the U.S. peaked later and bottomed earlier than the average, and also rose higher and fell harder, the trajectories of the two lines are still remarkably similar. Note that after hitting bottom, employment in the average experience grew very slowly. If we’re in for anything like that average, then we’re likely to see employment growth of only about 35,000 a month over the next year—less than a third what’s necessary just to accommodate population growth. That suggests that we could see an unemployment north of 10% in about a year.

Given the gyrations in energy prices over the last couple of years, reading the headline CPI has been very difficult. But the gyration does seem to be around the average line. And core CPI—for which we don’t have international data—is tracking the average pretty tightly. If inflation follows the script, it should continue to decline into next year. With core inflation at around 1%, it’s reasonable to expect that we could go into mild deflation sometime over the next few quarters.

Interest Rates
Rates on 10-year Treasury bonds have fallen harder in the U.S. than in other crisis-afflicted countries, but the trend is typically down for almost four years after the onset of crisis. Further declines in U.S. rates seem like a stretch, but the likelihood of an upward spike looks remote.

Stocks fell much harder in the U.S. than they did in the wake of the average financial crisis, though they did enjoy five quarters of nice recovery. As with interest rates, further declines seem unlikely; in fact, the average increase from here would be around 7% over the next year.

So, all in all, we’re getting pretty much what we might expect out of our major economic and financial variables: a weak, choppy recovery with a deflationary undertow. 

by Philippa Dunne· · 0 comments · Comments & Context

Impulse Control

Decomposing the deficit: structural, cyclical, and the fiscal impulse

Against a still struggling recovery, and continuing weakness in state revenues, talk in Washington is turning to cutting back. That may sound strange, but hear us out.

With the Obama administration released its proposed 2011 budget last month, a lot of attention has rightly been paid to the ginormous deficit—its possible corrosive economic effects and the possible difficulties in funding it. But what’s lost in those worries is what’s going to happen as the stimulus program expires.

Specifically, after the most fiscally stimulative budgets in modern history, barring major changes, policy is about to turn much tighter. 

Structure of the Deficit

The federal deficit can be thought of as having two major components, structural and cyclical. The structural deficit is what the balance would be were the economy at full employment; the cyclical component is the contribution that comes from departures from full employment, i.e., the state of the business cycle.

The graph below shows changes in the structure of the deficit from 2007 through 2018. Sometimes the cyclical component is positive, lessening the deficit (as was the case in 2007); sometimes it’s negative, as it is most other years:


(These estimates come from the Office of Management and Budget, as part of the President’s budget for 2011. Despite that authorship, the estimates look cautious to us. They define full employment as an unemployment rate of 5.5%, and we don’t see the economy returning to that level until 2017. And even if they’re optimistic on magnitudes and the longer-term trend, they’re probably not wrong about the direction of things over the next couple of years.)

The best way to isolate the policy effects of changes in government spending is to look at the cyclically adjusted balance. If the deficit passively swells because of recession, that’s just the so-called automatic stabilizers switching on. But if policy adds to it, through spending increases or tax cuts, then it becomes actively stimulative. 

The table below shows OMB’s estimate of the total budget deficit through 2018, and we are concentrating on the next few years.  In fiscal 2010, the total budget deficit is 10.5% of GDP, 3.2% of it the result of the recession and 7.3% of it structural, or from policy. That’s up from a deficit of 9.9% of GDP in 2009, 2.4% of it cyclical and 7.6% of it from policy. In other words, while the 2010 deficit is larger than 2009’s, the main reason for that is cyclical, not structural, since there’s less stimulus and bailout spending coming this year than last. Going forward, the structural deficit is projected to continue shrinking—to 5.1% of GDP in 2012, and 3.0% the following year. 


The Fiscal Impulse

Changes in the structural budget balance are sometimes called the fiscal impulse, shown in the right column. The decline in the structural deficit from 7.3% of GDP in 2010 to 5.1% in 2011 results in a contractionary fiscal impulse of 2.2% of GDP. Both the OMB and the CBO try to separate the cyclical and policy contributions to the deficit. The CBO’s number start in 1962 and end in 2011, and the OMB’s run from 2007 to 2017. If we splice the OMB and CBO series together, which is only slightly reckless since they’re pretty similar when they overlap, this is one of the starkest episodes of fiscal tightening in the last five decades, exceeded only by the 3.1% shift in 1969. A recession began in December 1969 and continued through November 1970. The second-biggest tightening was in 1987, the year of the stock market crash, which was followed a little later by a long period of sluggishness. 


Of course, the fiscal impulse can be stimulative. By the CBO’s measure, the 2009 impulse was expansive to the tune of 5.9% of GDP; by the OMB’s, it was 4.5%. These numbers are three or four times earlier maximums, like those of 1983 or 2002. And it’s not unreasonable to conclude that what economic recovery we’ve seen since mid-2009 is the result of this massive stimulus. This is apparent not only at the abstract macro level of budget numbers—it’s visible in specific cases, like the effect of cash-for-clunkers on car sales (which ebbed when the program expired) and the effect of federal support on the housing market (there would simply be no mortgage market without Washington’s support). So what is going to happen as the Fed’s purchase of mortgage securities ends in March? As the stimulus spending declines to a trickle

According to a simple regression, the fiscal impulse has an almost one-for-one influence on GDP growth. (See graph below.) So next year’s drag of 2.3% of GDP implies a brake on growth almost that large. Of course, fiscal policy, while important, is far from the only influence on growth; the regression’s r2 is .10, suggesting that it explains about 10% of the yearly variation in GDP growth (though from eyeballing the graph, we see that the extreme cases seem to matter most). That’s not beanbag, but it still leaves a lot to be explained.


A stronger influence on growth is the change in nonfederal credit; as shown in the graph below, it explains about 18% of the yearly variation in GDP growth. Together, the two explain close to 30% of the yearly variation in GDP growth. Putting the two together suggests that we’d need a very strong growth rate of 7-10% in nonfederal credit this year and next to offset the fiscal drag. We’ve only come close to that in two years out of the last 50. So we’re back to a dilemma we’ve identified many times: it looks like GDP growth needs a major revival of private credit expansion—but is that possible or even desirable?


Given that 70% of GDP growth remains unexplained by these two variables, we don’t mean them as literal projections. But it does offer support for fears that since the recovery was driven by fiscal stimulus, once that’s gone, we could be in trouble again.

by Philippa Dunne· · 1 comment · Comments & Context

Financial Crises: A Close-up

In our issue of May 7, we wrote about the IMF’s  study of 122 recessions in 21 “advanced” countries since 1960. They found that downturns associated with financial crises are far longer and deeper, and recoveries slower and weaker, than those that aren’t financially driven. Here’s a close-up of the behavior of interest rates, stock prices, inflation, and employment in the four years after the onset of the crisis in 15 major financially driven recessions identified by the IMF. (See notes below)

In a nutshell, we found that on average, interest rates and inflation generally decline for the full four years; stock prices rise steadily, though not explosively, after a two-quarter decline; and employment falls for about three years before beginning a weak recovery.

GDP experiences are quite varied, with some countries experiencing sharp, sustained declines; others, brief, sharp declines followed by a strong recovery; and still others, extended periods of stagnation. Those disparate experiences produced a very misleading “average” line, so we are not providing a GDP graph. But despite those contrasting GDP patterns, almost all countries suffered from a very weak job market for several years after the financial system hit a wall.

GDP Employment
Australia -1.7% -3.8%
Denmark -8.7
Finland -20.5 -19.2
France -1.0 -1.5
Germany -2.8 -3.1
Greece -1.6
Italy -2.2 -8.2
Japan 1 -3.9 -0.4
Japan 2 -3.4 -2.3
New Zealand -7.6 -6.9
Norway -7.9 -6.6
Spain -0.4 -9.0
Sweden -18.5 -13.1
UK 1 -3.4 -1.2
UK 2 -2.5 -6.2
average -5.8 -6.3
median -3.4 -6.2
Total decline in real GDP and total employment in recessions in the IMF sample, from pre-crisis maximum to cycle low

Comparing recent U.S. experience to the average yields the following conclusions. Interest rates, inflation, and stock prices are all down much harder than the “typical” experience. This suggests that interest rates are probably not at risk of rising sharply, but we’re almost certainly past their bottom; stock prices, even with the recent rally, are not acting with outlandish exuberance; and inflation isn’t much of a risk for some time to come. Employment, however, is tracking the average very closely, suggesting that while the worst of the job losses are probably behind us, we’ve got another year and a couple of million to go.

Interest rates: down
Although financial crises typically come with a huge fiscal cost, as revenues sag and bailout expenditures rise, interest rates on long government bonds tend to decline steadily throughout the four year period we studied. Rates fell in 12 of the 15 examples over the first 8 quarters following the crisis, and 13 of 15 over 16 quarters.

Stocks: mostly up
Stock prices do surprisingly well in financial crises, after an initial spill. Actually, prices tend to decline over the year leading up to the crisis (about 4–5% on average); the post-crisis leg down is sharper but shorter than what preceded it (about 12%). But after that decline, stock prices tend to rise, though at far from a barn-burning pace—only around 5% a year.

Inflation: down
Though a lot of market participants expect that the financial bailout will ultimately prove inflationary, the history of financial crises suggests otherwise.

Employment: down hard
Deep, sustained declines in employment are almost universal following financial crises. If these averages hold, we’re about two-thirds of the way through the contraction in numbers, and not quite that far in time.


In the four graphs, the line labeled “average” is the mean of the 15 financially driven recessions identified by the IMF, with the quarter of the crisis’ onset set to 100. The line labeled “U.S.” is the recent experience of the United States, with the onset of crisis set to the third quarter of 2007. Horizontal axis represents quarters before and after crisis onset (“C”).

These are the crises the IMF reviewed:

Australia 1990Q2–1991Q2
Denmark 1987Q1–1988Q2
Finland 1990Q2–1993Q2
France 1992Q2–1993Q3
Germany 1980Q2–1980Q4
Greece 1992Q2–1993Q1
Italy 1992Q2–1993Q3
Japan 1993Q2–1993Q4
Japan 1997Q2–1999Q1
New Zealand 1986Q4–1987Q4
Norway 1988Q2–1988Q4
Spain 1978Q3–1979Q1
Sweden 1990Q2–1993Q1
United Kingdom 1973Q3–1974Q1
United Kingdom 1990Q3–1991Q3

The Fed Evokes Shakespeare

There's no shortage of reasons to worry about the health of the U.S. dollar: a still-huge trade deficit, a huge and swelling budget deficit, pervasive credit troubles, a serious recession that may linger, the threat of capital flight, etc. etc. Should we be worried about a currency crash?

That question is ambiguously phrased. It's quite possible the dollar could crash. But how bad would it be if it did? A surprising answer comes from a recent study by Federal Reserve economist Joseph E. Gagnon. The title lays out a broad hint: Currency Crashes in Industrial Countries: Much Ado About Nothing?. Gagnon's answer is basically, yeah.

Gagnon looks at 19 episodes of sharp currency depreciations-15% or more over four quarters-in 20 industrial countries since 1970. Factors that caused the crashes include inflationary policies, large current account deficits, capital outflows, and rising unemployment rates. Sometimes one factor was enough to cause the slide, sometimes it took several. But his surprising finding is that crashes were followed by poor outcomes-slow GDP growth, rising bond yields, and falling equity prices-only when inflationary policies prevailed. But the currency crash seemed not to contribute to poor outcomes-if anything, they mitigated them. The inflation did the damage, not the currency troubles.

The greatest danger from a currency crash came when the central bank was pegging a specific currency value despite inflationary policies. If the exchange rate is flexible or floating, there's considerably less trouble.

It's important to note that an inflation must be underway, and not merely expected, for a currency crash to be truly damaging. The threshold level of inflationary risk is a rate that's more than two standard deviations above the 20-country average, which works out to 7.2 percentage points.

Gagnon also finds that devaluations can successfully stimulate GDP growth and improve the foreign balance with little effect on inflation. He concludes: "Non-inflationary currency crashes uniformly had good outcomes: GDP growth was average to above average, bond yields fell, and real equity prices rose."

We're not conspiracy theorists, sad to say, but a word on what this paper might mean, aside from its interesting conclusions. There must be talk within the Fed about what would happen should the dollar fall hard-and maybe even if such a devaluation might be a good move for the U.S. Though no central banker or finance minister would ever let on that he or she is thinking this way, you can imagine the temptation. And from all this we'd conclude: avoid betting the farm on dollar strength. But if you lead a dollar-denominated life, you have little to fear from a devaluation. Things might look a little different in Beijing, but that's another story.