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They aren’t coming back

Back in 2013 I argued that the low Labor Force Participation Rate was not evidence of lots of labor market slack:

It’s true the payroll gains and falling unemployment rate overlook the low labor force participation. In my view the falling LFPR is not a cyclical issue, even though the variable is itself cyclical.  This is very confusing to most people.  Imagine a LFPR that has a strong downward trend for structural (non cyclical) reasons.  Also assume the actual LFPR falls in a more cyclical pattern, falling steeply during recessions and leveling off during booms.  The level periods look like “nothing happening,” whereas the LFPR is actually growing relative to the declining trend line.  My prediction is that the LFPR will stay low even after we recover from the recession, and we always recover from recessions.  It’s not a cyclical problem.  This will become obvious by 2016.

Last October I explained the point further:

I noticed that the labor force participation ratio fell to 62.7%, the lowest rate since February 1978. Folks, it’s not coming back.  In less than a year the recession will completely end and we will get a normal unemployment rate (about 5%).  Jobs will be available and those people simply aren’t coming back.  They are early boomer retirements (perhaps discouraged by the previous job market), disabled (perhaps partly discouraged by the job market in previous years) and young people staying in school longer, or choosing to work less (as is true in affluent towns like my own Newton, Massachusetts.)  It pains me to say this but it’s pretty clear they aren’t coming back—the job market is good enough where the LFPR rate should not still be falling, if it really were nothing more than discouraged workers sitting there ready to plunge in again when things got a bit better.

Now it’s 2015 and the progressive mainstream media is finally beginning to contemplate the unthinkable.  Here’s the (Keynesian) New Yorker:

Despite the subsequent economic recovery, which has now lasted for more than five years, the rate has continued to fall. Last month, it stood at just 62.7 per cent, a tie for the lowest level since 1978 (a time when more women stayed at home and did domestic labor rather than join the official workforce).  .  .  .

Most policy-makers, including Janet Yellen, the chair of the Federal Reserve, have been assuming that much of the decline is cyclical and that, as the recovery picks up, more and more discouraged workers will return to the labor force.  .  .  .

I agree with that argument: indeed, I’ve used it myself. By now, though, we should be seeing signs of the participation rate rebounding. The fact that it isn’t is somewhat alarming.

But not surprising to readers of TheMoneyIllusion.

No, strong labor markets don’t cause higher wages (never reason from a quantity change)

The first Friday of every month I listen to all the “experts” on CNBC discuss the new jobs numbers. Today they were stunned by the fact that the recent upsurge in job creation has been accompanied by a slowdown in wage growth.  We got a 252,000 figure this month, and another 50,000 from the previous two months.  When all the revisions are finally in we’ll have about 3 million payroll jobs in 2014, well ahead of 2012 and 2103.  Yet wage growth for last month was revised down from 0.4% to 0.2%, and this month came in at negative 0.2%.  The 12-month wage gain is now only 1.7%, down from roughly 2% in recent years.

It was ROFL time for me as one commentator after another expressed puzzlement at why wage growth could be slowing during a time of strong job gains.  And to be fair, I’m just teasing CNBC; their views are quite widespread, as most economists have never heard of a theory called “supply and demand.”  Instead, economists work with a theory called “the supply curve.”  Their (upward sloping) supply curve theory says that as the quantity of workers employed rises, wages go up.  I recommend the alternative “supply and demand theory.”  In my alternative theory when workers lower their wage demands (perhaps because they’ve been unemployed for a long time, or perhaps because extended unemployment insurance ended in 2014, the labor supply curve actually shifts right, and you slide down along the labor demand curve toward higher employment and lower wages.  They have causality backwards.  Jobs are rising fast because wage growth is moderating, just as the sticky wage/natural rate hypothesis predicts.

OK, enough fun and games.  Now that 2014 is in the books, what happened?  The answer is plain as day, but you’ll never even see it mentioned in a Keynesian blog like Conscience of a Liberal.  There was a strong positive supply shock in 2014, which led to faster job growth and falling wage and price inflation.  The price inflation decline may partly reflect lower commodity prices, but the slowdown in wage inflation probably reflects (in part) the end of extended unemployment compensation. (I believe that many states are planning to raise minimum wages next year; it will be interesting to see what the aggregate wage growth numbers look like in 2015.)

Early in 2014 Paul Krugman argued that the fear that extended UI had been inflating unemployment numbers was refuted by the mediocre jobs numbers.  He spoke too soon—we had a tough winter, and at that time Congress was still debating an extension.  Once it was clear the extended benefits were gone for good, and would not be paid retroactively to the long-term unemployed, the jobs figures really took off.  I predict that if Keynesians discuss 2014 at all, it will be through the lens of aggregate demand.  They’ll say demand picked up, whereas it was supply that picked up in 2014.  But Keynesians often assume the SRAS curve is fixed, and that changes in Q (real GDP) are all about demand shifts.  Recall a few years ago when they blamed the slow British RGDP growth on a lack of AD, even as inflation soared above 4%?

Economics professors often bemoan the fact that students don’t really understand S&D, they don’t get the distinction between a shift in demand and a movement along the demand curve.  My question is, “Do the professors understand their model?”

BTW, the unemployment rate is now down to 5.6%.  You might recall that for quite some time I’ve been saying that unemployment will fall faster than most people forecast, as it had been dropping at 0.1% per month for years.  We are still on that pace, and should be at “full employment” or less by the time the Fed raises rates.  Does that mean they should raise rates in mid-year? It depends on what the Fed is trying to do. What is their policy objective? I wish they’d tell us.

(For instance, the “dual mandate” implies they should aim for countercyclical inflation, but I see no evidence that they understand that fact.)

Yield curve bleg (plus LA real estate)

Back from a long vacation—it will take me a while to catch up on what I missed.

I notice that 5-year Treasuries are currently yielding 1.56% and 10-year yields are 2.04%.  I was taught two theories of the yield curve:

1.  Expectations hypothesis—>  Long term yields are an average of expected future short term yields.

2.  Term premium hypothesis—> Long term yields are an average of expected future S-T yields, plus a term premium.

The first hypothesis implies the 5-year, 5-year forward yield is expected to be 2.52%.  The second predicts a somewhat lower expected yield.  Are these two theories still the state of the art, or is it possible that investors expect higher than 2.52% yields in 2020?

If I am correct, then investors are predicting stunningly low 5-year yields in 2020. Why do I say 2.52% is stunningly low?  Very young readers that are used to low rates might find that claim to be odd. But recall that the market cannot predict business cycles 5 years out in the future.  Thus investor forecasts for yields at that date essentially represent estimates of what rates will look like once they have been “normalized.”  (And by the way, I hate it when central bankers use that term; it does more harm than good.  There is no such thing as “normal” in an ever-changing world.)

Theories:

1.  Slightly lower expected inflation.  Although the Fed’s been targeting inflation at about 2% since 1990; during 1990-2008 the market probably thought they’d err a bit on the high side, now they’re expected to err a bit on the low side.

2.  Low real interest rates.  The 5-year TIPS yield is 0.29% and the 10-year is 0.38%, implying a 5-year, 5-year forward real rate of 0.47%.  That seems low to me—the Great Stagnation?

I’m looking for feedback from people who know more finance than I do (like David Beckworth.)

PS.  Speaking of blegs, our family will probably end up in Southern California when we retire (although the way things are going I’ll never really “retire.”)  We explored the entire area and sort of liked North Tustin in Orange County.  But our favorite was Glendale in LA County.  Anyone have any opinions on either place?  Also Woodland Hills/Sherman Oaks.  I’d like a house high enough up to have a view, but can’t afford west LA.  I like LA itself, but am too old for the gritty urban lifestyle of more central locations.  But I want to be close.

And I’ve always wanted a single family home.

PPS.  Did you know that Arcadia is considered the Chinese Beverly Hills?  This suburb is far from the coast, in the hot, flat, smoggy San Gabriel valley.  We ate lunch there.  This ad shows a 2100 sq. foot ranch for $1,680,000.  That’s the power of Chinese money.  In 2005 and 2006 Bush was expected to enact immigration reform that would have led to many more Asian and Hispanic immigrants to southern California.  You all know what happened when that reform failed.  But the Chinese immigrants will come, it’s just a matter of time.  In Arcadia house prices have already soared far above the 2006 “bubble” peaks:

Screen Shot 2015-01-05 at 3.08.06 PMLow rates as far as the eye can see and 1.4 billion Chinese who covet the SoCal lifestyle. Bubbles?  You ain’t seen nuthin yet.

Noah Smith on taxes and labor supply

Here’s Noah Smith on the disincentive effects of taxes:

There are reasons to think that taxes, unless they reach very high levels, don’t have a big effect on how much people work.

First, most jobs, even part-time jobs, require a minimum number of hours per week. Few people are likely to quit working entirely because of taxes.

The required number of hours worked is itself endogenous.  In Europe, required yearly hours are less than in the US, due to higher taxes.  Some claim the differences are cultural, but back in the 1960s when French tax rates were comparable to US tax rates, the French worked just as long hours as Americans.  Culture is endogenous.  In contrast, many of the so-called “tiger economies” in East Asia have lower tax rates than the US, and their citizens work longer hours.

Second, when you tax people, they are poorer, and they need to work more to maintain their standard of living.

This is a common misconception that I see all the time.  There is no first order effect of taxes on national income, as the tax money gets recycled into the economy.  Now it’s true that the government might waste the tax money, leaving a country poorer, but in that case it would be more accurate to say that government waste causes people to work harder.  In modern economies most extra spending at the margin goes back in transfer programs.  Since national income doesn’t fall from the direct impact of taxes, there is only a substitution effect on labor supply, not an income effect.  Of course income falls as people work less, but that is a second order effect.  All tax and transfer studies should use income-compensated labor supply curves.

When you look out at the world, you see lots of circumstantial evidence that taxes don’t have a crushing effect on the labor supply. For example, in a recent blog post at the NYT’s Upshot, Neil Irwin reports that countries with higher taxes and more generous welfare systems also tend to have a higher share of the population in the labor force:

Of course taxes are not the only factor that impacts labor supply, programs like free child care matter as well.  (And here I’ll diverge from Smith’s post, and get some things off my chest.) But it’s interesting to note that when progressives like Paul Krugman are confronted with the fact that the per capita GDPs of countries like France are only 70% of US levels, they insist that productivity is just as high, it’s just that the French work far fewer hours.  Indeed that’s generally true of Western Europe; the biggest reason they have lower incomes is that they work fewer hours.  Then they insist that this extra leisure should be counted in utility calculations, proving the European model actually does pretty well.  But when the topic switches to taxes and labor supply, progressives tend to make exactly the opposite argument; they claim the Europeans work just as long hours as we do.

A similar bait and switch occurs with the term ‘leisure.’  When criticizing the US model they focus on how unemployment is not just “leisure,” as those awful RBC models might imply.  It causes people to become depressed, as unemployed breadwinners lose self-esteem.  Fair enough.  But when the discussion turns to Europe the low labor supply is suddenly seen as evidence that the less materialistic Europeans wisely avoid the American rat race, even though a substantial part of the difference is due to much higher structural rates of unemployment in Europe.

Back to Noah Smith:

Also, if you look at the U. S.’s past, you see that although taxes have come down over time, people are not working more than they used to.

You don’t want to use time series data, as there is a long-term downward trend in hours worked due to increasing affluence.  If you look cross sectionally, hours worked in America relative to Europe have risen since the 1960s.  And it’s not clear that taxes have actually come down. Compared to the 1950s and 1960s the rich face a lower MTR, but very few rich people ever faced those 90% brackets. Lower income people face a much higher implicit MTR than in the 1950s and 1960s.

So why do economists such as Mankiw spend so much time warning about the dangers of moderate tax increases on the well-off? It might be because they are morally opposed.

I have no moral objection to very high tax rates, unless they reduce aggregate utility.

PS.  Of course there is one European country that has per capita GDP levels (PPP) that are comparable to the US, despite lacking oil—Switzerland.  Oh wait, that’s the European country with low taxes.

HT:  Saturos

What went wrong in Brazil?

Back in 2012, Paul Krugman did a post praising the “New Economic Policy” in Latin America, which focused on reducing inequality.  A few weeks later he singled out Argentina and Brazil for special praise:

Just to be clear, I think Brazil is going pretty well, and has had good leadership. But why exactly is Brazil an impressive “BRIC” while Argentina is always disparaged? Actually, we know why — but it doesn’t speak well for the state of economics reporting.

And it’s true that these countries had shown some impressive growth.  But that was more than 2 and 1/2 years ago.  How do things look today?  Obviously things are going downhill rapidly in Argentina, but what about Brazil?  Here’s The Economist:

IN 2005 a debate raged between the two most powerful figures in President Luiz Inácio Lula da Silva’s government. Antonio Palocci, the finance minister, proposed taking advantage of faster economic growth to eliminate Brazil’s persistent fiscal deficit—and thus lower its exorbitant interest rates—by capping the increase in federal spending. But Dilma Rousseff, Lula’s chief of staff, thought Mr Palocci’s plan “rudimentary” and blocked it. Ms Rousseff became Lula’s successor as Brazil’s president in 2011, implementing a “new economic model” that placed full employment and wage increases ahead of macroeconomic rigour.

Fiscal laxity has come back to haunt Ms Rousseff, who won a second term last month by the narrowest of margins. As we went to press she was due to announce that Joaquim Levy, one of Mr Palocci’s deputies in 2005, will become her new finance minister. Nelson Barbosa, the most capable economist in the ruling Workers’ Party (PT), will get the planning ministry. Mr Levy is a Chicago-trained economist who has been running a big asset manager; his presumptive appointment has been welcomed by investors. It seems that Ms Rousseff has at last tacitly accepted the error of her economic ways.

Big spending policies to promote jobs, and wage increases to reduce inequality—no wonder Krugman was impressed. Unfortunately Brazil is now paying the price, with only about 1%/year RGDP growth over the past three years.  Fortunately, after Keynesian economics makes a mess of things there’s always a few “Chicago Boys” available to clean up the mess.  I have another post at Econlog, discussing how Krugman’s preferred tax policy failed in France, and how a somewhat more moderate economic minister was brought in to clean up the mess.  Not a good two years for Keynesian/Piketty economics, maybe 2015 will be better.

Speaking of the supply-side, I endorse Miles Kimball’s post where he argues that Doug Elmendorf should be reappointed at the CBO. The GOP would be making a mistake if they force him out.

I won’t do much blogging over the holidays.  Merry Christmas to my Christian readers, and Happy New Year to everyone!

(Look for some big announcements in January.)

Update:  Here is an RSS feed for my Econlog posts:

http://econlog.econlib.org/indexsumner.xml