Wednesday, July 30, 2014

Regulatory Predestination and the Right to Exit

Tyler Cowen linked to a couple stories yesterday that touched on a similar theme, I think.

School Choice

First, was this NY Times Upshot story about school principals' estimation of school poverty.  According to the study, principals in the U.S. greatly overestimate levels of poverty among their students.

If I understand the variable on the x-axis properly, this is the percentage of principals who believe that more than 30% of their students come from disadvantaged homes.  If the problem in the US was related to socioeconomic segregation, then this number would be low, since most principals would have only a few disadvantaged students and a few principals would have many disadvantaged students.  If these principals have a reasonable perception, then this would imply that there is massive poverty in the US that is evenly distributed among schools.  As the article points out, widely distributed poverty among a 30%+ portion of the population doesn't seem objectively reasonable.

There are a number of subtle and complicated issues here that I won't begin to understand.  But, this fits with a set of cultural peculiarities that seem to be in place right now in the US.  First is the apparent socioeconomic factor in school performance.  US students who are poor seem to do especially poorly in school.  And, many educators and public education advocates appear to put a lot of weight on this idea - both in terms of advocating that public schools in poor neighborhoods need more public support and in terms of assigning responsibility of poorly performing schools and students to their poverty instead of to the educational institutions and their faculty and staff.

In short, we have school districts that are compulsory institutions, school leaders who attribute student failures to poverty, and school leaders who overstate the level of poverty in their schools.  Is there a bit of constructed fatalism here?  It seems to me that if we arranged a stronger right of exit and choice in primary education, we wouldn't even need to answer that question.  Dismayingly, one reason that public school advocates give for opposing the right to exit is that many poor children will be failed by a system that requires their parents to shop for the best school.  No doubt, there will be many failures of this kind, and it would be a tragedy that requires some sort of safety net for the children who fall through the cracks.  But, especially in light of evidence such as that from the Upshot article, the layers of fatalism in defense of coercion are a potential red flag.  If the attitude of many families to their local schools and the attitude of the schools to those families are both fatalistic - and clearly they are, in both directions - then how does this become anything but a vicious cycle?  Is there really more than one reasonable answer to inner city families in places like DC and LA who take to the streets demanding choice?

Dodd-Frank

The other piece was an excellent piece by Robert J. Samuelson in the Washington Post about Dodd-Frank.  He discusses the fact that Dodd-Frank might undermine the Federal Reserve's role as lender of last resort.  In a system with banking capital and reserve regulations and a public monopoly on currency creation, this might be the Fed's most important tool for crisis prevention.  Yet, this role has been categorized as a "bailout" in the accepted narrative of the recent crisis where private banks and financiers recklessly drove us over a financial cliff, only to be rewarded with "bailouts".

This is a right-of-exit issue again.  Because, what if that narrative is wrong?  What if the crisis was a product of a mishandling of currency production by the Fed, and playing the lender of last resort was one of the important tools the Fed used to save us from their errors?

As with the school issue above, this is an empirical question, but because of the complex nature of the subject, the interpreted facts become a product of the narrative itself, and so the narrative exists above and before the empirics.  The narrative is predicated on an assumption that markets consisting of thousands or millions of professionals devoting their professional lives to safely interpreting a complex ecosystem of human interaction are so uniformly driven mad by greed that they predictably join in consensus behavior that self-destructs.  Only a committee of high priests, chosen by the President and approved by the Senate, can stand above the fray and save us from these savage lemmings.

In a sane world, the transcripts of the FOMC meeting from September 2008 would have discredited this point of view. (Talk about too big to fail.).  The Fed was forced over and over again to substitute emergency liquidity for the sane, conventional liquidity that they refused to supply, and almost everyone seems to agree that the emergency liquidity is the one thing we definitely want to avoid repeating the next time this happens.

Then there are people like Ron Paul, who appear to be radicals, and who call for the abolition of the Fed.  But they are in complete agreement on this matter.  They also think it was the liquidity that was the problem.  Paul is supposedly the free market extremist, but he also thinks his view of the marketplace should be trusted over the millions of professionals who actually spend their working time trying to allocate capital.  He thinks they are savage lemmings, too, stupidly rushing off the cliff together and taking the economy with them, apparently because they can't forecast monetary policy as well as Mr. Paul can!  How is he any different than Barney Frank?

This is just textbook dogmatism (with a bigoted mindset) at work.  There is a widespread set of beliefs about the finance sector that is predicated on ungenerous, illogical, morally loaded presuppositions about how the financial world works.  The financial industry is a target you can safely treat with reflexive cynicism and receive social approval for it, among practically any political or social faction.  Is it that crazy to imagine that this leads to constructed narratives that - shock! - use finance as the antagonist?  I don't say this to paint financiers as victims.  That's not my point.  My point is that cheap cynicism and bigotry makes people stupid.  And stupid people have stupid opinions and support stupid policies.  The danger for me here is to use this as an excuse to dismiss all opinions that differ from my own.  But, so much of what I hear with the banks as the heavy and the Fed as the hero just appears to use convenient preconceptions, with no connection to facts.  In hindsight, nobody would have wanted to own banks over the past decade compared to other equities.  I know, Goldman Sachs owns the Treasury Department, and CEO's walked away with millions of dollars while firms failed, etc. etc.  These things, and many more, are true.  But, show me a bigot that doesn't have a briefcase full of incontrovertible facts in their defense.  I know this is a very convenient point for me that makes my argument non-falsifiable.  But, it happens to be true.  There are a lot of problems out there.  But, please.  Assuming that an entire industry, including financial representatives as well as high wealth individuals with their own capital on the line, will behave destructively pro-cyclically, but that a committee of political appointees won't, is madness.  It's believable if you're reflexively cynical about it, though.

The Fed transcripts from 2008 are damning in this matter, but you can't reason someone out of something they weren't reasoned into.  This intellectual framing is made possible, as with the school issue above, because there is no right to exit.  We are captives of our monetary and banking regulation framework.  I can buy or sell assets if I disagree with the marginal investor.  If I'm right, the marginal investor pays, and if I'm wrong, I pay.  Tread very carefully if you disagree with the marginal investor, by the way.  But, if I disagree with Chris Dodd, Barney Frank, or Ron Paul, I'm screwed either way.  If Ron Paul wants to give me the right of exit from a monopoly liquidity provider, more power to him.  But, if he wants to saddle me with some monetary policy based on what he thinks the S&P 500 should be going for, then he should go buy some puts and leave the rest of us alone.  At least he gets it half right, which is better than Dodd, Frank, and the rest of the folks writing the legislation that Mr. Samuelson is reviewing.

The Latest in Minimum Wage Politics (updated)

I really try to avoid posting about weak arguments for things that I disagree with, but I took a few minutes to look this over in another context, so I figured I'd make it a quick post.

Last month, the Center for Economic and Policy Research released a press release about job growth and MW.  They said that 13 states had increased the minimum wage in December 2013, and that those states had outperformed the average state in job growth since then.

Now, obviously this analysis is a bit weak to begin with, and I don't want to bother with all the details.  But, I was surprised, to begin with, to see that 13 states had increased MW.  I have spent a good deal of time looking at disemployment related to Federal MW hikes, which I have treated as a sort of event study.  If states were really increasing MW at this pace, it would be much harder to track the effects of future hikes with national data.

But, CEPR explained that 9 of the 13 hikes were simply inflation adjustments.  So, they had lumped together 9 states that had increased MW by 1.7% with 4 states that had increased it from 4% to 14%.  I thought this was a strange choice.  So, I copied the data from their article and graphed it to show the scale of the increases.

This outcome is being touted as evidence supporting a 40% increase in MW.

Now, even though I've looked a little harder at this than CEPR did, this still doesn't come close to being useful information.  So, I wouldn't want this post sent out as evidence against MW increases, either.  It does suggest that people who were very excited about this press release can be a bit credulous, although I'm sure we all can be credulous sometimes.


PS.  Mark Thoma links to this New York Times editorial that smugly touts the CEPR report with gems like:
That hasn’t stopped those opponents — especially in the restaurant industry — from attacking the findings. But their only argument is bluster.
and:
What is clear is that there is no need to fear a minimum wage increase — unless, apparently, you are a restaurant lobbyist, whose job depends on keeping wages low for already very low paid waitresses, waiters and fast-food servers.
The editorial even notes that 9 of the 13 MW hikes were only inflation adjustments, but apparently the editors weren't curious enough to wonder if that was a problem and were undeterred from their harrumphing.  It's funny that Mark Thoma sees fit to spread the news on this analysis.  Back in January, when this post of mine attained 15 minutes of fame, he linked to Tyler Cowen's post on my analysis, and added a rebuttal from Kevin Drum, to make sure nobody got the idea that my analysis was definitive.  I had put some effort into creating a way of measuring the various episodes of national MW hikes over the past 60 years as events.  After seeing the feedback of skeptics, I added to my analysis, and ended up with this.  I'm sure it's not PhD level work, but I think it introduces some significant signs of MW-based disemployment.

In any case, if, on a scale of 1-10, measuring if work is definitive, my little bit of analysis is a 3, the CEPR thing is about a negative 4.  Dr. Thoma thinks the titillated NY Times editors need some help getting the word out about it.

Oh, and, that Kevin Drum rebuttal actually included the phrase: "But but but....." unironically.  My graph actually caused him to type "But but but....".  I thought people only did that mockingly.  He wanted to dispute long term changes in teen labor force that weren't really related to my analysis.  In finance, we're used to event type studies because we see a lot of information shocks, like quarterly reports, that affect prices.  Like, what happens to the stock price over the next month after a company reports a positive earnings surprise.  That kind of thing.  That event based price behavior would be unrelated to the sort of broad changes in sentiment that would lead to changes in returns over long periods of time.  Maybe in economics they don't do that kind of analysis as much, or maybe this is a method of analysis that is discredited in some way I am not educated about.  I was just looking at the negative kink in employment that seems to happen a few months before MW hikes and persists for about 2 years.  I admittedly did not append any analysis about complicated long term trends and their causes to my discussion.

PPS.  To Dr. Thoma's credit, in the list of links that included the New York Times editorial, he also had a link to Stephen Gordon at the Worthwhile Canadian Initiative blog that discussed how recent increases in the Canadian minimum wage might be related to drops in teen employment.  It looks to me like this recent Canadian teen employment behavior is pretty similar to the scale of teen disemployment that I found in the US.  The New York Times editors should get on this story.  Apparently, Mr. Gordon is in the pay of US restaurateurs.

Monday, July 28, 2014

A Brief Look at Unemployment Persistence

I have been using this graph, which compares unemployment to insured unemployment, to guide expectations of labor trends.  I am afraid that we have a "new normal" where there will be strong pressures for pro-cyclical labor policies similar to those we have seen in the last 5 years, that continue to create persistence in unemployment as we move out of recessions.



Source: http://www.frbsf.org/economic-research/files/JEP-slides.pdf
There appear to be long term trends in the Beveridge Curve (job openings vs. unemployment), which are probably a product of policy and cultural changes and demographic factors.  It occurs to me that there may be some status quo bias in this thinking, though.  So, I extended the graph of total vs. insured unemployment back further.  I can get back to 1971 with data from Fred.  (I used the 12 month moving average of continued claims as a proportion of Civilian Labor Force for both better consistency in relative long term levels and noise reduction.)

The Beveridge Curve suggests that there were frictions in the labor market in the 1970's and 1980's that inflated the unemployment rate.  I would have expected this to be related to more persistent unemployment, higher unemployment durations, and thus higher unemployment compared to insured unemployment.  But, the recessions in this period don't exhibit high unemployment relative to insured unemployment.  And, later in the 1980's when unemployment remains high compared to insured unemployment, the Beveridge Curve implies a more robust labor market.

I take this as a sign for optimism.  Maybe short term trends aren't destiny...Of course short term trends aren't destiny.  The current cycle has been unusual in the level of total unemployment and in the persistence of high insured and uninsured unemployment.  The cycles in the early 1970's and 2000's had fairly low total unemployment, compared to insured unemployment.  The 1980 recession also was proceeding well until the second wave came.  Then the we moved through the worst of it pretty quickly.  (The red dots represent each month.)  But, after the recession ended, there was persistence in high unemployment for several years, and this persistence continued through the early 1990's recession, considering the very tame levels of insured unemployment. (The red dots are above the normal range of the relationship and are close together.)

This relationship might be an interesting one to watch as unemployment peaks during the next downturn.  Have pro-cyclical policy and cultural changes meant that this relationship been much steeper since the 1970's, but low relative peak levels of insured unemployment kept total unemployment low until the most recent downturn?  Or, is there a chance that the next time insured unemployment gets to 3% or 4%, that a healthy labor market will help push total unemployment down quickly as insured unemployment declines?

Maybe my interpretation of the Beveridge Curve is backwards.  Maybe instead of thinking the unemployment rate was high compared to vacancies in the 1970's, maybe we should think that the vacancies rate was high compared to unemployment, and this is related to the healthy recovery in total unemployment as insured unemployment declined from the peaks.  I have been thinking of the Beveridge Curve on a slope, and that a more robust labor market is signaled by a movement toward the origin (movement number 1).  But, maybe a better functioning labor market is signaled by a shift to the left, but also a flattening, in the Beveridge Curve (movement number 2).

Maybe right/left shifts are related to labor supply and up/down shifts are related to labor demand.  To the extent that the relationship moves cyclically, it moves diagonally along the curve as both supply and demand change through the sentiment changes of the business cycle.  But, possibly, the unusual position of the 1970's Beveridge Curve was a combination of loose monetary policy that kept vacancies high during cyclical downturns and other policies or cultural shifts that were keeping unemployment high during recoveries.  Maybe a little looser monetary policy with a less regulated labor market is the best of both worlds, but of course I would say that.

Thursday, July 24, 2014

Inflation and Interest Rates in 2014 & 2015

I have been generally expecting positive surprises in the labor market to lead to a steepening of rates in the short end of the yield curve.  The manifestation of recent economic improvements in rate movements has been more muted than I would have expected, especially considering recent strength in some inflation readings.  The 1st quarter GDP reading might have some influence here in addition to a deceleration of growth in housing, but most other economic indicators have been strong.

In any event, I will construct a forecast path for interest rates over the next couple of years.  This will probably be a bit too precious, but I would just consider this a possible narrative, built on some of the peculiarities where my model of the economy might differ from the marginal investor, and thus lead to potential profit or loss.
 
Here are graphs of recent changes in the Eurodollar yield curve.  The first graph shows the change over time in the expected first date of short term interest rate increases and the expected rate of further increases after that.  Since late 2013, there has been a slight positive trend in the expected date of the first increase, from summer 2015 to spring 2015.  But, at the same time, there has been a decrease in the expected rate of subsequent increases.  To put this in perspective, in the previous two cycles, the Fed Funds rate increased at a rate of about 35 to 50 50 to 75 basis points per quarter.  Currently, forward rates are priced for a rate of about 25 basis points per quarter.  This would be very slow.

This suggests that the market generally is pricing in some of the same expectations that I have about future monetary policy.  If we look at the full Eurodollar yield curve, we can see that, in terms of bootstrapping the rates of longer term bonds, these near term changes in short term rates have been swamped by a significant decline in the terminal rate at the long end of the curve.  I agree with what the market is saying here.  QE3 doesn't appear to be having much effect on the immediate economy, but the end of QE3 and other signals from the Fed suggest that they will continue to be very tight with monetary policy as we move forward.  Also, note that, as with the previous rounds of QE, the liquidity effect appears to be completely non-existent in the current environment.  When the Fed buys long term bonds, their prices go down (yields go up) and when the Fed stops buying long term bonds, their prices go up (yields go down).  The fact that so many observers, including the Fed itself, still frame monetary policy as if the liquidity effect is the overriding effect, in the face of repeated evidence plainly suggesting the opposite, gives me confidence that there are inefficiencies to be exploited regarding monetary policy.  But, as this graph demonstrates, the market in general is already with me, at least part way.

I expect rates to rise a little sooner and a little more steeply than current prices imply, and I expect them to level off a little sooner.  At that point, further developments will depend on discretionary decisions by the Fed, and the main speculative dilemma will be to guess when they will decide to be catastrophically tight again.  At that point, a long position in intermediate term bonds will be the potential speculative position.

I continue to have confidence about the near term forecast.  Bank credit continues to expand as we exit QE3 and employment continues to exhibit strength.  Here is my graph of continued unemployment claims and the unemployment rate.  There could be some statistical pull-back for the rest of the month, but if claims for July average what they were on the July 12 report, the expected decline in unemployment would take us down to 5.9%.  (And this week is already a confirmation of last week's low number.)  If we factor in the expectation that the unemployment rate should be edging back toward more typical levels, relative to continued claims, the unemployment rate range we should expect in July is probably 5.7%-6.0%.  (It would be really fun to see the bottom of that range.)

Before I move on, I want to pause a moment on this.  The other estimates that I have made of the unemployment rate declining to 5.5-5.7% by year end did not rely on continued improvements in unemployment insurance numbers.  The results for the rest of this year could be very strong.  And this brings me to a pseudo-fact that it seems we have concocted in the last decade.  Let's say the economy goes gang-busters, and we find ourselves looking at temporary YOY NGDP growth of maybe even 7% or 8%.  Does that mean the Fed should pump the brakes on the economy?  If you answer "Yes", then I have a question for you.  WHY?! WHY WHY WHY WHY?!?!?!  What possible evidence is there that NGDP growth occasionally hitting the high single digits is catastrophic?  I've seen highly informed and intelligent people claim that housing in the 2000's was a "bubble" that happened because the Fed temporarily allowed 7% NGDP growth.  What in the hell has gotten into the water?!  I'm all for an NGDP target, and if we had a target, then 5% would probably be fine.  But until we do, for the love of Pete, can we imagine it heading back into normal territory without having a communal freak out?  The average NGDP growth rate since 1948 has been 6.6%.  This includes recessions.  Nobody wants 8% inflation again.  But, it's almost as if the zeitgeist now has it that the Fed has to destroy the economy to save us from 3% inflation.  I wish everyone would stop being insane....Well, I take that back.  There would be no profit in my work if everyone wasn't a little bit insane.  But can we all try to be a little LESS insane?  Be just insane enough to leave a mispriced microcap here & there...

Anyway...inflation has also started to imply a healthier economy and rising interest rates, but this month it took a breather.  I think it is helpful to separate housing from Core CPI because of the peculiar nature of recent housing markets.  If we do that, we still see pullback in June inflation.  Core minus Shelter inflation has been much lower than other measures of inflation, but it also shows more upward momentum, even after the June pullback.

Here is a graph of the same three indicators, shown in the more traditional trailing 12 month measure, with some notes.  Here we can more clearly see the pattern of Core minus Shelter inflation, which was very weak until March of this year, and has now begun to move back up.

I estimated Shelter to be 40% of the Core CPI basket for the entire period, for simplicity.

We need to be careful about Shelter inflation, because home supply, prices, and rents have had a peculiar relationship recently that is not simply a product of the business cycle.  This is partly what caused the inflation signal that steered the Fed off course in 2007 and 2008, in my humble opinion.  Until 2005, (Period 1) home construction was boosted by the need for long term savings.  This helped to keep rent inflation in check.  The housing boom was deflationary.  (I will also note that while rent inflation was stable, it was by no means weak.  How exactly rent remained so steady in the story of massive overbuilding in a housing bubble, spurred on by predatory lenders and a crazed nation of homebuyers, should be a mystery.  It wouldn't be a mystery if the real story was that home prices were too low in 2002 & 2003 and sticky prices in real estate kept them from efficiently responding to low real interest rates until rates had increased in 2006.)  By 2006, (Period 2) long term real rates had increased, causing a pause in home construction growth, and this pause in production may have led to rent inflation.  (Core minus Shelter (CmS) inflation was down to 1 1/4% by mid 2007.  But, Core Inflation was boosted, counterintuitively, by the slowdown of supply.  Or, alternatively, I wonder if survey responses on Owner Equivalent Rent tend to track mortgage payments, which would have been increasing at the time, as house prices and mortgage payments topped out.  Whether stated rents were increased by supply or by statistical aberration, the effect would have been to boost stated inflation.)  By late 2007, (Period 3) the Fed was thoroughly engaged in fighting inflation.  By September 2008, when the Fed took its last, fated, stand against inflation, CmS, Core, and Shelter inflation were all at about 2.5%.  The collapse in rent lasted until about the end of 2010.  CmS Inflation bumped up above 2% during QE1 & QE2.  And, by 2011 rent and home prices were increasing again (Period 4).  While low real interest rates continue to justify high nominal home prices, the recovery of both indicators is probably mostly from cyclical demand recovery and limited supply.

That brings us to the summer of 2014.  Banks and regulators appear to be quantitatively and qualitatively loosening up on real estate lending, finally.  This is happening, not coincidentally, as home equity and debt levels reach their comfortable relative values.  I believe we have been seeing a short term dip in home building activity and home price appreciation, as the market transitions from an investor cash-only buyer market to a mortgaged homeowner market.  Commercial bank real estate loans have a lot of acceleration to go to get back to previous growth levels (at least double the growth rate of the first half of 2014).  As we proceed through 2014, home production and home prices will move up higher than is widely expected.  This will help GDP figures.  But, note, the added supply should cause rent inflation to moderate.  So, Core inflation will moderate.  This might leave room for the Fed to allow CmS Inflation to rise above 2%, even with their hawkish sentiment.  I think the economy will accelerate during this period, and the Wicksellian interest rate will rise dramatically.  This will also give the Fed cover among hawks, as this will be interpreted as the Fed raising rates.  So, we could see tame core inflation, NGDP above 5%, and short term interest rates above 2% or 3%.

The problem I am looking out for is that long term real rates will probably remain relatively low - in the range of the rates of the 2000's.  Home prices in a reasonable credit market should push up higher than the prices of the 2000's.  I am afraid that the Fed will misinterpret this as inflationary or as an asset "bubble", and will start to clamp down on credit markets and the money supply.  I hope that doesn't happen, but the speculative position to take then will be exposure to collapsing near-forward interest rates.  I hope that speculative opportunity doesn't present itself.

By the way, here is a graph (log scale) of home equity, home mortgage levels, and real estate loans kept on the balance sheet at commercial banks.  Of course, in the 2000's, we had a massive housing bubble where home prices and house construction went bonkers, fed by predatory and excessive mortgage debt, and banks unscrupulously unloaded all of that rotten real estate debt to unwitting securitization investors.  I have a Golden Ticket for anyone who can point that bubble out to me on this graph.  For the life of me I can't find it.  That sure is one heck of a something that happened in 2007 & 2008, though.

Tuesday, July 22, 2014

Unemployment and JOLTS, with demographic adjustments

I've done quite a few posts on the significant distortions that the baby boomer lifecycle is causing in comparative labor statistics.  There are so many places where we are using time series to assess the state of the economy, and we are using measures that have stable names but that are measuring something whose fundamental character is changing.  In broad terms, for instance, we think we are measuring "Quits" or "Unemployment Rate", a stable set of data regarding an economy over time.  But, really, we are kind of measuring "Quits or Unemployment among a lot of 50 year olds" today compared to "Quits or Unemployment among a lot of 35 year olds" 15 years ago.  We think we are comparing changes in our economy, ceteris paribus, but in some cases, we are being fooled.  The economy is the "ceteris paribus" and we are just measuring how 50 year olds are different than 35 year olds.

Last December, I tried to adjust the Quits rate from the JOLTS survey to account for age demographics.  I haven't revisited the adjustments since then.  Today I thought I'd update this and see where things stand.  The red line in this graph is where we would expect Quits to be if demographics had remained constant.  The trend lines in this graph are parallel.  Growth in Quits has more or less followed the trend from 2003 to 2006, except for the period from the summer of 2011 to the fall of 2012, where it leveled out.  (It might be worth noting that this period of stagnant Quits roughly falls in the time period between QE2 and QE3, with Quits increasing on trend during the QEs.)



Here is a graph of all of the JOLTS indicators, with this demographically adjusted Quits level added.  Note that, with this adjustment, Quits is back to the same level of early 2004, when the Unemployment Rate was at 5.7%.

Job Openings is back to the level of late 2005, when the Unemployment Rate was 5.1%.  Some combination of labor market frictions is probably responsible for the lower Quits rate among older workers.  They tend to have much lower employment churn and longer unemployment durations.  Some of this is probably due to greater specialization as a result of their more mature career development, etc.  These factors would tend to cause Job Openings to be overstated, relative to earlier periods, because employers would require more time to match jobs with workers, given these frictions.  I have a fairly direct way of adjusting the Quits rate by using unemployment and unemployment duration data, by age.  These inputs aren't available for Job Openings adjustments.  If we assume that the scale of the effect is similar between Quits and Job Openings, then adjusted job openings would imply an expected Unemployment Rate of about 5.7%.

The lower churn among older workers could also explain some of the lower hiring levels, so that hiring adjusted in a similar way to quits should also imply an unemployment rate in the high 5's.

Older workers also have lower unemployment, generally.  Adjusting for age, we might expect that the current unemployment rate would be about 0.4% higher than it is if demographics were still equal to what they were in 2000.

Comparing all of these measures to the previous recession, with these rough demographic adjustments, we have:
Stated Adjusted
Quits Rate
1.6% 1.8%
Job Openings Rate
2.7% 2.3%
Unemployment Rate
6.1% 6.5%
UER implied from Quits
6.4% 5.7%
UER implied from Job Openings
5.1% 5.7%

So, the measures, demographically adjusted to compare to the previous recession, give us a picture where Openings and Quits suggest that Unemployment should be nearly 1% lower than it is.  I have separately estimated that about 1.2% of the labor force remain drawn into unemployment because of the unprecedented generosity of Emergency Unemployment Insurance (EUI).  It seems like this group of workers could explain the disconnect between unemployment and the JOLTS data.

About 0.3% of the unemployed labor force is related to lower exit rates of cohorts who became unemployed in 2013 and were generally eligible for EUI.  These workers appear to be actively engaged in the labor market, even though their unemployment exit rates were a little slow.

Another approx. 0.8% of the labor force have very long unemployment durations and would have been expired out of EUI even if it hadn't been terminated at the end of 2013.  The Quits and Openings rates may suggest that these workers have a limited impact on quitting and hiring decisions of other workers and employers.

I have done a lot of posts on Labor Force Participation Rates where I have argued that LFP, once adjusted for demographics, is roughly where we would expect it to be at the end of a deep recession.  But, that LFP level includes these Very Long Duration Unemployed workers in the labor force.  So, these are not workers who would have left the labor force without EUI.  They are probably mostly workers who would have reentered the labor force.

I've been fairly clear that I don't think such long term EUI was a wise policy.  I'm not sure we did these workers any favors by having such generous EUI policy.  If the main point of this policy was to lessen the incentive for them to accept sub-optimal work opportunities in the months following their loss of work, it seems that what we have done is to create about a million and a half workers, who, at the end of the labor contraction, still are in a position where they will need to accept sub-optimal work opportunities, but now have to try to acquire those opportunities with a big red flag on their resumes.  So, they are likely, after having missed two years or more of potential productive work time, to be facing even worse opportunities than they had initially.  In trying to save workers from uncomfortable, but manageable, outcomes, we may have subtly pushed them into desperate outcomes with no obvious, systematic solution.

In any event, these workers are slowly leaving unemployment, though it is unclear where their marginal flow is going - to work or out of the labor force.  The net result may be that we have a labor market that, for the most part, is operating at full employment.  Normally, there would be some segment of opportunistic labor that would cause cyclical fluctuations in labor force participation.  Now there is an additional segment that will also reenter employment cyclically, which might be another reason to expect an exceptionally long recovery period, if we can avoid having all the "bubblemania" jibber-jabber push the Fed into unnecessarily hawkish monetary policy.

The best scenario probably involves short term interest rates hitting 2-3% pretty quickly after their initial lift, and then moving sideways, a la the late 1990's.  My fear, which is probably becoming a broken record, is that this scenario probably includes an equilibrium price of homes 30-40% higher than today's, adjusted for inflation over time, and I don't think the Fed and most everyone else wants to believe me (or the market) over their own lying eyes.

Friday, July 18, 2014

June Unemployment Review

With the June employment report, we are now 26 weeks past the end of EUI.  As I mentioned last month, the faster exit rates of the cohorts of workers newly unemployed since the normalization of unemployment insurance have now worked their way through all of the shorter duration categories, so that the remaining decline in unemployment will come from the ">26 weeks" category - both from the continuing extension of the more normally behaving unemployment cohorts into the longer durations and from the continued slow decline in the number of very long duration unemployed workers who had timed out of EUI.

This evolution is apparent in this month's numbers.  Here is a graph of the numbers of unemployed, by duration.  The arrival of the post-EUI cohorts in the ">26 weeks" category has accelerated the decline in this category in the last couple of months while the declines of the lower duration categories started accelerating last fall and have now leveled off.

My measure of the percentage of long term unemployed workers (15 weeks +) who exit unemployment over the following three months also continued to improve in June, jumping to 43%.  This measure has persistant cyclical behavior, and if this levels off at 45% between now and December, this should correspond to a drop of 0.4% in the ">26 week" category by December.  So, this indicator also points to a mid-5% range rate by year end, simply from inertia in employment trends.

Here is a graph of actual ">26 weeks" unemployment (blue) and the predicted level of long term unemployment, modeled as a linear combination of lagged short term unemployment durations.  We can see here the continued expected decline of long term unemployment to healthy levels (as cohorts with faster exit rates extend through the longer durations) as well as the convergence of actual long term unemployment to the expected level (as very long term unemployed workers continue to exit unemployment).

In the next graph, we can see how the unemployment rate has been inflated compared to the regular insured unemployment rate.  Since most of the reduction in unemployment has come from faster exits from workers unemployed after the end of EUI, the improvement in unemployment has mostly been in proportion to reductions to regular continued unemployment claims, in 2014.  The current level of continued claims would normally correspond to an unemployment rate of less than 5%.  About 0.8-0.9% of the difference, by my estimates, is due to very long term unemployed (average durations around 2 years) and about 0.2-0.3% of the difference is due to the remaining more typical excess unemployed workers.  We should see continued claims start to level out, and if the unemployment rate does fall to 5.5% by December, any remaining improvements in unemployment will probably be due to residual improvements in normal recovery unemployment behavior and the continued exit of 0.5% or so of remaining very long term unemployed, if they continue to exit at their established rate.  (Although, there appears to be unusual continued strength in the normal employment market, as continued claims continued to fall with this week's report.)

Thursday, July 17, 2014

Risk & Valuations, Part 11: Allocations with Stocks & Bonds

I previously published a series of posts where I concluded that, in practice, nominal fixed-rate bonds have not provided any diversification benefits in the classic bonds & stocks portfolio.  How does the model of risk and valuations in this current series of posts mesh with that idea?

I apologize for a little sloppiness here.  I am going to separate risk premiums out into the unlevered Equity Risk Premium (UERP) (the additional premium earned for holding equities over debt), real risk free interest rates (RRFR) (the premium earned for holding debt), and the inflation premium (the premium earned for the expected decay in the value of cash).  UERP comes out of my annual Black-Scholes valuation estimates for non-financial corporations from the Federal Reserve's Z.1 report.  RRFR is the rate on 10 year treasury bonds, minus inflation.  Ideally, for the inflation premium, I would have some indicator derived from inflation protected bonds, but since I don't have that data for a long time frame, I am just using the GDP price deflator.  In practice, this seems to be a decent approximation over the long term, but it probably adds a bit of point-to-point noise.

Here is a graph of these three premiums, stacked.  Even with my noisy estimates, the total required returns to unlevered equities (RRFR + UERP) appear to have a steady trend around 8%.  (The RRFR + UERP data series doesn't appear to reject the null hypothesis of an Augmented Dickey Fuller stationarity test.  But, a regression of UERP against inflation and RRFR returns a negative coefficient on RRFR of about -0.4 with a p-value less than .001.  In other words, there has been a strong negative relationship between UERP and RRFR, which should tend to stabilize the combined value as RRFR fluctuates over time, but with some possible fluctuations over time.)  A trend like this is what we would expect if there is a relatively stable return to productive assets, and the relative returns to RRFR and UERP reflect risk trading between debt and equity holders, as I described in the early sections.

There isn't a statistically significant relationship between inflation and UERP.  This makes sense, because the expected growth rate in net earnings should roughly adjust along with expected inflation.  In theory, unleveraged returns on assets should be roughly neutral to inflation.  In fact, this data presents weak evidence that UERP is lowest at inflation expectations between about 2% and 4%, and rises at inflation levels above and below that.  This is the relationship I previously found between inflation and RGDP growth.

So, this suggests that bonds and equities might provide beneficial diversification if real, fixed rate bonds are used instead of nominal bonds.  This makes sense if considered in the paradigm of the asset allocation process I described in Part 5, where a portfolio of stocks and bonds is rebalanced to match corporate leverage.  To the extent that changes in RRFR and UERP reflect their negative relationship, that portfolio should experience more stable returns as a result of its stock & bond allocation.

As discussed in the earlier series of posts regarding stock and bond allocations, this would explain the apparent benefit of home ownership.  Homes provide a sort of inflation protected return, as pre-paid rent, so they mimic the return on a RRFR portfolio allocation.  On the negative side, homes require a highly leveraged, non-diversified position in a particular real estate asset that is highly correlated with many risk factors a given household would be exposed to.  And the asymmetric risks of a mortgage also work against the stability of the household portfolio.  On the positive side, the inflation protection homes provide is probably more highly correlated to a household's local cost of living than a TIPS bond would be.  Also, limited access to homeownership tends to create above-market returns to home ownership.  This was probably not the case in the 2000's, but has generally been the case, including in the present market.  If home prices do manage to climb another 20 or 30% in the current recovery (as they should), many households might be better served with TIPS bonds in place of home ownership, as the advantage of above-market returns would again be reduced.

I think the problem with nominal bonds in a diversified portfolio can be explained with the risk trading model.  The inverse relationship between RRFR and UERP can be explained with risk trading.  But, inflation has tended to follow a path unrelated to RRFR and UERP.  Rather, it is a product of Federal Reserve policy, which seems to follow its own long-term biases.  And trends in inflation have tended to cover very long time periods in the mature Federal Reserve Era.  Inflation has generally been fairly low, except for a 20 year period from about 1965 to 1985.  So, mean reversion from the influence of inflation has not happened except in very, very long holding periods.  This has meant that the effect of inflation has been to push relative portfolio performance to the extremes for portfolios in a typical investor life-cycle.

This data only goes back to about 1960.  In the period from after the stock market crash of the late 1920's until the stagflation period of the 1970's, the experienced equity premium was extremely high.  This probably resulted from a combination of (1) very low bond rates throughout the period, (2) very high GDP growth rates, and (3) required equity returns that started out very high and declined over time, providing additional capital gains.  Gains over time come, in part, from the required returns that were in place at the time of the initial investment, but they also come from changes in required returns over the holding period, which provide trading gains.  Since much of the trading gains in the 1990's were related to falling risk free interest rates, both bonds and equities did well in the 1990's.  There was a small increase in the premium experienced from equities, but not as much as one would think simply by looking at the returns of the S&P 500.  Rates continued to fall in the 2000's, and ERP was high, but relatively stable.  This, combined with the fact that equities took the brunt of the demand shocks experienced in the two recessions, meant that experienced equity premiums in the 2000's were negative compared to bonds.  All portfolios, especially those initiated near the bottoms of the recent equity collapses, should experience very high equity premiums again over the next couple of decades as the pendulum swings back on relative RRFR and UERP levels, but continued demand shocks might make this a bumpy ride.  Every expert at the end of the bar seems to think every sign of progress is a bubble, and respected economic pundits refer to "new highs" in the stock market as if that is a problem to be solved, even as equity holders over the past 10 to 20 years have had Great Depression level returns relative to bonds.  There's a strange, self-destructive mood in this country, and so I'm afraid we might be in for some more demand shocks.  Except for that risk, we are probably in the midst of another decent period of high relative equity returns.

Tuesday, July 15, 2014

Risk & Valuations, Part 10: Risk Aversion and Demand for High Wage Labor in International Markets

I think one of the reasons my alleged inter-relationships between debt, equity, and labor in this series of posts sometimes seem counterintuitive is that there is a broad tendency to think of debt in terms of consumption time-shifting, so we tend to treat it as part of a narrative of greed, impatience, and risk-taking.  But, this is only fitting for unsecured consumer debt, which is a small portion of outstanding debt.

Most debt is simply an instrument of ownership, and represents risk aversion.  Debt is the product of risk trading, where asset owners buy local certainty (see Parts 1 through 9) while retaining ownership.  (Here, I am treating debt and equity holders as owners, since they are both claimants on the output of productive assets and are both sources of capital in an enterprise.  The difference is that debt holders buy local certainty from equity holders - receiving a fixed payout in exchange for an uncertain return with an expected premium.) More debt in this context represents a context where more owners wish to avoid manageable volatility.  Note that more debt would still create systemic risk, since it would push local risk onto a smaller portion of the economy's owners, but this risk comes from a surplus of risk aversion, not a surplus of greed.

I don't know how much this matters in cyclical analysis.  Here is a historical graph of US financial liabilities.  To the extent that there is a cyclical pattern, liabilities have risen when demand shocks led to sharp declines in equity values and pushed liabilities into disequilibrium, especially in the most recent two cycles when demand shocks were especially sharp.  Liabilities have returned to lower levels as the economy has recovered.

(I have been putting the idea forward that baby boomers are creating demand for local certainty, but the long term trend in liabilities as a proportion of financial assets does not reflect a unusually high demand for liabilities.  The tax effect that reduces corporate debt levels, the lower corporate leverage that results, and the coincident high equity premiums could lead to a context where the higher levels of equity mean that equity represents a less leveraged position on local volatility.  The demand for low risk might be accommodated with equity that, itself, represents lower risk as an alternative to debt which is in lower supply and which has very low returns.  Equity becomes less systemically risky as its share increases, whereas debt becomes more systemically risky as its share increases, so, possibly, markets naturally accommodate high risk aversion without leading to systemic risk by accommodating that risk aversion with less leveraged equity.)

So, we have a model where the motivating factor is the avoidance of local volatility, which is achieved through risk trading, where remaining equity holders take more of the manageable risk and debt holders and laborers enjoy more stable near-term contexts.  The counterintuitive result of this trade, facilitated by the tax benefits of debt and labor expenses is that relatively higher equity risk premiums and lower interest rates lead to lower levels of debt and labor utilization.

This relates to another topic where I would reverse the standard narrative - international capital flows and wage levels.  It frustrates me to see economists universally referring to the movement of production to low wage economies, when the opposite is true.  Sometimes when the earth revolves around the sun, it looks like the sun is circling the earth.  And, here, we have uncontroversial data that capital flows overwhelmingly to high wage economies.  In cases where capital flows change noticeably, it is usually where institutional improvements in a developing economy lead to an expansion in the productive basket of goods they can supply, and so capital flows there to accommodate the new production.  Because wages are generally low at an absolute level, it appears that production is moving to exploit low wages, but this is absolutely wrong.  The trigger for expanded production is also a trigger for higher wages.  Production doesn't move to where wages are low - it moves to where wages are rising.  This subtle distinction is so fundamental and so important to a proper understanding of international economics, and yet so universally misstated.

http://conversableeconomist.blogspot.com/2014/06/snapshots-of-foreign-direct-investment.htmlTimothy Taylor had a recent post on Foreign Direct Investment.  Here is a graph he posted, from UNCTAD.  Capital flows are much higher to developed economies, but flows to developing economies are increasing as those economies catch up.  Here is a table from UNCTAD of the major recipients of capital from the US, which are all high wage economies:

And, this idea happens to line up quite well with my counter-intuition about labor and debt levels.  Firms invest in economies with higher wages.

Of course, much of the wage differential reflects different levels of productivity.  But, if we think in terms of risk trading, some of the wage differential is a payment to equity capital from the risk trade with labor.  In developing economies with higher risk premiums, wages will capture a smaller portion of the producer surplus.  Again, this will appear as if corporations are exploiting low-wage economies in order to increase profits, but the higher profits are just a product of the higher risk posed by the foreign investment.  And, because we have a risk averse nature, owners will be enticed to move more capital to contexts with low risk premiums.


Here is another Timothy Taylor post - this one on labor share of national incomes.  He points to a global decline in labor's share of income.  To his list of reasons for the drop, I would add the global baby boomer demographic pattern, which is probably feeding the current decline in risk free interest rates and the high premiums on equity investments.  Here are three graphs he posts from an International Labour Organization Global Wage Report, which compare labor portions of income from several developed and developing economies.  The relationship between GDP and labor share is clear.  My risk trading paradigm argues that improving institutions leads to lower risk premiums and higher productivity.  Increasing wages come about due to both increasing productivity and decreasing equity risk premiums, which decreases the price of the risk trade labor tends to make with equity owners.  Investment is attracted to this high wage, low risk context.  Higher compensation shares come, in part, from lower equity risk premiums.  We are the 100%.

Monday, July 14, 2014

Risk & Valuations, Part 9: The Greenspan Put

The complaint about the Greenspan Put is misplaced, in a way.  The Greenspan Put is the whole point of a functional central bank.  If the Fed could dependably put a floor under the nominal economy, then we could all operate a little bit more nearly to the regime of certainty.  We could all optimize more.  Equity premiums would be lower, labor compensation would be higher.

Many believe that this sort of optimization, created from a sort of misplaced expectation of certainty, was the kindling for the crisis in 2008.  Low rates, a sign of easy money, led to an over-leveraged economy and to a massive disruption in the American and world economies.

As Scott Sumner would point out, low long term rates are a sign of tight money, not easy money.  While real estate was bid up to high nominal prices, the level of mortgages compared to home equity was not especially high until home values collapsed.  Firms were less leveraged than they had been in 30 years.

Yet, even though the facts describe a situation much less explosive than the standard narrative would suggest, we still had the largest economic dislocation of a lifetime.

The standard narrative is that the Greenspan Put created a false sense of security - that markets basically underestimated the standard deviation of potential outcomes, and investors left themselves with no breathing room.  The tide went out and nobody was wearing shorts.

The real problem is that the Fed manufactured a black swan.  The problem is that a central bank will always have political risk, which is much more binary in nature than market risks.  NGDP level targeting with futures markets would go a long way toward removing this discrete variable from the risk profile of the American economy.  If some of the relationships I have outlined over these last several posts are accurate, stable growth in nominal demand might slightly increase debt leverage, but it would also increase labor compensation, prevent the excessive leverage that would accompany very high rates, and prevent the unplanned shocks to leverage that lead to disinvestment and unemployment.  It should lower equity risk premiums.  And, in general, it would incentivize more financial resources into the sort of risk-taking endeavors that grow an economy.

The public fear of inflation, then, is ironic.  The trick isn't in the comparison between the growing cost of living and growing incomes.  That's all going to come out in the wash.  The problem with low inflation is that business downturns can more easily turn into demand crises.  As long as interest rates and inflation are so low, there will be additional risk hovering over equity holders.  The low rate environment causes equity risk premiums to increase.  This affects equities themselves by decreasing the price investors are willing to pay for equities.  But, this also effects wages paid to labor.  Because the equity risk premium is higher, and because of the implicit risk-trade that firms make with employees, firms must demand a higher discount from the gross value of wages.  Low inflation, paired with a discretionary monetary policy, pushes down wages because it pushes up equity risk premiums.

The one caveat, however, is that, in the end, if we insist on having the most important product in the economy, the one product that is a part of every transaction, managed by a committee, then there will be some amount of discrete extreme downside risk, because committees always hold the possibility of making a huge error.  And, as I have discussed in these posts, if the local context of the economy is stable and certain, we will optimize for it.  Our participation in this economy means that we are preselected as optimizers.  The only alternatives to optimization are failure or exit.

But, a successful regime of NGDP level targeting, with a market-based indicator, would (1) create the sort of certainty regime that creates real added value in human experience and (2) move that discrete, black swan, committee-based outcome potential way out on the outcome distribution.  A FOMC would need to completely change the monetary paradigm to screw things up.  Simply being human, as they were in 2008, wouldn't be enough.

And, as where we now stand, there appears to be a near consensus among voters, economists, and FOMC members that the Fed in 2008 wasn't the problem, but instead was the necessary medicine.  And they are prepping to do it again.  In the 2000's, Equity Risk Premiums were at the high end of their range, risk free interest rates were at the low end of their range, corporate leverage was at the low end of its range, and the main area with significant levels of private debt was mortgages, which are almost totally the product of middle class household saving....Oh, I know, I know.  Every middle class household has a mortgage as a part of their conservative long term financial plan, but we all know a guy who knows a guy who totally leveraged up on real estate in the boom because he thought home prices would go up forever.  Even though the mortgage market is flatlined, so that even this explanation for an "overheated" economy is not available, the Fed is concerned about "financial stability".  So, before we get an NGDP targeting regime, the Fed is likely to create another NGDP shock, and just like last time, it will be blamed on a problem that doesn't exist, and everyone will pat each other on the back, and congratulate themselves for seeing bubble after bubble and popping them.  And the popping will be painful, especially for vulnerable households.  And greedy corporations and speculators will be blamed for making the supposed bubbles even as, incongruously, economic imbalances are blamed on their profits.  I don't see how this cycle gets broken, yet NGDP targeting does appear to be gaining acceptance.  Let's hope.

Thursday, July 10, 2014

Risk & Valuations, Part 8: Beta has its own alpha.

Think of any investment valuation as a sum of discounted cash flows of the form a sum:

 
x = cash flow in time, t
y = interest rate

Over time, short term bills, which have very little exposure to changes in rates and no exposure to cash flow volatility, have tended to have a small positive return.  Longer term fixed rate bonds have a maturity beta.  They tend to earn more because of their exposure to interest rate volatility.  But, cash flow remains stable.

The equity premium comes from exposure to Cash Flow fluctuations.  The CAPM model, in its simplest form, is summarized by this equation:

It is an estimate of the required return of a given equity.  Theoretically, if we have two firms with exactly the same operational expectations, but different levels of leverage.  Investors could mimic the investment of the most leveraged firm by leveraging their own portfolio and investing in the least leveraged firm.  So, there should be a tendency for arbitrage investing to push equities toward prices that reflect their relative market-related volatility.

Some research has found an anomaly where low beta stocks seem to outperform high beta stocks, at least on a risk adjusted basis. In other words, returns may not correspond to beta on a full 1:1 basis.  I think there are several issues at play here.  Equity premiums are hard to pin down.  I think some of this anomaly tends to go away when long duration risk free rates are used, instead of short term rates.  There have been long periods with high equity premiums and long periods with negligible equity premiums, depending on how you measure bond returns.

But, I would like to propose a theoretical explanation for at least part of any anomaly that might exist.  Going back to Part 6 of this series, I want to reintroduce the idea that there is a sort of regime shift that happens when we move from a context of uncertainty to a context of certainty.  In a context based on nominal certainty, functions can be optimized to a very high degree.

I don't know if this is too obvious to require an example.  But think of a calendar.  If you have a job that requires you to be on call, your entire schedule must be tentative.  If you have a job with broad deadlines and the ability to be flexible, then planning that 2 week long trip to Seattle is a lot easier to do.  Household income has the same effect.  The budget process for a household with salaried professionals can be much more precise than the budget for a household with a sole proprietor's income.  As long as the context is stable, this certainty allows for much more rational and optimal behavior.  The certainty itself provides value.

So, moving from bonds to equities moves us from a context where there is exposure to just one variable (interest rates) to a context where there is exposure to two variables (interest rates and cash flow).  In both bonds and stocks we can see a discrete payout for this added exposure above and beyond the proportional level of the exposure.

So, even adjusted for inflation, short term bonds, over time, have provided a premium over cash, plus they have provided a maturity premium that relates to their exposure to interest rate changes.  In other words, bond returns have an alpha and a maturity beta.

I want to suggest that equity also has an alpha and a beta.  So, properly rendered, CAPM should have a third variable, which is the Equity Alpha.  This is the added return one earns simply for stepping into the world of unknown cash flows and unsecured existential risk.  This premium would apply equally to all equities.  In addition to this premium, then, equities would also have an Equity Premium beta, which would relate to their proportional market risk.

In the hypothetical world of identical equities that can be arbitraged, this alpha would seem to be bid away.  But, in the actual world of investing, it is not difficult to imagine a discrete set of risks that come from life as a stand-alone firm, that would exist in a constant form, somewhat unrelated to temporary fluctuations in market values.  So, before adding factors to the CAPM model, I think that to be properly specified, it might need to look like this:

 
The expected return on an equity would consist of the alpha return on discount rate risk (short term risk free rates), plus the return on maturity risk (risk free duration premium), plus the equity alpha (cash flow risk), plus the equity beta (proportional volatility risk).
 
None of this is particularly complicated.  But, it does provide a method for accounting for risks that aren't proportional.  In addition to discrete, firm-based issues, a low equity beta increases an equity's proportional reaction to changes in other variables, such as real rates, growth expectations, and changes in beta.  Many types of risks might be accumulated within the Equity Alpha.