Saturday, April 19, 2014

Perception is reality

Commenter Michael Byrnes hits the nail on the head at :

A big problem: If monetary policy is tightened inappropriately, so as to pop bubbles, it will produce (what appears to be) evidence that there were bubbles that needed popping. This will happen whether or not there are any bubbles.

Friday, April 18, 2014

The value of low risk investments for emerging markets

This is a follow-up to the previous post on the benefits of international capital flows in helping to match risk demands between emerging markets and developed markets.

I think the idea that capital from the developed world is a beneficial input for production growth in developing economies is easy to intuit.  But it seems somehow strange, or wrong, or at least not the result of some natural equilibrium, that so much emerging market capital would be parked in low risk securities in the developed world.  After all, we don't need emerging market capital; they do.

But, I think it is easy to underestimate the value of low risk savings vehicles for emerging markets.  For economies that exist within a context of high risk premiums and high uncertainty, relative to developed economies, I think we can see how there would be a demand for low risk investments.

But, I think the benefits of these savings outlets may be much deeper than is obvious.  The rise of functional market economies, at their base, is a triumph of a set of cultural and institutional norms that is fundamentally entangled with the conflicted human relationship with risk.  So many of the social impediments to market-based abundance are seated in a desire to avoid risk - the complex sharing norms of extended families in subsistence economies, political impositions of power of one group over another, limited access property rights, corruption in the service of protecting the existing control of land, production, captured demand, etc.

In many ways, these mechanisms that end up blocking the universal, individual right and access to property are the products of a demand for safety.  At their worst, in political form, these mechanisms create safety for a limited class at the expense of others.

Could it be the case that the external availability of highly trusted low-risk savings vehicles helps to meet this demand for safety, and allows the more powerful, capital rich factions of developing economies to achieve a level of risk low enough that the demand for more corrupt versions of risk abatement is sated?  I submit that this seemingly inapt escape of capital from the very places where capital would be most useful might be the most important leg of the set of international capital flows that have defined our era.  Functional mechanisms for protecting prior gains in emerging economies might be replacing the dysfunctional mechanisms that have kept generations of peasants from access to the possibility of accumulation.

Thursday, April 17, 2014

Hooray for International Capital Flows

Antonio Fatas presents these charts (HT: Mark Thoma) comparing global growth rates  and investment rates among advanced and emerging economies.

It seems to me that this relates to a topic I have touched on here:

And here (with probably a little too much sarcasm):

It looks to me like we have a set of growing emerging markets, who are accumulating their own capital.  But, their own economies are still characterized by high risk premiums.  So, emerging market capital is hungry for a source of low risk income.  Western sovereign debt, low-yield bonds, and real estate fill that need.  So, emerging market capital is moving to the developed world.

And, in return, developed world capital is filling the gap.  American capital, especially, is lured by profitable risk, so our corporations are investing very profitably in emerging markets.  As the Western baby boomer bulge enters their twilight years, we are confronted with a time mismatch between boomer production abilities today and boomer consumption needs in 20 or 30 years.  Part of that mismatch is being bridged through investment in durable property like homes.  Part of that mismatch is being bridged through the investment of boomer savings into emerging economies, where growth of labor output is not as constrained by demographics.  Here is a graph of labor force growth in the US.  This looks like it tracks pretty closely with Antonio Fatas' graph of GDP growth.  Maybe in the US, investment is constrained by the availability of labor.

So, there is this huge, mutually beneficial transfer happening between emerging market capital and developed market capital.  This causes all sorts of problems for politically charged statistics, because, for starters, it makes it look like developed nation capital is capturing a larger portion of production, God forbid.  And, it creates a sustained trade deficit in the US.

But the actual result here is basically what we should have hoped for from global finance.  Risks are being traded off to where they are more appropriate.  And the end result is that huge populations of the world's laborers are being exposed to more opportunities for prosperity.

The increasing wages in these economies, the high growth rates, and the high returns to capital, are all products of improving market-securing institutions.  This is why I hate the subtly incorrect notion that production moves to places with low wages.  Production moves to places with rising wages, not low wages.  From a previous post:
This is basically the problem with developing economies, where institutional improvements make capital investments safer, and foreign investment is lured into the growing economy.  But, since reversals are possible, and trust requires the passage of time, firms require a higher rate of return.  Nations that reverse to poorer institutions will lead to losses for those firms.  In nations that continue to improve, the realized returns of the investing firms will appear to be high.  Over time, as trust is gained, realized returns will settle to a long term reasonable equilibrium.

This is why it appears that production moves to places with low wages, when production really only moves to places with rising wages.  The necessary development of trust creates a lag effect where the higher required returns cause wages to rise more slowly than they would without this long tail risk.  So, there is a period of time where firms earn seemingly oversized profits at the expense of lower wages for the laborers in the developing economy.  Of course, the profits aren't oversized, they are just the payment received for taking on long tail risk with a binary and unpredictable payoff.  This generally calls for a high return, and also tends to produce survivorship bias in hindsight.
 In a way, the ability of US corporations to earn excess profits by moving production to developing economies is very similar to the well-documented momentum effect on individual US stocks.  Markets have a trust-but-verify mentality.  Efficiency means that prices fairly quickly react to new information, but not all the way, because the veracity of new information has its own risk distribution, with its own long tail of failure risk.

CEO's don't necessarily even need to model their investment decisions this way.  These factors will be built into their assumptions about wage growth and other costs, and their heuristics for how risky each location is.  So, they could account for all this and still misunderstand their investment decisions as being the result of moving to places with low wages.

But, it's not the low wages that attract capital.  Improving institutions lead to capital investment and increasing wages.  That's why most capital flows to high wage countries and why Korea and Taiwan are now among them.  That's why low wages aren't drawing capital to Congo, Zimbabwe, and Niger.  And, it's why American inner cities lack retail.

We are living in much better times, globally, than is sometimes acknowledged.

Follow up post.

Wednesday, April 16, 2014

The deceptively strong 1st quarter

With the unemployment rate stuck at 6.7%, where it was in December, one might be tempted to think that the labor market is going through a period of weakness.  It turns out that 2014 1Q has seen a large upswing in labor force participation.  Here is a chart showing the employment-population ratio (EPR) and the labor force participation rate (LFP).

The purple line is the LFP trendline.  In other words, that is what labor force participation would be if the LFP of each age group followed long term trends.  This is what LFP would be without cyclical fluctuations.  So, we can see that LFP has dipped below trend, which is normal for a recession.

The Unemployment Rate is the difference between the EPR and the LFP (with the LFP as the denominator).  What we can see in the graph is that the past 6 months have seen an impressive uptick in both employment and LFP (the downtick in October was related to the government shutdown).  The household survey has reported a gain of over 1.1 million jobs in the 1st quarter.

That little green line at the end is the LFP that would correspond to a 6.0% unemployment rate, given the recorded EPR.  In other words, if LFP hadn't jumped so much this quarter, unemployment would nearly be down to 6.0% in March.

Now, there is a lot of noise in the household data.  But, even if we assume this is noise, and adjust LFP back down to the short term trend, unemployment would have fallen to below 6 1/2% by March, given the statistical relationship between short term noise in the EPR and LFP series.

April 2010 was the last time this sort of jump happened in LFP, and the unemployment rate dropped by 0.5% over the next two months.

The pessimistic reading of this would be that LFP has been running parallel to the trend LFP for the past two years, except that the LFP in 2013 4Q was a negative statistical outlier, so that the reported December 2013 unemployment rate was too low, and now the LFP has recovered to the short term trend.  This interpretation would mean that the current 6.7% unemployment rate isn't inflated, but we would still be looking at a good trend in EPR.

I suspect that this is partly statistical noise and partly a maturation of this cycle, where the LFP will begin to move back toward trend.  In light of the demographic trends, a sideways EPR is enough for a recovery, so if we see a sustained positive trend in EPR, this should be a very good sign for the economy.

Friday, April 11, 2014

Employment Flows

 Just poking around employment flows some more, and I thought I'd share some of the patterns I see.

In the first graph, which shows all the main flows since 1995, we can see three pairs of flows that tend to move together:
Flows between employment and not-in-labor-force (NLF)
Flows between employment and unemployment
Flows between unemployment and NLF.

These pairs basically move in proportion to the number of workers in the common category.  So, flows between E and NLF move up and down with the employment rate.  Flows between U and E move up and down with the unemployment rate.  And, flows between U and NLF move up and down with the number of workers marginally attached to the work force.

What we currently have is the E/NLF and the E/U flows basically back at levels we would see during the mature phase of a recovery.

The one pair that is not healthy is the U/NLF pair, reflecting the large number of workers who are marginally attached to the labor force.  How this recovery phase matures comes down to how this pair of flows behaves.  The trend will definitely be down for both directions of the flow.  The thing to watch will be how quickly it trends down, together with the relative movement of each flow in the pair.

There seems to be some acceleration down, which I would have expected after the end of EUI, but the acceleration downward has come from U to N movement.  I would have expected it to come from N to U movement.  The best case scenario here, which I think there is some hope for, is that N to U flows decline quickly to catch up to recent movement in the U to N flow.  If that happens, the unemployment rate will drop quickly.  Everything is moving in a healthy direction now, so there doesn't appear to be a scenario in the wings that reflects a slowdown in the recovery.

The last graph is looking at the net difference between the opposite flows in each of the flow pairs.  Here we can see that there tends to be a circular flow from NLF to Unemployment to Employment back to NLF - on net.  All three net flows tend to move cyclically, and it seems to me that when all three net flows are declining, this could be a useful leading indicator for a coming recession and labor market hiccup.

Here also, I believe is evidence for my claim that the portion of the decline in the labor force participation rate (LFP) that we can attribute to cyclical factors is as much a product of an unusually high LFP in 2007 as it is of an unusual decline in 2009 & 2010.  There was a little bit of both.  But, the strong net flow from N to E throughout 2005-2007 relative to the flow from U to N, looks like a sign that there was significant opportunistic employment during that period for marginally attached workers.  So, the net flow to NLF we see in 2009-2010 is partially just an unwinding of this opportunistic cyclical employment.

In very recent flows, there is evidence again of unusually high flows from NLF to E.  This is likely to reflect some noise in the data.  But, if this proves to be persistent, it could reflect coming positive pressures on employment, wages, production, interest rates, etc.

PS:  One final graph, showing the relationship between the unemployment rate and the level of continued regular unemployment claims, with beginning and end of EUI noted in each cycle.

Wednesday, April 9, 2014

February JOLTS and March Labor Flows

JOLTS data continue to portray steady recovery.  Hires are still below the 2003 trough, which puts the hires indicator at about the same relative place as the current unemployment rate.  Job openings continues to grow and is back to the levels of 2005 when unemployment was down to 5%.  Quits continue to grow and are back to where they were in 2003 when unemployment was at 6%.

The slopes of all the series continue to be reliably positive, even if not particularly steep.

Flows have been updated through March, and they also continue to show positive trends.  Flows between Employment and Not-in-Labor-Force (NLF) are at a level similar to previous economic peaks, believe it or not.  Flows between Employment and Unemployment are also back to levels associated with unemployment rates at 6% or less, and with a strong bias for flows back into Employment.

The flows between unemployment and NLF are the set of flows that remain elevated.  This is a sign, I believe, of the large pool of long-term unemployed.  Trends in the unemployment rate and other indicators of economic strength over the near term will depend on the outcomes of this group of workers.  I have suspected that we would see a normalization of this group of workers after the end of EUI.  While long-duration unemployment hasn't accelerated downward since the beginning of the year, there does appear to be some downward acceleration in these flows.  In fact, over the last two months, as many unemployed workers became employed as left the labor force.  That's the first time that has happened since 2008.  But, generally, the long term unemployed/NLF group remains a bit of a mystery.

The last graph shows net flows between unemployment and both NLF and Employment, plus the total net outflows from unemployment since 2011.  I expected to see 2014 begin with small outflows from U to N and significant outflows from U to E.   Both flows would have created downward pressure on the unemployment rate.

Instead, we have seen the opposite.  (The pattern in November and December was out of Unemployment, but there wasn't an unusual decline in EUI beneficiaries before the program ended, so this is more likely statistical noise than a trend related to EUI.)  Net outflows to Employment have been slightly under trend and Net inflows from NLF to U have been significantly above trend.

Good news over the longer-term is that, while the net rate of workers leaving unemployment has been very steady at about 110,000 workers a month since the beginning of 2011, hidden in this net figure are two positive, but countervailing trends.  Net movement both back into the labor force and into employment have been trending up.

One last graph is a comparison of JOLTS data with the yield curve spread (10 year minus 1 year treasuries, inverted).  It would be nice to have JOLTS data going further back.  Somewhere, there is some sort of job openings data that goes further back.  Please let me know if you know where this might be free and available on the web.  Both JOLTS data and the yield curve appear to have some value as forward indicators.  The yield curve right now predicts that the yield curve spread will peak in about a year, at a little over 3%, then slowly flatten as we approach 2018-2019.  I don't quite know what to make of this coincident pattern, but it might be interesting to watch over time.