Six years of pain

Six years ago this month, the US economy officially peaked. We didn’t know it till a year later when NBER made the call, but the labor market has never been the same. The unemployment rate crept upward through the summer of 2008, before exploding that fall and reaching double digits the next fall (up from 4.5% in the first half of 2007), several months after the recession officially ended in June 2009. People call that devastating eighteen months the Great Recession, but I prefer to call this whole six years (and counting) the Little Depression because the economy — and the labor market in particular — remains so depressed.

Consider the change from December 2007 to now (or rather to November 2013, the most recent month we have data for):

The adult (age 16+ population) grew by 13,411,000.

Employment shrunk by 1,887,000.

Unemployment rose by 3,262,000.

“Not in labor force” (neither employed nor actively looking for a job) rose by 12,035,000.*

(*And no, most of that does not come from old people retiring. The drop in the employment/population ratio is 4.1 percentage points if you include all of the adult population, and 3.8 percentage points if you include only those in the 25-54 age range.)

Sometimes the numbers really do speak for themselves.

Dammit Janet, I love you!*

I am very pleased with the president’s nomination of Janet Yellen to be the next Federal Reserve Chair. Ms. Yellen has impeccable credentials, the best economic forecasting record of any recent Fed official, and appears to take the regulator part of the Fed Chair job seriously.

This last part is important. Larry Summers, the original front-runner for the job, helped push through the key deregulation of the late Clinton years, has dismissed the idea that it contributed to the bubble or crash, and has basically never admitted a mistake in this area. Alan Greenspan was essentially hostile to financial regulation, and bears as much responsibility as anyone for the housing bubble of the 2000s. Ben Bernanke has acknowledged that the Fed failed as a regulator during the housing bubble, but he was a Fed governor for most of that bubble and Chair for the last two years of it. Economist Bill Black finds Bernanke to have been sorely lacking as a regulator. The Fed’s main regulatory task is to try to detect and reduce systemic risk, i.e., risky activities that threaten the larger financial system and economy. Granted, Yellen told the Financial Crisis Inquiry Commission in 2010 that she failed to see several of those risks (securitization, credit rating agencies, Special Investment Vehicles) when she was San Francisco Fed President in 2004-2010, but on the other hand she was among the first at the Fed to publicly call attention to the housing bubble

Granted, monetary policy, not financial regulation, is the main part of the job. I agree with those who have said she will probably be very similar to Bernanke as far as that goes, and I’d call that a good thing. The Fed needs to do what it can to pull us out of this Little Depression, and since interest rates cannot fall below zero, additional measures like buying long-term bonds and mortgage-backed securities (i.e., quantitative easing, or QE) make sense, as long as they work. Yellen is often stereotyped as a “dove” because in recent years she favored expansionary policy and did not state that inflation was an imminent risk, but those recent years were the Little Depression that began in 2008. When unemployment is not the nation’s biggest problem, Yellen is more concerned about inflation. Such as in the roaring 1990s, when Yellen was Clinton’s Chair of the Council of Economic Advisers and then a Fed governor. With unemployment down to its lowest levels in decades, Yellen was an inflation “hawk,” as Matthew O’Brien details.

Whether the Senate is capable of that much nuance as it considers her nomination remains to be seen. I expect she’ll win majority support, including a handful of Republicans, and that Republicans will resist the temptation to filibuster her nomination. The right-leaning American Enterprise Institute offers several reasons why an anti-Yellen filibuster would be a disaster. Then again, flirting with disaster seems to be the Congressional Republicans’ game plan of late.

PS Here is a recent (Nov 2012) interview with Janet Yellen.

* Title stolen from EconoMonitor, who of course got it from Rocky Horror:

What more could the Fed do? (cont’d)

The New York Times joins the chorus of complaints that the Fed has not done enough to jump-start this stalling economy. In yesterday’s lead editorial the gray lady ruefully notes that Ben Bernanke basically ruled out further quantitative easing when he said at the Fed’s June meeting that it would not happen unless there was a heightened risk of deflation. Then the editorial offers a paragraph’s worth of additional measures the Fed could take. One by one:

‘For starters, the Fed could take modest steps, like shifting its portfolio toward bonds with longer maturities, which would help to keep long-term rates low and nudge investors into riskier investments.’

In other words, QE3, or QE2 on steroids. Normally the Fed targets the shortest of short-term rates (the fed funds rate) and does so through its open market purchases and sales of short-term T-bills. And T-bills are the security of choice because the Fed does not want to make too big a splash (at least not directly) in the markets for particular bonds. The logic here is the reverse: of course the Fed wants to make a splash in the bond market by lowering long-term interest rates — that’s the penultimate goal of monetary policy, behind stimulating business investment and consumer spending. In today’s extraordinary circumstances, ending the Little Depression seems more important than not disrupting the bond market. So it’s hard to argue against this one, other than to note that the Fed would probably be monetizing a lot more of the federal debt than otherwise, which could raise inflation fears. (Of note: In the early 1930s Keynes thought the central banks should buy up long-term debt so as to lower long-term interest rates, too. So this isn’t exactly a new idea.)

‘It could reduce the interest it pays on the banks’ huge reserves or even tax the reserves to try to encourage more lending.’

Absolutely. Reduce it to 0%, which was the rate on reserves prior to 2008. Bernanke’s main rationale paying interest on reserves, as I understand it, was to reassure the markets that the huge pools of bank reserves, which the Fed created in response to the crisis, would not lead to a runaway inflation when the economy began to recover and banks loaned those reserves out. The idea was that as the economy recovered the Fed would “soak up” those reserves by raising the interest rate on them so that banks would be less inclined to loan them out. At this point, however, hardly anyone seem to be worried about the inflation threat posed by those reserves. They’re more worried about how they continue to just sit there. Lowering the rate to zero can only help, though maybe not by much.

‘It could also resume buying Treasuries or other securities to provide additional monetary stimulus.’

This is a lot like the first suggestion. It could get more radical if the “other securities” are things like mortgage-backed securities, in which case it’s more like QE1 (when the Fed effectively bought up many of the toxic subprime securities, thereby taking them off the market). This brings to mind the dramatic proposal by Joseph E. Gagnon of the Peterson Institute for International Economics, which has gotten a lot of attention lately. Gagnon: “First and foremost, the Federal Reserve should announce an additional $2 trillion of asset purchases, including longer-term Treasury bonds, agency mortgage-backed securities (MBS), and foreign exchange. This is more than three times the size of the woefully underpowered quantitative easing of late last year (dubbed QE2) and it should be accompanied by a clear statement that more is forthcoming if the economy continues to underperform.” I haven’t digested Gagnon’s proposal yet, but this is what a radical proposal looks like. Krugman and Brad DeLong seem to like it.

‘A more aggressive strategy would be letting inflation rise above the Fed’s comfort level of 2 percent or so to, say, 4 percent. That could help the economy by easing the repayment of debt.’

This would have promise if the Fed could actually control the rate of inflation like that. As I’ve written before, I don’t think it can, not when the economy is in a depression and seems to be tending on its own more toward deflation than to 4% inflation. The Fed has already flooded the banking system with reserves; when they don’t get loaned out (as so many of them haven’t), they don’t raise aggregate demand, the money supply, or the price level.

In sum: The first two steps seem worth taking, but are probably too modest to have much impact. The third step can be about as big as the Fed wants it to be; it has the most potential, though as with QE1 just moving a lot of assets from the private sector onto the Fed’s balance sheet doesn’t necessarily generate a surge of private investment. The fourth step looks impossible at present, even without the inevitable political resistance to the Fed backing down on inflation.

‘The market is rational and the government is dumb’

The above quote is a favorite of former House Speaker Dick Armey (R-TX). He even used to write it on the blackboard on the first day of class when he was an economics professor. Armey has been out of government for years, but as a founding member of a Tea Party group, he’s been a big influence on that wing of the Republican Party. Not surprisingly, he seems pleased with the pounds of flesh they’ve extracted in the new Budget Control Act of 2011.

Armey and I have different ideas of “dumb.” He favors slashing government spending during our Little Depression and also favors a balanced budget amendment that would supposedly compel further slashing. I think those things are time-tested recipes (the times being 1932 and 1937) for worsening a depression. What do the markets think?

The stock market is on track for its eighth straight day of decline (as of 11:55 a.m., the S&P 500 is down 0.5%, and its biggest drop, 2.6%, was yesterday, when the Budget Control Act finally passed). 10-year Treasury bond prices have been rising, and T-bond interest rates falling, over the same span, now down to 2.57%. How to interpret those numbers?

Hard to do, because nobody (as far as I know) takes scientific polls of market participants to ask them why they did what they did. Armey would probably say, as some commentators have, that stocks have tanked because the $2.1 – 2.5 trillion in cuts over a decade aren’t enough. I would say, as have others, that the market is reacting to the dismal state of the economy and to the likelihood that, as basic macroeconomic theory tells us, the spending cuts will make it even more dismal.

What about bonds? The rosy view would be that T-bond prices have improved because the debt-ceiling vote means no default through 2012 and the spending cuts reduce the overall burden of debt. Armey and I might actually agree that the unrosy view is correct: T-bonds are in higher demand because of a worldwide “flight to safety,” as grim economic news causes people to move away from risky, cyclical assets like stocks and toward safe assets like T-bonds. Again, is the grimmer news the “failure” to slash spending more or the weakening economy?

I’m thinking Armey’s quote fits right now, except it’s the budget bloodletters who are dumb and the markets are rationally reacting by anticipating that they will cause further hemorrhaging of the economy.

P.S. At least one market participant agrees. From the Aug. 2 Financial Times:

‘Jim Reid, strategist at Deutsche Bank, . . . has warned the US could be approaching a “1937 moment” – when authorities removed post-Depression stimuli from still-fragile markets and triggered another recession. This risk, he says, has in fact only been magnified in the markets’ eyes by agreement on raising the US debt ceiling.’

(Hat tip: Brad DeLong)

Fed up with Bernanke?

Greg Mankiw has a good column in today’s NYT in defense of embattled Fed Chair Ben Bernanke. How embattled is Bernanke? Mankiw notes an (admittedly unscientific) online CNBC poll from June, in which the question was “Do you have confidence in the way Ben Bernanke is handling the economy?” 95% of respondents answered no.

Mankiw says the Fed has done basically all it can to combat the Little Depression (unfortunately “all it can” is not enough), while steering clear of high inflation. The core inflation rate in recent years has been just 2%, widely believed to the Fed’s unofficial target inflation rate. Mankiw suggests making that 2% target official, but otherwise sees no obvious room for improvement in Bernanke’s performance.

I tend to agree that Bernanke’s Fed has done about all that monetary policy can do here, but Scott Sumner, one of the more interesting monetary thinkers I’ve come across lately, says the Fed actually has a lot more ammunition in its arsenal and compares the situation to the early 1930s, when the Fed increased the monetary base but needed to do a lot more to stem the massive tide of bank failures and monetary collapse. Unfortunately, I’ve yet to find the specifics of his argument, but I’ll share them with you when I do.

Sumner, by the way, loves the idea of a 2% inflation target and even suggests that Mankiw be appointed to the Fed’s Board of Governors. Maybe Mitt Romney (to whom Mankiw is an adviser) can do that next year.

Yes, kick the can down the road

I don’t say this often, but Eric Cantor is half right. The Republican House Majority Leader’s mantra in the current debate over a long-term budget fix has been “You don’t raise taxes in a recession.” That is good policy advice, and any Keynesian economist would tell you the same. Tax increases lower GDP, indirectly, by lowering people’s disposable income — if they have less money, most people will spend less money, so consumption drops. But any Keynesian economist would also tell you, “Don’t cut spending in a recession.” Cuts in government spending directly lower GDP and indirectly lower it by lowering the consumption of laid-off government workers and government contractors. So neither tax increases nor spending cuts are a good idea in this time of 9.2% unemployment.

(It’s a pity that Cantor doesn’t understand the second part, or pretends not to. But not a surprise. Misrepresenting Keynes is a cottage industry among Republican politicians and pundits. Ezra Klein notes that Cantor wrote in his campaign manifesto of last year that Keynesianism is the theory that “government can be counted on to spend more wisely than the people.” But I digress . . .)

Right now, we’re told August 2 is the deadline for an agreement by Congress to raise the national debt ceiling or face a partial government shutdown in which some Treasury bondholders, government employers, government contractors and/or other government creditors won’t get paid. I’ve written again and again that the whole concept of a debt ceiling is self-destructive and a waste of time — and, as usual, The Onion says it better than I ever could — but the “grand bargain” that the president seeks could easily be self-destructive as well. Both Democrats and Republicans say they want to pass a long-term deficit reduction plan that reduces the national debt by several trillion dollars over the next decade. That’s fine in a broad sense, as health care costs continue to jump by leaps and bounds, two wars continue to drain our resources, and federal taxes as a share of GDP are at their lowest level in a half-century. But if the tax increases and spending cuts kick in while the economy is still in this Little Depression, with unemployment well above its normal range of 5-7%, then the grand bargain becomes a starvation diet.

If we could just fine all politicians and pundits a dollar each time they say “we can’t afford to kick the can down the road any more,” we could pay off the national debt. Barring that, we can at least question that bit of conventional wisdom, telling them, no, it’s not a good idea to raise taxes or cut spending while the economy is still in the tank, and any plan to do either or both that kicks in while unemployment is still above 7% is a bad one. Worse than defaulting on the government’s obligations? Probably not. But a lot worse than doing nothing on both fronts.