Jobs, Growth and the Stimulus

Jobs, Growth Slowdown and the Stimulus

Carlos M. Pelaez

The objective of this post is to analyze the need for a shift in government policy in the US. The stimulus strategy is analyzed in (I) in terms of general strategy, monetary policy (IA) and fiscal policy (IB). The report on the employment situation with 27 million people in continuing job stress is discussed in (II). There is a comparison of growth and job creation in four US recessions in (III). Financial turbulence is discussed in (IV), economic indicators in (V) and interest rates in (VI). The conclusion is in (VII). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Stimulus Strategy. The monetary and fiscal stimulus of the US government has extended over two administrations, the Federal Reserve and Treasury. There are two different aspects of government policy working in opposite directions of growth and jobs: the objective and size of the stimulus and parallel restructuring/regulatory shocks. First, the objective of the combined stimulus is to turn around the economy, creating the conditions for the private sector to grow and create jobs. The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by March 2009 to $11.6 trillion committed and $3.0 trillion used by September 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc# see Pelaez and Pelaez, Regulation of Banks and Finance 224-7, Financial Regulation after the Global Recession, 157-70). The Federal Reserve total commitment by September 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. The role of the government should be to provide the institutions and governance rules that facilitate private sector activities that increase the productivity of the economy, or output per unit of input, by innovation or new forms of production and the organization of productive activities (Pelaez and Pelaez, Government Intervention in Globalization, 1-12). Second, content with the supposition that the fiscal stimulus would be sufficient to promote growth and job creation, government policy engaged in profound and complex legislative restructurings, regulatory shocks and mandates that changed significantly the existing organizational and operational models of private sector business of all sizes. The largest fiscal deficits since World War II create the specter of an unsustainable government debt. The eventual unwinding of the monetary stimulus by the Fed together with the burden of the government debt creates the expectation of large, widespread tax increases and higher interest rates. The result of this inopportune profound change is uncertainty in decisions of investment by business and families and hiring by business of all sizes. Even if the massive stimulus helped partially to turn around the economy, which is debatable, the inopportune change and expectations of higher taxes and interest rates flatten the growth path of the economy and perpetuate high rates of unemployment and underemployment.

IA Monetary Policy. A major threat to growth is the unwinding of the $1.9 trillion of long-term securities purchased by the Fed with resulting increase in long-term interest rates and the eventual increase of short-term interest rates from the current level of 0 to 0.25 percent for the fed funds rate. Fed policy has consisted of three measures: (1) fixing the fed funds rate near zero; (2) credit facilities; and (3) quantitative easing. First, the Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years (http://www.federalreserve.gov/fomc/fundsrate.htm ). The policy counterfactual posits that the credit crisis originated in four excessive types of stimuli in 2001-2004 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining that rate indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. Second, the Fed used about 11 facilities of monetary policy during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Third, when policy interest rates are near zero, the central bank can manage its balance sheet by purchasing long-term securities. This quantitative easing can rebalance investment portfolios, causing increases in prices of long-term securities. The resulting decline in long-term interest rates could increase investment and stimulate economic recovery as analyzed by Ben Bernanke and Vincent Reinhart (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 103-7). The current balance sheet of the Fed is bloated to $2.3 trillion with a portfolio of long-term securities of $1.9 trillion, consisting of $712 billion of Treasuries, $159 billion of federal agency debt securities and $1117 billion of mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ).

IB Fiscal Policy. The strategy was for Congress to appropriate close to $1 trillion of government spending and then concentrate on the profound restructuring of the economy by complex legislation and regulation. The cornerstone of fiscal policy was the American Reinvestment and Recovery Act of 2009 (ARRA) with initial appropriated investment of $787 billion, consisting of tax cuts, incentives to investment, support to people affected by the recession, aid to states and direct investment by the government (http://www.whitehouse.gov/sites/default/files/microsites/Estimate-of-Job-Creation.pdf ). The intention of ARRA was “to save and create jobs, as well as to cushion the economic downturn and make crucial public investments. The Administration has summarized the results by looking at the number of jobs (relative to the baseline) as of 2010Q3. Our finding was that the ARRA would increase employment relative to the baseline in this quarter by approximately 3.5 million” (Ibid, 2-3). The Council of Economic Advisors (CEA) finds in its report of Jul 14, 2010, that “the ARRA has raised employment relative to what it otherwise would have been by between 2.5 and 3.6 million” and that “ARRA has raised the level of GDP as of the second quarter of 2010, relative to what it otherwise would have been by between 2.7 and 3.2 percent” (http://www.whitehouse.gov/files/documents/cea_4th_arra_report.pdf ). The “what it otherwise would have been” is a counterfactual on which there will never be proof (on counterfactuals see Pelaez and Pelaez, Globalization and the State, Vol. I, 17, 124-5).

II Employment Situation. The possibility of failure of the stimulus policy is shown by the dire employment situation in the US. For many people willing to work the recession has not ended and the rest fear the uncertainty of losing their jobs or low salaries and wages in a weak labor market. The alleged long-term benefits of the legislative restructuring and regulatory shocks may constitute a tradeoff consisting of persistent unemployment and underemployment. The monthly report on employment by the Bureau of Labor Statistics (BLS) continues to show 27 million people in job stress in July: 14.6 million unemployed (of whom long-term unemployed of 6.6 million or 44.9 percent who have been unemployed more than 27 weeks), 8.5 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). Total nonfarm payroll employment fell by 131,000 in July, the unemployment rate remained at 9.5 percent, 143,000 temporary workers finished their job for 2010 census and “private-sector payroll employment edged up by 71,000” (Ibid, 1). The average work week for employees on nonfarm payrolls reached 34.2 hours for an increase of 0.1 hour and hourly earnings grew by 4 cents, or 0.2 percent, reaching $22.59 in July. Private sector job creation was reduced to only 31,000 in Jun while the overall loss of jobs was revised to 221,000.

III Growth Slowdown and Jobs. The growth rate and job creation in the expansion of the economy away from recession are subpar in this recession compared to others in the past. Four recessions and their corresponding job creation are considered below, following the reference dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles/cyclesmain.html ): 1957-1958, 1973-1975, 1981-1983 and the ongoing 2008-2010. The data for the three earlier contractions illustrate that the growth rate and job creation in the current 2008-2010 recession are inferior. The two sharp recessions of 1957 and 1958 are considered in Tables 1 and 2. The data in Table 1 show the Bureau of Economic Analysis (BEA) quarter-to-quarter, seasonally adjusted (SA), yearly-equivalent growth rates of GDP. The 1950s recession had negative growth rates ranging from -1.0 percent to -10.4 percent followed by growth rates ranging from 8.3 percent to 10.5 percent. The 1970s recession had growth rates ranging from -1.6 percent to -4.8 percent followed by growth rates ranging from 3.1 percent to 9.4 percent in 1Q76 (not shown in the table because of space limitations, see http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Qtr&FirstYear=1973&LastYear=1977&3Place=N&Update=Update&JavaBox=no ).

 

Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Quarter	1957	1958	1959	1973	1974	1975
I	2.5	-10.4	8.3	10.6	-3.5	-4.8
II	-1.0	2.5	10.5	4.7	1.0	3.1
III	3.9	9.7	10.5	-2.1	-3.9	6.9
IV	-4.1	9.7	-0.5	3.9	-1.6	5.3

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&Freq=Qtr&FirstYear=2008&LastYear=2010 

 

Table 2 provides the number of monthly change in jobs also seasonally adjusted. Large losses in jobs during the recession were followed by large increases in jobs. The US economy, similar to those of other countries, has been able to recover growth and jobs in past recession by expansion paths resembling V shapes. 

 

Table 2, Monthly Change in Jobs, Numbers SA

Month	1957	1958	1959	1973	1974	1975
Jan	-42	-308	393	350	69	-360
Feb	210	-501	206	397	149	-378
Mar	58	-276	329	269	42	-270
Apr	92	-274	304	170	89	-186
May	-89	-114	229	190	163	160
Jun	-83	-1	129	240	55	-104
Jul	56	125	125	25	32	249
Aug	6	106	-466	255	-15	386
Sep	-196	283	91	115	-5	78
Oct	-167	-21	-69	324	13	303
Nov	-208	458	276	304	-368	144
Dec	-172	145	540	126	-602	338

Source: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet 

 

The corresponding data for the 1980s recession and the recession after 2008 are shown in Tables 3 and 4. The NBER dates another recession in 1980 that lasted about half a year. If the two recessions of the 1980s and after 1981 are combined, the impact on lost GDP is comparable to the revised 4.1 percent drop of the recession in 2008-2009. The recession in 1981-1982 is quite similar on its own to the 2008-2009 recession. Table 3 provides the BEA quarterly growth rates of GDP in SA yearly equivalents. There were four quarters of contraction in 1981-1982 ranging in rate from -1.5 percent to -6.4 percent and five quarters of contraction in 2008-2009 ranging in rate from -0.7 percent to -6.8 percent. The striking difference is that in 2Q1983 GDP grew at the pace of 9.3 percent while struggling to grow at 2.4 percent in 2Q2010. Inventory change contributed to initial growth but was rapidly replaced by growth in investment and demand in 1983. The key difference may be found in the negative incentive to business and household investment and business hiring from the structural shock to business models resulting from legislative restructuring with alleged benefits in the long-term but adverse short-term growth and jobs effects.

 

Table 3, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Quarter	1981	1982	1983	2008	2009	2010
I	8.6	-6.4	5.1	-0.7	-4.9	3.7
II	-3.2	2.2	9.3	0.6	-0.7	2.4
III	4.9	-1.5	8.1	-4.0	1.6
IV	-4.9	0.3	8.5	-6.8	5.0

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&Freq=Qtr&FirstYear=2008&LastYear=2010 

 

The monthly change in jobs in the 1980s and the current recessions are provided in Table 4. Rapid growth resulted in accelerated job creation in 1983 while the economy in 2010 is maintaining 27 million people in job stress. The final column in Table 4 shows the mediocre job creation by the private sector that is frustrated by legislative restructuring, regulatory shocks and mandates and expected major increases in taxes and interest rates. 

 

Table 4, Monthly Change in Jobs, Numbers SA

Month	1981	1982	1983	2008	2009	2010	Private
Jan	95	-327	225	-10	-779	14	56
Feb	67	-6	-78	-50	-726	39	62
Mar	104	-129	173	-33	-753	208	158
Apr	74	-281	276	-149	-528	313	218
May	10	-45	277	-231	-387	432	74
Jun	196	-243	378	-193	515	-221	31
Jul	112	-343	418	-210	-346	-131	71
Aug	-36	-158	-308	-334	-212
Sep	-87	-181	1114	271	-225
Oct	-100	-277	271	-554	-224
Nov	-209	124	352	-728	64
Dec	-278	-14	356	-673	-109

Source: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet 

http://www.bls.gov/schedule/archives/empsit_nr.htm#2010

 

IV Financial Turbulence. Four economic and policy factors have caused significant financial turbulence: (1) doubts on the growth of China, affecting commodity prices and interregional trade in Asia; (2) sovereign risk problems and bank exposures in Europe; (3) growth and job slowdown in the US; and (4) legislative restructuring in the US. In addition, the carry trade from the near zero short-term interest rate imposed by the Fed to high-risk exposures in commodities, exchange rates and equities is a major cause of harmful financial turbulence in global financial markets (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). Table 5 provides a summary of turbulence in stocks, commodities, the dollar and Treasury yields. The columns provide the dates of the recent peaks and troughs of financial variables and the percentage change from recent peak to trough, peak to Aug 6 and change in the week ending on Aug 6. There has been significant recovery in global equity markets, appreciation followed by depreciation of the dollar and increase in commodity prices. The uncertainty is reflected in the decline of the 10-year Treasury yield from 3.9866 on Apr 5 to 2.822 on Aug 6 in what appears a “realize profit and run” strategy with use of high-quality fixed income securities as temporary haven from financial turbulence.

 

Table 5, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	% Trough	% 8/6	Week 8/6
DJIA	Apr 26	Jul 2	-13.6	-4.9	1.8
S&P 500	Apr 23	Jul 2	-16.0	-7.9	1.8
NYSE Fin	Apr 15	Jul 2	-20.3	-10.3	1.3
Dow Global	Apr 15	Jul 2	-18.4	-8.6	2.8
Asia Pacific	Apr 15	Jul 2	-12.5	-4.5	2.7
Shanghai	Apr 15	Jul 2	-24.7	-16.0	0.8
Europe STOXX	Apr 15	Jul 2	-15.3	-7.4	1.4
Dollar	Nov 25	Jun 25	22.3	13.9	-1.8
UBS Com	Jan 6	Jul 2	-14.5	-6.7	0.8
10 Year T	Apr 5	Aug 6	3.986	2.822

Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3004 

 

V Economic Indicators. The expansion of the economy continues but at slower pace. The Jul index of business conditions of the Institute for Supply Management (ISM) appears stable with a decline of only 0.7 point but the leading indicator of new orders declined by 5 points and inventories increased by 4.4 points, suggesting drops in new orders and sales (http://www.ism.ws/ISMReport/MfgROB.cfm See http://blogs.ft.com/econoclast/2010/08/02/ism-survey-confirms-sharp-slowdown-in-us-economy/#more-101 ). All major economies, with the exception of Germany, are experiencing slower expansion of industrial activity (http://blogs.wsj.com/economics/2010/08/02/world-wide-factory-activity-by-country-7/ ). The nonmanufacturing index of the ISM gained 0.5 point in Jul while new orders gained 2.3 points and inventories declined by 3 points, which is much better at the margin than the index for industry (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Construction spending increased 0.1 percent in June relative to May partly because of revisions but the cumulative value in the first six months of 2010 fell by 11.2 percent relative to the same period in 2009 (http://www.census.gov/const/C30/release.pdf ). New orders for manufactured goods fell 1.2 percent in Jun after dropping 1.8 percent in May (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Personal income and personal consumption expenditures were flat in Jun (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). The Fed estimates that consumer credit fell at the annual rate of 3.25 percent in the second quarter, revolving credit dropped at the annual rate of 9.5 percent and nonrevolving credit was flat (http://www.federalreserve.gov/releases/g19/Current/ ). The index of pending home sales of the National Association of Realtors (NAR) fell 2.6 percent in Jun and 18.6 percent relative to Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/08/pending_ease ). Initial jobless claims seasonally adjusted increased by 19,000 in the week ending Jul 31 to reach 479,000. The unadjusted claims were much lower at 399,570, decreasing by 14,247 while they were at 466,695 in the comparable 2009 week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).

VI Interest Rates. The yield curve of Treasuries continues to shift downward with the 2-year declining to 0.51 percent from 0.55 percent a week ago and 0.62 percent a month ago and the 10-year falling to 2.82 percent from 2.91 percent a week ago and 3.01 percent a month ago. The10-year government bond of Germany traded at 2.51 percent for negative spread relative to the comparable Treasury of 0.31 percent (http://markets.ft.com/markets/bonds.asp?ftauth=1281275606639 ). There is evident parking of cash in government securities and cash-rich balance sheets of corporations. There could be several factors combined or in isolation that can channel that cash into risk exposures again in a relief rally before the end of the year that could be magnified by M&A using corporate cash and leverage to benefit from consolidation opportunities: (1) increase in the growth rate of the economy and job creation; (2) policy shift more attentive to encouraging business and household investment and business hiring; and (3) election results. Interest rates could climb much faster than they declined not only because of the flows into riskier assets but also because of continuing high deficits and the Fed balance sheet. Financial turbulence is far from over with the threat of continuing growth slowdown and persistent job stress of 27 million persons.

VII Conclusion. There is evident need for a policy shift to promote growth and job creation by encouraging investment by business and households and hiring by business. Combining many conflicting short-term and long-term objectives may result in far many targets than available effective policy instruments. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

The Slowing Economy and the Stimulus Debate

 

The Slowing Economy and the Stimulus Debate

Carlos M. Pelaez

The rate of growth of the US economy has declined from 5 percent in the final quarter of 2009 to 3.7 percent in the first quarter of 2010 and 2.4 percent in the second quarter of 2010. Various economic indicators suggest deceleration. The objective of this post is to relate the slowing economy to the growing debate on the effectiveness of the fiscal stimulus and restructurings of major segments of economic activity. The slowing economy is analyzed in (I) by means of new data and comparisons with a similar earlier recession. The essence of the stimulus debate is considered in (II). Financial turbulence is illustrated with data in (III), economic indicators in (IV) and interest rates in (V). The conclusion is in VI.

I Slowing Economy. The Bureau of Economic Analysis (BEA) of the Department of Commerce released the National Income and Product Accounts on Jul 30 together with important revisions for 2007-2010 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp2q10_adv.pdf ). Economic activity is measured by GDP or product accounts and expressed in quarter to quarter percentage changes that are adjusted for seasonality and converted into an equivalent annual rate. GDP increased at the seasonally-adjusted annual rate of 2.4 percent in the second quarter of 2010, which is the rate equivalent to growth from the first into the second quarter that would occur if repeated over four quarters, adjusting for seasonal factors in the second quarter. Table 1 shows three blocks of data. The first block provides the GDP rate in the quarters of recession and in recovery from the third quarter of 2008 (3Q08) to the latest preliminary estimate for the second quarter of 2010 (2Q10). A common misleading statement is to compare the current recession, with the grandiose title of the “Great Recession,” to the Great Depression of the 1930s, in efforts to propose or defend policies. Systematic review of the rich academic literature on the 1930s reveals two entirely different economic contractions (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217). In both the current recession and the Great Depression, government policy was important in causing the recession. There is still time to reverse policy so that it does not prolong unemployment and idle capacity while implementing damaging regulation as it actually happened in the 1930s. During the contraction of the 1930s, real GDP declined in four consecutive years: -8.6 percent in 1930, -6.4 percent in 1931, -13.0 percent in 1932 and -1.3 percent in 1993 for cumulative decline of -26.5 percent (BEA cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The most relevant period for comparison of the current situation is not with the Great Depression much the same as pointed out by Franco Modigliani relative to a speech in 1981 in which President Reagan “began by suggesting that ‘we are in the worst economic mess since the Great Depression,’ a statement than an objective review of the situation would find highly exaggerated” (Franco Modigliani, Reagan’s economic policies: a critique. Oxford Economic Papers 40 (3), 399). The decline of output in the current recession is now estimated by the BEA at -4.1 percent. The correct comparison is precisely with the early 1980s as shown in Table 1 and routinely analyzed in this blog as well as by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748703995104575389430430274968.html

). The main reason is not to compare different approaches to policy to score partisan political points but rather to compare the deepest contraction in recent times, which had similar depth and global spread. The causes and resolutions of both crises and their dimensions were different. There is also hope in the comparison because the economy never recovered from the Great Depression, maintaining high idle capacity and double-digit unemployment rates (Harold Cole and Lee Ohanian cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7) but the expansion phase in the 1980s was in the desired V shape with eventual recovery of employment.

The second line of Table 1 shows that the contraction occurred in four quarters from 3Q08 to 2Q09 at high annual equivalent rates for cumulative -4.1 percent. The third line of Table 1 shows similar rates of contraction also in four quarters. The hope in Table 1 is in the last line 6 showing rates of GDP growth between 7.1 percent and 9.3 percent in five consecutive quarters preceded by 5.1 percent in 3Q08 and followed by rates in excess of 3 percent after 3Q84. The rates of GDP growth in line 2 after the recovery began in 3Q09 are mediocre so far: 1.6 percent in 3Q09, 5.0 percent in 4Q09, 3.7 percent in 1Q10 and 2.4 percent in 2Q10. In the first year of strong recovery the rate of growth jumped from 2.2 percent in 2Q82 to 9.3 percent in 2Q83 while in the current recession the rate of growth has increased from a decline of -0.7 percent in 2Q09 to 2.4 percent in 2Q10. These rates of growth if continued will not solve the worrisome labor market conditions in the US.

Table 1, GDP Seasonally Adjusted Annual Rates %

3Q08	4Q08	1Q09	2Q09	3Q09	4Q09	1Q10	2Q10
-4.0	-6.8	-4.9	-0.7	1.6	5.0	3.7	2.4
2Q81	3Q81	4Q81	1Q82	2Q82	3Q82	4Q82
-3.2	4.9	-4.9	-6.4	2.2	-1.5	0.3
1Q83	2Q83	3Q83	4Q83	1Q84	2Q84	3Q84	4Q84
5.1	9.3	8.1	8.5	8.0	7.1	3.9	3.3

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2007&LastYear=2008&Freq=Qtr

 

The “headline” number of GDP of 2.4 percent growth in 2Q10 is disappointing but detailed analysis of the data in Table 2 reveals some hope. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points (pp) only in a few quarters: 3.5 in 2Q83, 3.1 in 4Q83 and 5.1 in 1Q84. Growth was driven by personal consumption expenditures and fixed investment. Table 2 provides the critical breakdown of the contributions to the rate of GDP growth by segments. Change in inventories was a major driver of GDP growth in 4Q09, 2.83 pp, accounting for most of gross investment of 2.7 pp, and 2.64 pp for inventory change with 3.044 pp for gross investment in 1Q10. Restocking decreased in 2Q10 with change in inventories contributing 1.05 pp. Personal consumption expenditures (PCE) have contributed positively in all quarters, including 1.15 pp in 2Q10. The doubt is whether PCEs will continue to be strong in current uncertainty and weak labor markets. An important item is net exports that had a negative contribution of -2.78 pp in 2Q10. The BEA report measures an increase of 10.3 percent in real exports of goods and services in 2Q10 relative to 11.4 percent in 1Q10 but an increase in real imports of goods and services of 28.8 percent in 2Q10 relative to 11.2 percent in the prior quarter.

Table 2, Percentage Point Contributions to the Growth Rate of GDP

Segment	3Q09	4Q09	1Q10	2Q10
Total	1.6	5.0	3.7	2.4
PCE	1.41	0.69	1.33	1.15
Gross Investment	1.22	2.7	3.044	3.14
Fixed Investment	0.12	-0.12	0.39	2.09
Change Inventories	1.1	2.83	2.64	1.05
Net Exports	-1.37	1.9	-0.31	-2.78
Gov	0.33	-0.28	-0.32	0.88

Source: same as Table 1.

 

There is growth and recovery but it is not enough relative to what is required for job creation. Table 3 provides comparison of unemployment and the fiscal position of the US currently and in the 1980s. The second block of numbers provides both hope and caution. The rate of unemployment rose from 7.6 percent in 1981 to 9.6 percent in 1983 but collapsed to 7.5 percent in 1984 and then to 5.5 percent in 1988. It takes time in recovering employment from sharp contraction even with rates of growth in five consecutive quarters ranging from 7.1 to 9.3 percent; high sustained rates of economic growth must be maintained in providing relief to job stress. Table 3 also shows that the current deficits as percent of GDP have been much higher after 2009, actually the highest since World War II and around 10 percent of GDP, while the deficits in the 1980s peaked at 6.0 percent in 1983 and declined to 3.1 percent by 1988. Government revenue remained at close to the historical average of 18 percent of GDP in the 1980s while it collapsed to slightly below 14.8 percent in 2009 and 14.9 percent in 2010. Government expenditures or outlays increased to 24.7 percent of GDP in 2009 and 24.3 percent in 2010. The projections of expenditures and outlays after 2012 are from the alternative scenario of the Congressional Budget Office (CBO) to illustrate the argument that bringing government revenue above 20 percent of GDP to meet expenditures of more than 20 percent of GDP may be unfeasible and could cause a long-term path of unsustainable government debt. Continuing stress in labor markets will coincide with a tough fiscal situation.

Table 3, Rate of Unemployment and Deficit, Outlays and Revenues as Percent of GDP

	2007	2008	2009	2010	2011	2012	2013	2014
Un	4.6	5.8	9.3	9.5J
Deficit	-1.2	-3.2	-9.9	10.0	-9.2	-5.6	-4.2	-3.9
Exp	19.6	20.7	24.7	24.3	24.5	22.9	22.6	22.8
Rev	18.5	17.5	14.8	14.9	16.9	17.6	18.2	18.7
	1981	1982	1983	1984	1985	1986	1987	1988
Un	7.6	9.7	9.6	7.5	7.2	7.0	6.2	5.5
Def	-2.6	-4.0	-6.0	-4.8	-5.1	-5.0	-3.2	-3.1
Exp	22.2	23.1	23.5	22.2	22.8	22.5	21.6	21.3
Rev	19.6	19.2	17.5	17.3	17.7	17.5	18.4	21.3

Source:

http://www.bls.gov/cps/cpsaat1.pdf

http://www.whitehouse.gov/omb/budget/Historicals/

https://www.cbo.gov/doc.cfm?index=11659

 

II Stimulus Debate. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). The economic strategy for job creation in the short run consists of the American Recovery and Reinvestment Act of 2009 (ARRA) with fiscal stimulus of $787 billion. The Council of Economic Advisors (CEA) finds in its report of Jul 14, 2010, that “the ARRA has raised employment relative to what it otherwise would have been by between 2.5 and 3.6 million” and that “ARRA has raised the level of GDP as of the second quarter of 2010, relative to what it otherwise would have been by between 2.7 and 3.2 percent” (http://www.whitehouse.gov/files/documents/cea_4th_arra_report.pdf ). Counterfactual claims consist of empirical issues that are quite difficult to measure such as “what would have been otherwise.” These counterfactuals abound in economics but are almost impossible to prove rigorously (Pelaez and Pelaez, Globalization and the State, Vol. I, 17, 124-5). In this case, proving that the stimulus “saved” millions of jobs requires detailed data on the US economy with and without the stimulus while data are only observed with the stimulus and it is very difficult to separate the effects of alternative hypotheses. Persistent high unemployment raises doubts on the effects of the fiscal stimulus. There is a widely anticipated tax increase after the November elections to recover the fiscal credibility of the US. The effects of legislated taxes on the rate of growth of GDP are extremely difficult to measure because many other variables influence GDP growth such as monetary policy, natural disasters and expectations and so on. The professional literature has been enriched by a current essay by Christina D. Romer and David H. Romer (The macroeconomic effects of tax changes: estimates based on a new measure of fiscal shocks. American Economic Review 100 (Jun 2010): 763-801 http://elsa.berkeley.edu/~dromer/ ). They created a sample that intends to isolate legislated tax changes that would be “exogenous,” or unrelated to other factors that simultaneously affect GDP growth. A similar method is used revealingly by Romer and Romer to measure lags of monetary policy effects on income and prices (A new measure of monetary shocks: derivation and implications. American Economic Review 94 (4): 1055-84 cited in Pelaez and Pelaez, Regulation of Banks and Finance, 102). The major finding in the 2010 essay by Romer and Romer is that “our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent. We find suggestive evidence that tax increases to reduce an inherited budget deficit do not have the large output costs associated with other exogenous tax increases” (The macroeconomic effects of tax changes, 799). Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. There is active debate on the fiscal stimulus that is surveyed by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704720004575376923163437134.html?mod=wsjproe_hps_LEFTWhatsNews ). This debate will be actively reviewed by future posts in this blog. Sudden regime change can be highly disruptive. The economy of Russia in transition to freer markets declined throughout most of the 1990s with -14.5 percent in 1992 and -12.7 percent in 1994 (Pelaez and Pelaez, Government Intervention in Globalization, Vol. II, 102-5). The legislative restructurings, regulatory shocks and mandates impose radical changes in the way of making business that is affecting investment decisions by business and families as well as hiring decisions. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. There is a conflict between economic recovery and structural changes for alleged long-term benefits that disrupt current economic activity, creating a perverse tradeoff of persistent high unemployment now for alleged benefits decades ahead.

III. Financial Turbulence. Financial turbulence has moderated in the past two weeks. Investors remain cautious by managing positions more actively instead of sitting on positions based on anticipated trends. The percentage performance of major US indices to Jul 30 was: DJIA -6.6 from the recent peak on Apr 26 and 0.4 in the week; S&P 500 -9.5 from the recent peak on Apr 23 and -0.1 in the week; and NYSE Financial -11.4 since Apr 15 and 2.3 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 30 was: Dow Global -11.1 and 1.0 in the week; Dow Asia Pacific TSM -7.0 and 1.3 in the week; Shanghai -16.7 and 2.5 in the week; and STOXX Europe 50 -8.7 and 0.2 in the week. The euro moved sideways, trading at $1.3045/EUR on Jul 30. The dollar has gained 16.0 percent relative to the euro since the recent trough on Nov 25, 2009, and dropped -1.0 percent in the week. The DJ UBS commodity index fell 7.4 percent since the recent peak on Jan 6 and gained 3.3 percent in the week. The 10-Treasury traded at 2.905 percent on Jul 23 as funds flowed back into risk positions. There are still risks in the world economy from possible slowdown in China that could affect commodities and interregional trade in Asia; sovereign risks in Europe and doubts on bank exposures to countries with troubled debt; and the worldwide impact of US slower growth and persistent unemployment.

IV Economic Indicators. Real estate continues to be weak and the economy is advancing at a modest pace relative to past recovery from a sharp contraction. New home sales in Jun stood at the seasonally adjusted annual rate of 330.000, jumping by 23.6 percent relative to the revised rate of 267.000 for May 2010 but still below by 16.7 percent of the rate in Jun 2009 (http://www.census.gov/const/newressales.pdf ) and 76.0 percent below the rate of 1,374,000 in Jun 2005 (http://www.census.gov/const/newressales_200506.pdf ). Durable goods orders are very volatile, especially the transportation component with aircraft segments, posing difficulty in identifying trends. New orders for manufactured durable goods fell by 1 per cent in Jun after a fall of 0.8 percent in May. The decline excluding transportation was 0.6 percent and 0.7 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). The Beige Book of the Fed finds continuing growth in economic activity, with some districts reporting steady economic activity and moderate growth in districts reporting improvement (http://www.federalreserve.gov/fomc/beigebook/2010/20100728/default.htm ). Initial claims of unemployment insurance stood at 457,000 in the week ending Jul 24, falling 11,000 from the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Initial claims have stabilized around 450,000 in 2010, suggesting weak labor market conditions. The Chicago ISM index of business jumped from 61.5 in Jun to 64.9 in Jul, suggesting growth from the earlier month (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20July%202010.pdf ).

V. Interest Rates. The yield curve of the US shifted downwardly with the 10-year Treasury falling to 2.91 percent from 2.99 percent a week ago and 2.94 percent a month ago because of the use of Treasuries and highly-graded fixed income securities as safe haven from risk exposures. The 10-year German government bond traded at 2.66 percent with negative spread relative to the 10-year Treasury of 25 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1280673329435 ). The US yield curve continues to show a peculiar shape of yields: 0.14 percent for 1 month, 0.20 percent for 6 months, 0.55 percent for 2 years, 1.60 percent for 5 years, 2.91 percent for 10 years and 3.99 percent for 30 years (Ibid). The 2007-2009 credit crisis and global recession were caused by prolonged low interest rates near zero by the Fed in 2003-2004, artificial lowering of mortgage rates, housing subsidy of $221 billion per year and purchase or acquisition of $1.6 trillion of nonprime mortgages by Fannie and Freddie (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). Interest rates are again near zero with the added policy restriction of the Fed balance sheet of $2.308 trillion that includes a portfolio of $2.043 trillion of long-term securities ($712 billion of US Treasury bonds and notes, $159 billion of Federal agency debt securities and $1117 billion of mortgage-backed securities) (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The recovery is not only threatened by widespread and high tax increases but also by interest rate increases as the Fed unwinds more than two trillion dollars of securities acquired to lower long-term interest rates. There may be merit in explaining the surge of commodity prices in the carry trade of shorting the dollar and buying commodity futures that was induced by the zero interest rate on fed funds (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The rise of oil to $149/barrel in 2008 during a major world crisis can only be explained by carry trade positions; the decline to less than $60/barrel can only be explained by the unwinding of those positions. Exotic monetary policy has complicated the recovery and threatens its strength. The President of the Federal Reserve Bank of St. Louis warns that the US may be caught in a near zero nominal interest rate and deflationary steady state similar to that of Japan if it continues to maintain a low nominal interest rate (http://www.stlouisfed.org/ ). Policy could consist of increasing the nominal interest rate to 2.8 percent consistent with inflation of 2.3 percent that is attained at the intersection of the Irving Fisher equation relating real rates of interest to the nominal interest rate discounted by the expectation of inflation and the Taylor Rule relating the central bank policy rate, or fed funds rate, to inflation, the deviation of output from trend and the discrepancy of inflation from the target inflation desired by the central bank (John B. Taylor cited in Pelaez and Pelaez, Regulation of Banks and Finance, 111). There is a tough adjustment of monetary policy facing the Fed and other central banks around the world. Experimenting with exotic policy should be reserved for working papers.

VI Conclusion. The US is fighting a perverse tradeoff of continuing unemployment or underemployment of 27 million persons with a rush during a tough recovery of economic activity of legislative restructurings, regulatory shocks and mandates. A policy shift could move the economy toward higher growth rates and job creation. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

The Rise of the Era of Uncertainty

The Rise of the Era of Uncertainty
Carlos M Pelaez

“All human planning and execution involve uncertainty, and a rational social order can be realized only if all persons have a rational attitude toward risk and chance,” Frank H. Knight (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565).

The objective of this post is to relate uncertainty as widely perceived today to the frustration of investment by business and individuals and the weakening hiring decisions by small and large business. (I) relates the work of Frank Knight and the era of uncertainty, (II) provides the information on financial turbulence and (II) and (IV) evaluate economic indicators and interest rates. (V) concludes.

I Frank Knight and The Era of Uncertainty. The economist Frank H. Knight considered in his 1921 classic opus Risk, Uncertainty, and Profit three different types of probability (http://www.econlib.org/library/Knight/knRUP6.html#Pt.III,Ch.VII ). First, a priori probability is explained by the example of tossing the perfect die that will show a given number one-sixth of the time (see William Feller, An introduction to probability theory and its applications. Wiley, 1968, 7-25). Second, there is the work of actuarial science in insurance in which past information is used to calculate the fair premium. The present value of the actuarially fair premium is equal to the expected costs of the benefits to be received from the plan, or costs weighted by probability of occurrence, if the load, or administrative costs, is assumed to be zero. Knight finds that the distinguishing characteristic of this type is that “it rests on an empirical classification of instances” (Ibid). Third, there is what Knight calls “estimates,” for which “there is no valid basis of any kind for classifying instances” and constitute an “uncertainty” (Ibid). Knight argues that “an uncertainty which can by any method be reduced to an objective, quantitatively determined probability, can be reduced to complete certainty by grouping cases.” The process of Value at Risk (VaR), measuring the maximum loss in a target horizon for a desired level of confidence, could fit into this category (Pelaez and Pelaez, International Financial Architecture, 106-12). For example, JP Morgan Chase reports a decline of the investment bank trading VaR from $170 million in 2Q09 to $72 million in 2Q10, measuring the highest loss per day 99 per cent of the time from the trading transactions of the investment bank (http://files.shareholder.com/downloads/ONE/889418027x0x387171/79855d7d-cc5f-4a91-87ed-8ca848266fd8/2Q10_ERF_Supplement_7-14-10_FINAL.pdf ). An important concept used by Knight is that change causes uncertainty.

The method used by business in reducing uncertainty is capital budgeting in investment decisions. As Knight argues in his classic work, the entrepreneur receives the difference between the selling price and cost. An entrepreneur deciding on a project would construct the “estimates” mentioned by Knight. The method is similar to the cost/benefit analysis of economics (Pelaez and Pelaez, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32, Government Intervention in Globalization, 52-6, 87, Globalization and the State, Vol. I, 119-25) and applied in the economics of climate change (Pelaez and Pelaez, Globalization and the State, Vol. II, 59-63). The entrepreneur projects forward to the horizon or year of maturity of the investment the cash flows to be received, or revenue, and the cash flows to be paid, or costs. For each year, the projections would show net revenue, or revenue less cost. The future net revenues have to be converted into dollars of today by discounting them by another estimate of the rate of interest. The sum of the discounted net revenues is the present value of the project. The entrepreneur chooses projects with positive present value.

Consider the development of pharmaceuticals. Industry data reported to the Federal Drug Administration (FDA) find that 5 of 5000 compounds entering preclinical testing actually move on to clinical testing and only 1 of the 5 is finally found satisfactory for sales to the public (http://www.fda.gov/Drugs/ResourcesForYou/Consumers/ucm143455.htm ). The estimate of expenditure costs per approved new drug is $403 million but rises to $802 million when discounting sales backwards and capitalizing costs forward over the gestation period. The time cost of investment is about 50 percent of the cost (Joseph DiMasi, Ronald Hansen and Henry Grabowski, The price of innovation: new estimates of drug development costs. Journal of Health Economics 22 (2)). The capital budgeting of a pharmaceutical requires the estimation of the revenue that it will bring, which depends on the capacity of the pharmaceutical company to anticipate a host of uncertain future decisions by patients, providers, institutions, health insurance and regulation. The costs require estimates of the transition probabilities and costs of moving the compound from the synthesis to animal testing, New Drug Application at the FDA, human testing in three clinical phases of the FDA process and the costs of approval and final marketing. The development of drugs is characterized by risk because of thousands of compounds only one reaches the pharmacy counters as the compound moves through this prolonged and costly process to final approval and marketing. The conversion of costs to current time when the decision is made requires a continuum of investments over time. The costs to be incurred are brought to current time by an appropriate discount rate. The pharmaceutical company would require estimation of the sales of the new product in the “in patent” period less the costs to calculate if it could remunerate the investment at the rate of return required by investors. The process absorbing two decades more or less is similar to the third category of probabilities that Knight calls “estimates.” In his subsequent work on The Ethics of Competition, Knight adds that “a rational social order can be realized through individual action only if all persons have a rational attitude toward risk and chance” (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565). Harold Demsetz provides the check by government of the rational risk attitudes that can encourage prosperity by “the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival” (Information and efficiency: another viewpoint. Journal of Law and Economics 12 (1, Apr 1969), 20). The essence of the argument is that both government and markets may fail, requiring adequate balance of their institutional roles (Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 80-6, Globalization and the State, Vol. I, 133-43, Financial Regulation after the Global Recession, 11-5, Regulation of Banks and Finance, 33-5). An adequate role of government can create incentives to innovation that result in prosperity while an asphyxiating role of government imposed by drastic changes in one year can frustrate innovation, causing lower living standards, unemployment and underemployment.

The entrepreneur has to finance the project in the capital markets for debt and equity, a process that shows the equivocal political discourse of a dichotomy of “Wall Street” and “Main Street” when in fact there is only one and indivisible general economy. A misleading characterization of the credit/dollar crisis is that financial institutions took careless risks on products that nobody understands. The fact is that financial institutions face the same uncertainty as other types of business and used methods to reduce them to “certainty,” similar to those considered by Frank Knight that are used by business and individuals in making investment and hiring decisions. A high school student considering a medical career faces an even more complex decision of at least a million dollars of costs incurred or in foregone income over the next fifteen years that may be more uncertain in terms of returns than those of a pharmaceutical company pondering on a new drug or actually almost any business large or small. Banks and other financial institutions use models of risk management to estimate their exposures to risks and to protect the market value or capital of their institutions. The models did not fail (Christopher C. Finger cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 131, 176, 193, Regulation of Banks and Finance, 236). What failed was the illusion of a floor on house prices and real estate wealth created by government policy of a near zero interest rate on the Fed funds rate in 2003-4, the reduction of mortgage rates by suspension of the auctions of 30-year Treasuries in 2001-5, the housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). These combined actions clogged the securitization of credit with mortgage-based securities and their derivatives referenced to nonprime mortgages that brought down world finance, causing the global recession. Investors would evaluate the project of the drug manufacturer that could be financed by multiple alternatives such as bank loans, corporate bonds, and placement of equity and so on. There would then be a calculation by lenders and investors of the discounted net cash flows. The entrepreneur would receive the funds and begin hiring and spending on the project. Breaking the functions of the final system and its own process of innovation by the Dodd-Frank bill will prevent the calculation of the cost of investment, retarding the overall economy, frustrating technological progress and undermining future prosperity and employment. The criticism that financial products and risk management are not understandable to users such as borrowers of car loans with funds from securitized credit is as ridiculous as requiring airplane travelers to hold a PhD in physics.

Chairman Bernanke states in the Fed’s Monetary Policy Report to the Congress that “of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.pdf page 7). The economy is in the world of doubts about the future that Frank Knight analyzed in his 1921 magnum opus on Risk, Uncertainty, and Profit. Business and individual cannot calculate risks and rewards of decisions that generate economic growth and hiring. The critical concept in the work of Frank Knight is that uncertainty is caused by “change.” Uncertainty means that it is almost impossible to calculate with some confidence the future net cash flows of investments or the appropriate rate of discount to use in measuring net present value. The uncertainty frustrates the calculations of entrepreneurs for investment and hiring and the vital investment in education and training by people of all ages. There is just too much change at the inopportune time when confidence is required to generate sufficient economic growth that will alleviate the plight of 27 million people unemployed or forced to work part time because no other opportunity is available. The Dodd-Frank bill of financial regulation creates lethal uncertainty by reduced availability of credit and the likely higher interest rate to be paid for whatever credit is available. Legislative restructurings of large segments of economic activity and other draconian regulation cloud the calculations of net present value of investments and business decisions. The government forecast for the deficit of 2011 has been increased from $1.27 trillion estimated in February to $1.4 trillion, or 9.2 percent of GDP, released on Friday with upward revisions for the next three years (http://professional.wsj.com/article/SB10001424052748703294904575385481462433508.html?mod=wsjproe_hps_LEFTWhatsNews ). The Fed balance sheet is bloated at $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1c ). The largest government deficits in a peace period and the eventual unwinding of the portfolio of long-term securities of the Fed create the uncertainty of large increases in taxes and rising interest rates.
The US economy is decelerating with lowering forecasts for second-quarter GDP. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ).

The President of the European Central Bank, Jean-Claude Trichet, has called for global fiscal consolidation (http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html ). There is no dispute on the need for fiscal consolidation but rather on the timing. Trichet finds that in the four years after 2007 government debt will grow by 20 percentage points in the euro area, 35 percentage points in the US and 45 percentage points in Japan. The three elements of Trichet’s argument are: (1) fiscal consolidation with appropriate restructuring policies promote stable growth; (2) consolidation is required to prevent loss of confidence from debts perceived as growing nonlinearly; and (3) consolidation is needed to recover fiscal strength that may be used in future crises.

Lawrence Summers, chief economic adviser to the President and Director of the White House National Economic Council, argues that the US follows the correct policy of supporting economic recovery in the short term while pursuing fiscal consolidation in the medium and long term because of likely general agreement by economists on three propositions (http://www.ft.com/cms/s/0/966e25b8-9295-11df-9142-00144feab49a.html ). First, in normal economic times, increasing budget deficits may not have an impact on output and employment, affecting only the composition instead of the level of aggregate economic activity. Second, in an economy with idle capacity and a near zero interest rate that cannot be reduced further, fiscal policy may have substantial impact on output and employment. Third, anticipations of fiscal consolidation in the medium and long term will maintain confidence in an adequate environment for investment and job creation. The time may have arrived to strengthen the anticipations of fiscal consolidation to avoid adverse investor expectations such as those that occurred during the Asian crisis of 1997-1998, requiring a “credible plan” for crisis resolution (Lawrence Summers Richard T. Ely Lecture, AER 2000, cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 106). The “fundamentals” of the US are deteriorating because of lack of a credible plan for fiscal consolidation.

Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. The legislative restructurings, bailouts, regulation and mandates are forcing non-business decisions on the economy that is anticipating the uncertainty of decisions and rules by the new laws and regulations. The combined environment has created the uncertainty analyzed by Frank Knight that prevents investment and hiring.

II Financial Turbulence. Equity markets improved substantially but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices to Jul 23 was: DJIA -7.0 from the recent peak on Apr 26 and 3.2 in the week; S&P 500 -9.4 from the recent peak on Apr 23 and 3.6 in the week; and NYSE Financial -13.4 since Apr 15 and 3.9 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 23 was: Dow Global -11.9 and 2.8 in the week; Dow Asia Pacific TSM -8.3 and 1.0 in the week; Shanghai -18.7 and 6.1 in the week; and STOXX Europe 50 -8.8 and 2.8 in the week. The euro moved sideways, trading at $1.2930/EUR on Jul 23. The dollar has gained 17.2 percent relative to the euro since the recent trough on Nov 25, 2009, and gained 0.3 percent in the week. The DJ UBS commodity index fell 10.4 percent since the recent peak on Jan 6 and gained 1.8 percent in the week. The 10-Treasury traded at 3.000 percent on Jul 23 as funds flowed back into risk positions. Earnings of corporations have been strong, in particular with growing revenue and enhanced prospects for Caterpillar and UPS that reflect higher economic activity. Favorable news was that only seven of 91 banks in Europe had Basel Tier 1 capital ratio of less than 6 percent after stressing their balance sheets with a scenario of weak economy and sovereign risks (http://professional.wsj.com/article/SB10001424052748703294904575384940544522582.html?mod=wsjproe_hps_LEFTWhatsNews http://online.wsj.com/public/resources/documents/cebs-Summaryreport-20100725.pdf ). These tests will be scrutinized during the week.

III. Economic Indicators. Housing starts in Jun were at a seasonally-adjusted annual rate of 454,000, which is below the May estimate by 0.7 percent and 5.8 percent below the Jun 2009 rate of 583,000 (http://www.census.gov/const/newresconst.pdf ). In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). The decline from Jan 2006 to Jun 2010 is by 80 percent, a contraction of physical data that is very difficult to find in recorded history. This disaster is impossible to explain by lack of financial regulation but it can be explained by government policy of near-zero interest rates, subsidies to housing and the mismanagement of Fannie and Freddie. Building permits increased by 2.1 percent from May into Jun but were below 2.3 percent relative to Jun 2009. Existing home sales dropped 5.1 percent from May into Jun but remain 9.8 percent higher than in Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/07/ehs_june_above ). Initial claims for unemployment insurance increased by 37,000 in the week ending Jul 17 from the prior week, reaching 464,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).

IV Interest Rates. There was a slight upward shift in the US yield curve as funds flowed back from the safe haven of Treasuries and highly-rated fixed income into risk exposures. The 10-year Treasury increased to 3.00 percent from 2.94 percent a week ago but declined from 3.11 percent a month ago. The 10-year German bond traded at 2.75 percent, tightening its spread to -0.25 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1280055941689 ).

V Conclusion. There is promise of further review of regulatory measures (http://professional.wsj.com/article/SB10001424052748703467304575383490332411012.html ). A policy shift in the form of concrete measures could encourage decisions on investment and hiring by business and investment on education and training by people of all ages that could reduce the uncertainty in the economy, promoting prosperity. Increasing uncertainty will worsen the plight of the 27 million unemployed or underemployed. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

The Rise of the Era of Uncertainty

The Rise of the Era of Uncertainty
Carlos M Pelaez

“All human planning and execution involve uncertainty, and a rational social order can be realized only if all persons have a rational attitude toward risk and chance,” Frank H. Knight (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565).

The objective of this post is to relate uncertainty as widely perceived today to the frustration of investment by business and individuals and the weakening hiring decisions by small and large business. (I) relates the work of Frank Knight and the era of uncertainty, (II) provides the information on financial turbulence and (II) and (IV) evaluate economic indicators and interest rates. (V) concludes.
I Frank Knight and The Era of Uncertainty. The economist Frank H. Knight considered in his 1921 classic opus Risk, Uncertainty, and Profit three different types of probability (http://www.econlib.org/library/Knight/knRUP6.html#Pt.III,Ch.VII ). First, a priori probability is explained by the example of tossing the perfect die that will show a given number one-sixth of the time (see William Feller, An introduction to probability theory and its applications. Wiley, 1968, 7-25). Second, there is the work of actuarial science in insurance in which past information is used to calculate the fair premium. The present value of the actuarially fair premium is equal to the expected costs of the benefits to be received from the plan, or costs weighted by probability of occurrence, if the load, or administrative costs, is assumed to be zero. Knight finds that the distinguishing characteristic of this type is that “it rests on an empirical classification of instances” (Ibid). Third, there is what Knight calls “estimates,” for which “there is no valid basis of any kind for classifying instances” and constitute an “uncertainty” (Ibid). Knight argues that “an uncertainty which can by any method be reduced to an objective, quantitatively determined probability, can be reduced to complete certainty by grouping cases.” The process of Value at Risk (VaR), measuring the maximum loss in a target horizon for a desired level of confidence, could fit into this category (Pelaez and Pelaez, International Financial Architecture, 106-12). For example, JP Morgan Chase reports a decline of the investment bank trading VaR from $170 million in 2Q09 to $72 million in 2Q10, measuring the highest loss per day 99 per cent of the time from the trading transactions of the investment bank (http://files.shareholder.com/downloads/ONE/889418027x0x387171/79855d7d-cc5f-4a91-87ed-8ca848266fd8/2Q10_ERF_Supplement_7-14-10_FINAL.pdf ). An important concept used by Knight is that change causes uncertainty.
The method used by business in reducing uncertainty is capital budgeting in investment decisions. As Knight argues in his classic work, the entrepreneur receives the difference between the selling price and cost. An entrepreneur deciding on a project would construct the “estimates” mentioned by Knight. The method is similar to the cost/benefit analysis of economics (Pelaez and Pelaez, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32, Government Intervention in Globalization, 52-6, 87, Globalization and the State, Vol. I, 119-25) and applied in the economics of climate change (Pelaez and Pelaez, Globalization and the State, Vol. II, 59-63). The entrepreneur projects forward to the horizon or year of maturity of the investment the cash flows to be received, or revenue, and the cash flows to be paid, or costs. For each year, the projections would show net revenue, or revenue less cost. The future net revenues have to be converted into dollars of today by discounting them by another estimate of the rate of interest. The sum of the discounted net revenues is the present value of the project. The entrepreneur chooses projects with positive present value.
Consider the development of pharmaceuticals. Industry data reported to the Federal Drug Administration (FDA) find that 5 of 5000 compounds entering preclinical testing actually move on to clinical testing and only 1 of the 5 is finally found satisfactory for sales to the public (http://www.fda.gov/Drugs/ResourcesForYou/Consumers/ucm143455.htm ). The estimate of expenditure costs per approved new drug is $403 million but rises to $802 million when discounting sales backwards and capitalizing costs forward over the gestation period. The time cost of investment is about 50 percent of the cost (Joseph DiMasi, Ronald Hansen and Henry Grabowski, The price of innovation: new estimates of drug development costs. Journal of Health Economics 22 (2)). The capital budgeting of a pharmaceutical requires the estimation of the revenue that it will bring, which depends on the capacity of the pharmaceutical company to anticipate a host of uncertain future decisions by patients, providers, institutions, health insurance and regulation. The costs require estimates of the transition probabilities and costs of moving the compound from the synthesis to animal testing, New Drug Application at the FDA, human testing in three clinical phases of the FDA process and the costs of approval and final marketing. The development of drugs is characterized by risk because of thousands of compounds only one reaches the pharmacy counters as the compound moves through this prolonged and costly process to final approval and marketing. The conversion of costs to current time when the decision is made requires a continuum of investments over time. The costs to be incurred are brought to current time by an appropriate discount rate. The pharmaceutical company would require estimation of the sales of the new product in the “in patent” period less the costs to calculate if it could remunerate the investment at the rate of return required by investors. The process absorbing two decades more or less is similar to the third category of probabilities that Knight calls “estimates.” In his subsequent work on The Ethics of Competition, Knight adds that “a rational social order can be realized through individual action only if all persons have a rational attitude toward risk and chance” (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565). Harold Demsetz provides the check by government of the rational risk attitudes that can encourage prosperity by “the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival” (Information and efficiency: another viewpoint. Journal of Law and Economics 12 (1, Apr 1969), 20). The essence of the argument is that both government and markets may fail, requiring adequate balance of their institutional roles (Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 80-6, Globalization and the State, Vol. I, 133-43, Financial Regulation after the Global Recession, 11-5, Regulation of Banks and Finance, 33-5). An adequate role of government can create incentives to innovation that result in prosperity while an asphyxiating role of government imposed by drastic changes in one year can frustrate innovation, causing lower living standards, unemployment and underemployment.
The entrepreneur has to finance the project in the capital markets for debt and equity, a process that shows the equivocal political discourse of a dichotomy of “Wall Street” and “Main Street” when in fact there is only one and indivisible general economy. A misleading characterization of the credit/dollar crisis is that financial institutions took careless risks on products that nobody understands. The fact is that financial institutions face the same uncertainty as other types of business and used methods to reduce them to “certainty,” similar to those considered by Frank Knight that are used by business and individuals in making investment and hiring decisions. A high school student considering a medical career faces an even more complex decision of at least a million dollars of costs incurred or in foregone income over the next fifteen years that may be more uncertain in terms of returns than those of a pharmaceutical company pondering on a new drug or actually almost any business large or small. Banks and other financial institutions use models of risk management to estimate their exposures to risks and to protect the market value or capital of their institutions. The models did not fail (Christopher C. Finger cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 131, 176, 193, Regulation of Banks and Finance, 236). What failed was the illusion of a floor on house prices and real estate wealth created by government policy of a near zero interest rate on the Fed funds rate in 2003-4, the reduction of mortgage rates by suspension of the auctions of 30-year Treasuries in 2001-5, the housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). These combined actions clogged the securitization of credit with mortgage-based securities and their derivatives referenced to nonprime mortgages that brought down world finance, causing the global recession. Investors would evaluate the project of the drug manufacturer that could be financed by multiple alternatives such as bank loans, corporate bonds, and placement of equity and so on. There would then be a calculation by lenders and investors of the discounted net cash flows. The entrepreneur would receive the funds and begin hiring and spending on the project. Breaking the functions of the final system and its own process of innovation by the Dodd-Frank bill will prevent the calculation of the cost of investment, retarding the overall economy, frustrating technological progress and undermining future prosperity and employment. The criticism that financial products and risk management are not understandable to users such as borrowers of car loans with funds from securitized credit is as ridiculous as requiring airplane travelers to hold a PhD in physics.
Chairman Bernanke states in the Fed’s Monetary Policy Report to the Congress that “of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.pdf page 7). The economy is in the world of doubts about the future that Frank Knight analyzed in his 1921 magnum opus on Risk, Uncertainty, and Profit. Business and individual cannot calculate risks and rewards of decisions that generate economic growth and hiring. The critical concept in the work of Frank Knight is that uncertainty is caused by “change.” Uncertainty means that it is almost impossible to calculate with some confidence the future net cash flows of investments or the appropriate rate of discount to use in measuring net present value. The uncertainty frustrates the calculations of entrepreneurs for investment and hiring and the vital investment in education and training by people of all ages. There is just too much change at the inopportune time when confidence is required to generate sufficient economic growth that will alleviate the plight of 27 million people unemployed or forced to work part time because no other opportunity is available. The Dodd-Frank bill of financial regulation creates lethal uncertainty by reduced availability of credit and the likely higher interest rate to be paid for whatever credit is available. Legislative restructurings of large segments of economic activity and other draconian regulation cloud the calculations of net present value of investments and business decisions. The government forecast for the deficit of 2011 has been increased from $1.27 trillion estimated in February to $1.4 trillion, or 9.2 percent of GDP, released on Friday with upward revisions for the next three years (http://professional.wsj.com/article/SB10001424052748703294904575385481462433508.html?mod=wsjproe_hps_LEFTWhatsNews ). The Fed balance sheet is bloated at $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1c ). The largest government deficits in a peace period and the eventual unwinding of the portfolio of long-term securities of the Fed create the uncertainty of large increases in taxes and rising interest rates.
The US economy is decelerating with lowering forecasts for second-quarter GDP. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ).
The President of the European Central Bank, Jean-Claude Trichet, has called for global fiscal consolidation (http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html ). There is no dispute on the need for fiscal consolidation but rather on the timing. Trichet finds that in the four years after 2007 government debt will grow by 20 percentage points in the euro area, 35 percentage points in the US and 45 percentage points in Japan. The three elements of Trichet’s argument are: (1) fiscal consolidation with appropriate restructuring policies promote stable growth; (2) consolidation is required to prevent loss of confidence from debts perceived as growing nonlinearly; and (3) consolidation is needed to recover fiscal strength that may be used in future crises.
Lawrence Summers, chief economic adviser to the President and Director of the White House National Economic Council, argues that the US follows the correct policy of supporting economic recovery in the short term while pursuing fiscal consolidation in the medium and long term because of likely general agreement by economists on three propositions (http://www.ft.com/cms/s/0/966e25b8-9295-11df-9142-00144feab49a.html ). First, in normal economic times, increasing budget deficits may not have an impact on output and employment, affecting only the composition instead of the level of aggregate economic activity. Second, in an economy with idle capacity and a near zero interest rate that cannot be reduced further, fiscal policy may have substantial impact on output and employment. Third, anticipations of fiscal consolidation in the medium and long term will maintain confidence in an adequate environment for investment and job creation. The time may have arrived to strengthen the anticipations of fiscal consolidation to avoid adverse investor expectations such as those that occurred during the Asian crisis of 1997-1998, requiring a “credible plan” for crisis resolution (Lawrence Summers Richard T. Ely Lecture, AER 2000, cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 106). The “fundamentals” of the US are deteriorating because of lack of a credible plan for fiscal consolidation.
Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. The legislative restructurings, bailouts, regulation and mandates are forcing non-business decisions on the economy that is anticipating the uncertainty of decisions and rules by the new laws and regulations. The combined environment has created the uncertainty analyzed by Frank Knight that prevents investment and hiring.
II Financial Turbulence. Equity markets improved substantially but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices to Jul 23 was: DJIA -7.0 from the recent peak on Apr 26 and 3.2 in the week; S&P 500 -9.4 from the recent peak on Apr 23 and 3.6 in the week; and NYSE Financial -13.4 since Apr 15 and 3.9 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 23 was: Dow Global -11.9 and 2.8 in the week; Dow Asia Pacific TSM -8.3 and 1.0 in the week; Shanghai -18.7 and 6.1 in the week; and STOXX Europe 50 -8.8 and 2.8 in the week. The euro moved sideways, trading at $1.2930/EUR on Jul 23. The dollar has gained 17.2 percent relative to the euro since the recent trough on Nov 25, 2009, and gained 0.3 percent in the week. The DJ UBS commodity index fell 10.4 percent since the recent peak on Jan 6 and gained 1.8 percent in the week. The 10-Treasury traded at 3.000 percent on Jul 23 as funds flowed back into risk positions. Earnings of corporations have been strong, in particular with growing revenue and enhanced prospects for Caterpillar and UPS that reflect higher economic activity. Favorable news was that only seven of 91 banks in Europe had Basel Tier 1 capital ratio of less than 6 percent after stressing their balance sheets with a scenario of weak economy and sovereign risks (http://professional.wsj.com/article/SB10001424052748703294904575384940544522582.html?mod=wsjproe_hps_LEFTWhatsNews http://online.wsj.com/public/resources/documents/cebs-Summaryreport-20100725.pdf ). These tests will be scrutinized during the week.
III. Economic Indicators. Housing starts in Jun were at a seasonally-adjusted annual rate of 454,000, which is below the May estimate by 0.7 percent and 5.8 percent below the Jun 2009 rate of 583,000 (http://www.census.gov/const/newresconst.pdf ). In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). The decline from Jan 2006 to Jun 2010 is by 80 percent, a contraction of physical data that is very difficult to find in recorded history. This disaster is impossible to explain by lack of financial regulation but it can be explained by government policy of near-zero interest rates, subsidies to housing and the mismanagement of Fannie and Freddie. Building permits increased by 2.1 percent from May into Jun but were below 2.3 percent relative to Jun 2009. Existing home sales dropped 5.1 percent from May into Jun but remain 9.8 percent higher than in Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/07/ehs_june_above ). Initial claims for unemployment insurance increased by 37,000 in the week ending Jul 17 from the prior week, reaching 464,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. There was a slight upward shift in the US yield curve as funds flowed back from the safe haven of Treasuries and highly-rated fixed income into risk exposures. The 10-year Treasury increased to 3.00 percent from 2.94 percent a week ago but declined from 3.11 percent a month ago. The 10-year German bond traded at 2.75 percent, tightening its spread to -0.25 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1280055941689 ).
V Conclusion. There is promise of further review of regulatory measures (http://professional.wsj.com/article/SB10001424052748703467304575383490332411012.html ). A policy shift in the form of concrete measures could encourage decisions on investment and hiring by business and investment on education and training by people of all ages that could reduce the uncertainty in the economy, promoting prosperity. Increasing uncertainty will worsen the plight of the 27 million unemployed or underemployed. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )