The Structural Unemployment Delusion

My latest article in the Imperial Management Review:

The lingering reverberations of the Great Recession continue to send an unpleasant sting throughout the global economy. Although in the United States we’re witnessing steady—albeit sluggish—growth, effective policy targeted at job creation is still very much needed to reduce ongoing unemployment, which currently stands at 7.4%.

Both the Federal Reserve and policy makers in Washington are meant to implement measures aimed at boosting employment. The efficacy of the policies that they offer depends upon a proper understanding of the nature of unemployment. Currently, a number of underlying causes have been attributed to the ongoing inertia of US jobs growth.  On the one hand, sustained deregulation, a debt-driven housing bubble and fly by night activity on wall street—among a host of other factors—led to the most severe economic downturn since the Great Depression. Unemployment that results from these sources is termed cyclical unemployment.

On the other hand, the transition from a labor-based economy to an increasingly more global and knowledge-based economy is beginning to require the workforce to possess fundamentally different skills. Some assert that these shifts have obfuscated the natural rate of unemployment; they argue that the ongoing high rate of unemployment has little to do with the lingering effects of the recession, but rather is the result of a skill shortage for available jobs. This type of unemployment, stemming from a mismatch between the supply and demand of skills, is termed structural unemployment.

Each type of unemployment requires a different prescription to overcome. The classic remedy for cyclical unemployment is expansionary monetary and fiscal policy aimed at stimulating the business cycle and boosting aggregate demand. Once demand is restored, the thinking goes, firms will ramp up production and again begin to hire. Structural unemployment, however, is much different in nature and requires a fundamentally different prescription. Because this type of unemployment is the result of a mismatch between the supply and demand of skills, monetary and fiscal policy will do very little, if anything at all, to alleviate it. Instead, the existing incongruity must be reconciled with education and job retraining in order to provide the workforce with the required skills to secure employment.

So, then, what is anchoring employment? Are structural or cyclical factors mainly to blame? The answer is a little bit of both, but, right now, the evidence tells us that it’s mainly cyclical.

 *****

According to the Economic Policy Institute, job vacancies are currently 16% below their prerecession levels. In 2007, there were 1.5 unemployed job seekers for every job vacancy in the US. This ratio jumped to 6.7:1 in 2009, and has since declined to 3.1:1 in April, 2013. As job seekers outnumber job vacancies in every sector, the data strongly suggest that cyclical factors are to blame for weighing on unemployment.

Research from the Brookings Institute has further substantiated this claim. “Even if we could magically endow all job seekers with precisely the skills needed to find work in expanding industries,” writes Gary Burtless, “we would not have reduced the unemployment rate in the Great Recession very much, and for a very simple reason: There were comparatively few job vacancies to fill.”

Does this mean that structural employment isn’t an important concern? No. Structural sources do have a role to play in unemployment, and they will likely become more relevant going forward. But attributing unemployment to structural sources alone, and discarding the efficacy of further monetary and fiscal policy in favor of job retraining—or nothing at all—is both shortsighted and ineffective.

Yes, we should encourage children and young adults to pursue a STEM (science, technology, engineering and math) curriculum, as STEM related fields are expected to be among the fastest growing jobs. But for the 3.6 million unemployed Americans between the ages of 45 and 65, the investment in retraining for a STEM career is unlikely to bear fruit. Return on investment for education is likely only to pay off after a long time horizon—perhaps spanning decades. The closer individuals are retirement, the more unwilling they will be to incur the cost of retraining.

Most notably, the sectors that are expected to have supply shortages in the coming years—including STEM related fields, such as computer science—do not currently have supply shortages. What does this mean? Well, even if an unemployed adult invested in an education in computer science, he or she would still face an environment with fewer jobs than applicants. Moreover, firms are much more likely to tender offers to recent graduates looking to build careers over older applicants nearing retirement.

These findings tell us something very important; namely, expansionary monetary and fiscal policy can still play an important role in alleviating unemployment. Rather than a mismatch between the supply and demand of skill, it is depressed aggregate demand that remains the main source of lingering unemployment. Congress and the Fed must act accordingly if our economy is to recover.

Hysteria in the Time of Austerity

Originally published in the Imperial Management Review

Prior to the Great Depression, economists conceived of their field as something bordering on a perfect science; capitalism, so it was thought, had proven to be an economic system devoid of major inefficiencies. This point of view, buffeted by the bull market of the 1920s, abruptly disintegrated at the end of that decade, leaving economists aghast at the approaching Great Depression

With traditional monetary policy ineffective, it took a fresh and invasive look at the capitalist system, most notably by John Maynard Keynes, to understand the challenges that capitalist economies faced. In his General Theory of Employment, Interest and Money, Keynes attributed the depression to a lack of private sector demand, which could only be made up by increased government spending. It was the role of the government, said Keynes, to stimulate the economy. This basic idea comprised the policy prescription taken by America and Britain during the 1930s and 1940s.

As memories of the Depression dwindled, economic thinking shifted away from Keynesianism. The efficient markets hypothesis, which conceives of markets as being rational, gained traction. After World War II, monetary policy was effective in combating economic challenges, including soaring inflation of the 1970s. Keynesian fiscal policy no longer seemed necessary and soon fell out of favor.

The success of economics as a field was again trumpeted, with major thinkers touting the merits of economic policy for balancing employment, inflation and growth. The back patting extended in to 2008, with a number of esteemed economists ardently believing their profession to have reached a pinnacle. Complex and beautifully crafted mathematical models conjured up just the right prescriptions to indefinitely maintain the goals of central banks.

And then the housing bubble burst. And global credit markets dried up. And unemployment skyrocketed. And unmanageable sovereign debt engulfed Europe. The Nobel garnished makers of those mathematical models appeared worryingly close to cosmeticians caking on layers of make-up to conceal a severely scarred truth. With the Fed lowering interest rates near the zero-lower bound, monetary policy met its limits. And thus our story begins.

*****

Austerians, who believe that in a recession government should cut deficit spending and make room for private sector investment, faced off against Keynesians, who believe that recessions represent an absence of private sector demand; the government, according to the Keynesians, must increase deficit spending to stimulate the economy. Which policy is the right one is currently at the heart of economic debate.

Although the Austerity v. Stimulus debate is not a new one, the global economic community has yet to reach a consensus on which is really most effective. Context often compounds clear-cut conclusions, and many adherents—in either camp—have a shifty penchant for exaggerating contextual differences to resuscitate their beleaguered ideology.

If the economic elite were to come together to organize an experiment wherein two countries of similar context were to receive two different policy responses during a recession—austerity for one and stimulus for the other—ethical review boards would be spinning like tops trying thwart it. Which country you believe would be the dead guinea pig depends on your perspective. But it’s clear that one of the countries would suffer unnecessarily.

Sometimes, however, the most seminal of experiments occur naturally. Despite their differences, the economies of the United States and the United Kingdom are similar in a number of important ways, including having and borrowing in their own currencies. While the relationship is not 1:1, those who would downplay the similarities will have a fairly conspicuous agenda.

And so the experiment begins. With the inauguration of the coalition government, the United Kingdom began to invoke fiscal austerity; they reneged on Labour’s stimulus program, which saw GDP growth at 2.5% annually, in favor of across the board spending cuts.

George Osborne, Chancellor of the Exchequer, instituted an aggressive policy of deficit reduction and tax increases, effectively foisting contractionary policy on an already sclerotic economy. Government spending, he argued, would crowd out private investment, thereby thwarting further growth and prolonging recession. The answer was simple: curtail government spending.

How has this turned out for the UK? Well, last year its economy shrank .1%, a far cry from the .8% growth it had projected. The most recent report from the Office of National Statistics revealed that the UK narrowly avoided consummating its ongoing flirtation with a triple-dip recession. Despite lowering its growth forecast for 2013 from 2% to 1.2%, Osborne maintained that “it’s a hard road but we are getting there. Britain is on the right track. Turning back now would be a disaster.”

Quite at odds with Osborne, the National Institute for Economic and Social Research has attributed the UK’s sustained depression and its worsening outlook to austerity. Although most European countries followed a path of austerity, some of them are now beginning to shy away from it, after years of negative growth and rising unemployment.

Portugal recently announced a far-reaching stimulus package. Italy’s new Prime Minister has promised to curb austerity programs and begin stimulus. Most notably, perhaps, the IMF has had an about-face with regard to austerity. Christine Lagarde, Managing Director of the IMF, recently impugned the efficacy of Osborne’s deficit reduction plan, warning that cuts are likely hampering growth and prolonging recession.

Moreover, IMF Chief Economist Olivier Blanchard stated that Osborne is “playing with fire” by remaining on a path of austerity.  Blanchard, once a proponent of Britain’s austerity plans, conducted a review of previous IMF projections. He found that countries that engaged in austerity notably underperformed IMF projections of growth. Conversely, countries that took a more Keynesian approach, like the United States, tended to outperformed IMF projections. After reviewing the findings, Blanchard has advanced the IMF’s evolving viewpoint on austerity, stating that raising taxes and cutting spending succeed only is dragging out depression.

*****

Two notable papers serve as the academic pillars for austerity: Alesina and Ardagna’s Large Changes in Fiscal Policy and Reinhart and Rogoff’s Growth in a Time of Debt. Both have been championed as a coup de grace to Keynesianism. Both have been ignominiously refuted.

When we distance ourselves from the dizzying political discourse and focus on the differential outcomes over the last five years, it’s clear which side of the Austerity v. Stimulus debate has triumphed. The United States, with its comparatively more Keynesian approach, has had a comparatively stronger recovery.

According to critics of the Obama Administration, the United States was supposed to be Greece by now. Interest rates were meant to have skyrocketed, deficits to have rapidly expanded, large capital outflows to have abounded and the dollar to have deteriorated.  But none of this transpired. Instead, GDP growth averaged 2.1% since 2009, compared to .9% in the UK. Unemployment is trending downward and is projected to reach 6.5% by next year, and the deficit is expected to shrink to 4% of GDP by 2014.

More than 5 years into the Great Recession, the verdict is clear. The IMF, the World Bank and the WTO have all warned that austerity will hamstring growth and exacerbate unemployment. They were able to look at the data objectively and come to sensible policy recommendations based on empirical evidence.

Yet Austerians cling to their a priori judgments and increasingly refuted ideologies. They refuse to acknowledge the role austerity has played in hindering recovery. We’re hoping to resuscitate our injured guinea pig, but the wheel of death spins on.

Technology: Friend or Foe?

The Boston bombings have again led us to a serious question that has yet to be seriously answered. Namely, what measures should be implemented to more effectively preempt terrorism, and how do we balance those measures with our civil liberties?

Tamerlan Tsarnaev, who is thought to have masterminded the bombings, is now known to have engaged in a number of radical content on social media. Tsarnaev’s YouTube account revealed a playlist labeled “terrorism”, videos of an obscure Dagestani jihadist, and a song by Timur Mutsurayev entitled “Life Devoted to Jihad.” Criticisms about the failure to identify Tamerlan Tsarnaev as a potential terrorist are starting to appear, with some commentators asserting that the “signs were there.”

So how could federal authorities have done a better job at fingering the Tsarnaev brothers? Could expanding provisions in the USA Patriot Act have allowed them to identify Tamerlan as a potential terrorist threat and monitor his activities? Perhaps this would have helped the FBI confirm Russian suspicions that he was connected to Chechen militants.

How about the increased use of technology for public safety? Following the attack, the FBI and Boston Police Department were able to identify the Tsarnaev brothers with the help of Closed Circuit Television, or CCTV. Some of the CCTV footage of Dzhokar Tsarnaev’s reaction after the first explosion may now be a key piece of evidence in his prosecution.

Would increasing the number of CCTV cameras in our cities help authorities identify criminals more efficiently and effectively? Moreover, to what extent would the presence of CCTV help deter future crime? CCTV has already proliferated in a number of European countries, such as the United Kingdom where it is welcomed by 90% of Londoners surveyed by UrbanEye.

Technology that improves the government’s ability to identify and monitor criminal activity could reduce crime rates and help prevent a catastrophe like the Boston bombings from occurring in the future. Of course, while technology has an amazing capacity to hamstring crime, it also has an uncomfortable ability to threaten our privacy and undermine fundamental civil liberties. The primary criticism against increased surveillance is that the government would be monitoring possible criminal activity, which may very likely turn out to be non-criminal activity.

Following the Madrid bombings in 2004, Brandon Mayfield, a lawyer from Portland, Oregon, became a suspect after the FBI had erroneously matched his fingerprints with those found on a bag of detonators associated with the attacks. Under provisions of the USA Patriot Act, the FBI began wiretapping Mr. Mayfield’s conversations, conducting secret searches of his home and gathering bank and phone records—acts that normally require probable cause and judicial approval.

While the inclination after a highly symbolic act of violence may be to give the authorities carte blanche to prevent a similar act from occurring again, we must be careful not to let fear shepherd our decision-making. Nor must we fail to seriously consider the extent to which we can implement more invasive security measures without jettisoning our privacy. How often have the utopian societies of science fiction plummeted precariously into dystopian nightmares?

In an ad hoc poll conducted by Marblehead, 69% of respondents reported that Dzhokar Tsarnaev should not have been read his Miranda rights at the time of his arrest. Whether the public safety exemption is a key method for gathering intelligence or a pernicious dismissal of the constitution is a question about which we should not be cavalier.

In the aftermath of September 11^th, some of the most important decisions we made were governed by fear. Justice was supplanted by revenge and rational thought was demoted in favor of emotion.

The Tsarnaev brothers may be despicable. Their wickedness has shaken our collective spirit in a way that we have felt far too often this year. But it is precisely when our American spirit is shaken that our constitution must stand firm.

Extreme Political Attitudes

Interesting article from the APS:

Having to explain how a political policy works leads people to express less extreme attitudes toward the policy, according to new research published in Psychological Science, a journal of the Association for Psychological Science.

The research suggests that people may hold extreme policy positions because they are under an illusion of understanding — attempting to explain the nuts and bolts of how a policy works forces them to acknowledge that they don’t know as much about the policy as they initially thought.

Psychological scientist Philip Fernbach of the Leeds School of Business at the University of Colorado, Boulder and his co-authors were interested in exploring some of the factors that could contribute to what they see as increasing political polarization in the United States.

Read the full article here.

The Reinhart Rogoff Response

The Reinhart Rogoff response in the New York Times. A bit flaccid for a blunder of this magnitude.

The Reinhart-Rogoff Danger Zone

Paul Krugman's latest column sheds some more light on the idea that we're approaching a danger zone with our national debt:

"Finally, Ms. Reinhart and Mr. Rogoff allowed researchers at the University of Massachusetts to look at their original spreadsheet — and the mystery of the irreproducible results was solved. First, they omitted some data; second, they used unusual and highly questionable statistical procedures; and finally, yes, they made an Excel coding error. Correct these oddities and errors, and you get what other researchers have found: some correlation between high debt and slow growth, with no indication of which is causing which, but no sign at all of that 90 percent “threshold.”

In response, Ms. Reinhart and Mr. Rogoff have acknowledged the coding error, defended their other decisions and claimed that they never asserted that debt necessarily causes slow growth. That’s a bit disingenuous because they repeatedly insinuated that proposition even if they avoided saying it outright. But, in any case, what really matters isn’t what they meant to say, it’s how their work was read: Austerity enthusiasts trumpeted that supposed 90 percent tipping point as a proven fact and a reason to slash government spending even in the face of mass unemployment.

So the Reinhart-Rogoff fiasco needs to be seen in the broader context of austerity mania: the obviously intense desire of policy makers, politicians and pundits across the Western world to turn their backs on the unemployed and instead use the economic crisis as an excuse to slash social programs."

Is Our Debt Really That Dangerous?

Perhaps the most frequently asked question Perhaps the most frequently answered question by policymakers relates to the paradox of preempting our long-term debt burden while continuing to stimulate our currently depressed economy. (The asking part is usually omitted).

The deficit hawks assert that we need to cut spending, and cut it now. This, of course, is the intuitive response. For the more money we borrow and spend now, the worse our interest burden becomes in the future. More tax revenue will be used to service our interest payments; we might even borrow to pay off interest on other loans. To compound the issue, entitlement spending is ballooning as social security and healthcare costs continue to grow.

With more and more tax revenue being directed toward interest payments and entitlements, investments in our future—like R&D, education and infrastructure— will increasingly diminish. This combination of slowing growth and dwindling revenue could mean that we are unable to service our current interest burden, resulting in soaring interest rates and even a default on our sovereign debt. The medicine that many prescribe for preventing the chaos is an unpleasant decrease in spending—otherwise known as austerity. Sound logical? Sure it does.

But wait a minute. We happen to be in the worst economic downturn since the Great Depression. Although spending cuts may appear to be the intuitive course of action, the reality may be quite different. In fact, many economists assert that the immediate need for stimulus must supersede the hysteria about our long-term debt.

Why? Because contractionary policies will put us back into recession. The different outcomes between the policy responses of the United Kingdom and the United States offer valuable insight in to what works.

The UK plans to cut the overall spending of government agencies by 10% by next year. While the object of this policy is to bring the deficit to 0%, it has instead only managed to hamstring growth. As a result, the UK is currently about to consummate its ongoing flirtation with a triple-dip recession.

The coalition government in the UK fails to understand that Britain’s primary problem is not growing deficit spending, but a revenue decrease attributable to a depressed economy—of which a growing deficit is a symptom. Foisting contractionary policies on a beleaguered economy cripples recovery. Austerity has left the UK with a sclerotic negative growth rate of -.3%, a far cry from the 4.8% the government expected.

 *****

During a debate with Joe Scarborough on Charlie Rose, economist Paul Krugman forwarded the viewpoint that the immediate need for stimulus must take precedence over the long-term debt challenge. He remarked that focusing on improving employment now would generate sufficient revenue to offset our deficit and to prevent a long-term debt crisis. Scarborough himself conceded that during the Clinton administration the Republican Party spent years trying to cut deficit spending, only to find that once the labor force was fully utilized, the deficit was evaporated by the additional revenue

However, many deficit scolds are worried that in an effort to stimulate the economy, accumulated debt will reach a point of no return—a danger zone at which public debt-to-GDP will alarm investors who will then view US debt as riskier and lose confidence in US credit.

If the US were to hit that tipping point, the Treasury will have to offer higher-interest rates to compensate investors for their risk, effectively making borrowing more costly. With a more severe interest burden, our debt would worsen leading to a vicious feedback loop in which confidence would plummet, interest rates would sky-rocket and large capital outflows would abound. With a current debt-to-GDP of 75%, some argue that we are close to that danger zone and marginal increases in debt grow increasingly more pernicious.

However, there is no clear consensus about where this danger zone is. Neil Irwin cites a paper by David Greenlaw, James D. Hamlton, Peter Hooper and Frederic S. Mashkin who state that this tipping point is around a debt-to-GDP of 80%. Carmen Reinhart and Kenneth Rogoff published a frequently cited paper asserting the tipping point to be around 90%.

However, many economists—including Eric Rosengren and Jerome Powell—impugn these findings, charging that they ignore key factors that allow the US to safely sustain a much higher debt-to-GDP ratio, such as its ability to set interest rates and borrow in its own currency.

In fact, Krugman asserts that a debt-to-GDP of 100% is acceptable, and notes that both Japan and the UK have sustained ratios of around 200% without a serious rise in interest rates. If there is a danger-zone, it is far above current level of 75%, which according the CBO, is expected to remain steady. The perception of where that danger zone is will influence policy. A higher danger zone implies more room for fiscal stimulus.

Nevertheless, this still fails to mention the icing on the cake. Because of the instability in the Euro Zone, investors are flocking to US Treasuries, which have seen their highest demand since 1995. The real yield on US Treasury bonds remains negative—meaning we are borrowing without any real interest. In other words, we can continue to borrow cheaply in order to stimulate the economy and get employment back to a healthy rate. Instead, however, we are fighting tooth and nail to cut a deficit that is accompanied by historically low interest rates. As the global economy improves, and investors find other safe investments, this opportunity will dissipate.

The deficit scolds have spun a touching narrative by framing the depressed economy as a generational responsibility. But economic forces seem to lack a corresponding empathy. Moreover, this argument ultimately falls into a logical trap. By failing to stimulate our ailing economy now, we are only succeeding in exacerbating both our long- and short-term challenges. It is akin to skipping the midterm so we can study for the final.