The BLS this morning reported U.S. job gains of 163,000 in July, which is good news in the eyes of the financial markets.  The jobs data had been disappointing over the preceding three spring months.  Before that, during the winter months, employment growth was strong.

In terms of perceptions and politics, pundits will say that today’s report is good news for Obama’s re-election prospects, just as they said the spring jobs numbers were bad news for the President.  But my interest is in economics and reality, rather than perceptions and politics.   From a longer-term perspective, a few important facts have not been adequately discussed.

• 1. The rate of job growth over the last two years, 137,000 jobs per month, inadequate as it is, has actually been greater than the rate of job growth during the George W. Bush Administration (101,000 per month) even if one excludes the two Bush recessions that occurred in the first and last years of his administration, respectively.   The Obama Administration looks even better if one confines the numbers to private sector employment, since the government has been shedding jobs under Obama and was growing rapidly under Bush. Of course this is still nothing like the sort of progress we would ideally want to see - say, the 237,000 jobs that were created month in and month out on average during the 8 years of the Clinton Administration. And the number of long-term unemployed remains worryingly high. But the situation is a big improvement over the economy that Obama inherited three years ago.  

• 2. An unemployment rate of 8.3% shows that the economy is still in unsatisfactory shape.   (The July numbers show a rise from 8.21 to 8.25, which the BLS labelled “essentially unchanged” in the first sentence of its release.)   Unemployment remains higher than what the Obama Administration hoped we would have by now at the time it took office in January 2009.  Most of the difference can be explained by the fact that the level of economic activity in January 2009 - as a result of the free-fall in the last part of 2008 - was much worse than was realized at the time. The subsequent downward revision by the Commerce Department in the official statistic for the level of GDP at the start of 2009 can explain why the level of the economy is disappointing 3 ½ years later, more than the rate of growth over the intervening period. After all, those horrendous 2008 rates of decline in GDP and employment turned around during the six months immediately following the day Obama took office.  

• 3. Most private-sector and independent economists agree that the Obama fiscal stimulus made a positive difference; that - together with TARP and monetary easing by the Fed, unpopular as they are in some circles — it helps explain the mid-2009 economic turnaround; and that it helps explain the moderate growth that followed (2 ½ % growth p.a. in the 2nd half of 2009 plus 2010).   A good explanation for the disappointingly slow rate of growth in output and employment since the end of 2010 is that the fiscal stimulus has been withdrawn and the government sector has been contracting. (Since the November 2010 election, there have been enough Republicans in Congress to block the American Jobs Act and every other action that Obama proposes.)  One can see this in the composition of both GDP and employment. Today’s jobs report features another 9,000 jobs cut in state, local, and federal governments, continuing the pattern that has held throughout the recovery: jobs and output in manufacturing and the rest of the private sector have been expanding, partially offset by contraction in the public sector.

       The world is in the grip of a debate between fiscal austerity and fiscal stimulus.  Opponents of austerity worry about contractionary effects on the economy.  Opponents of stimulus worry about indebtedness and moral hazard.

Is austerity good or bad?   It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right.   It depends where the car is on the road. Sometimes left is appropriate, sometimes right.  When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.    

True, it is hard for politicians to get the timing of countercyclical fiscal policy exactly right.  This is the reason, more than any other, why Keynesian policy lost its luster.  “Fine-tuning” it was called.  Sometimes the fiscal stimulus would kick in after the recession was already over.   

But this is no reason to follow a pro-cyclical fiscal policy.  A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns.  Budgetary profligacy during expansion; austerity in recessions.  Procyclical fiscal policy is destabilizing, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions.  In other words, a procyclical fiscal policy magnifies the severity of the business cycle.

Yet many politicians in the United States, the United Kingdom, and the eurozone seem to live by procyclicality. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak.  Exactly backwards.

            Consider the positions taken over the last three decades by some American politicians. 

First cycle:    During a recessionary period, President Ronald Reagan in his 1980 campaign and in his 1981 Inaugural Address urged immediate action to reduce the national debt “beginning today.”  (Recession: austerity.)    But in 1988, as the economy approached the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits, even though the national debt was rapidly approaching three times the level it had been when Reagan had given his speeches.   “Read my lips, no new taxes,” Bush famously said.  (Boom: profligacy.)

Second cycle:  Predictably, the first President Bush and the Congress finally summoned the political will to raise taxes and rein in spending growth at precisely the wrong moment, that is, just as the US was entering another recession in 1990.   (Recession: austerity.)  Although the timing of the legislation was poor, the action was courageous.    The Pay as You Go Rule and other reforms switched government finances back onto a path that eventually was to eliminate the deficits by the end of the decade.   

But three years later — and even though the most robust recovery in American history had begun — every Republican congressman voted against Clinton’s 1993 legislation to continue Bush’s spending caps, PAYGO, and tax increases.  Nor did they change their minds in response to the subsequent success of the policy.   Even after seven years of strong growth, with unemployment at the peak of the business cycle dipping below 4% for the first time since the 1960s, George W. Bush based his 2000 campaign on a platform of large long-term tax cuts. (Boom: profligacy.)

Third cycle:  Even after the Bush fiscal expansion had turned the inherited record budget surpluses into record deficits, the Administration went for a 2^nd round of tax cuts in 2003, and continued a rate of growth of spending that was triple the rate under Clinton (both national security and domestic spending).  Vice President Richard Cheney said “Reagan proved that deficits don’t matter.”   These policies were maintained for five more years, as another $ four trillion was added to the national debt.  (Boom: profligacy.)  

Predictably, when the worst recession since the Great Depression hit in 2007-09, politicians felt constrained from an adequate fiscal response due to the big deficits and debts the government had already been running. Republicans suddenly re-discovered the evil of budget deficits and decided that retrenchment was urgent.  They opposed Obama’s initial fiscal stimulus in February 2009, even though GDP growth and employment were much worse than they had been when Reagan and Bush had launched their tax cuts and spending increases.  (Recession: austerity.)   Subsequently, with a new majority in the House, they succeeded in blocking further efforts by Obama when the stimulus ran out in 2011.  The government spending cutbacks of the last two years are the most important reason, in my view, why the economic recovery which began in June 2009 subsequently stalled in 2011.

Three cycles.   Three generations of politicians who favored expansionary fiscal policies during a boom and then decided after a recession had hit that budget deficits were bad after all.  (See the graph below.)

This is not to say that the procyclicalist politicians have always succeeded in getting their policies adopted.   Clinton had a strong enough congressional majority in August 1993 that he was able to pass his budget balancing legislation (Omnibus Budget Reconciliation Act) — even though every Republican in Congress voted “no” at a time when the economy was expanding.  Similarly, Obama had a strong enough majority in January 2009 that he was able to pass some initial fiscal stimulus (the American Recovery and Reinvestment Act), without a single Republican vote, at a time when the economy was in freefall.  But too often the countercyclicalists are overpowered by the procyclicalists.

            Trying to turn left or right at precisely the wrong points in the road is a worse record than one would get by switching policies randomly.  To explain this perverse pattern, let us switch metaphors in mid-stream.   It is the old problem of needing to fix the hole in the roof when the sun is shining, rather than waiting for a storm to realize that it is necessary.  When the economy is booming, there is no political support for painful spending cuts or tax increases.  After all, everything seems fine; why make a change?   Then when the deluge comes, sinners suddenly see the evils of their ways and proclaim the necessity of reforming.  Of course it is very difficult to fix the roof in the middle of a thunderstorm.

Procyclical Politicians:  Support for fiscal contraction (down-arrows) and fiscal expansion (up-arrows) 

 (Click here for larger version) (more…)

 
            The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2.  Ben Bernanke and his colleagues are right not to give in to these attacks.

            Critiques seem to be of four sorts. (Some are mutually exclusive.)

            1)  “QE is weird.”    Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations.    This has been a bold strategy, which nobody would have predicted 3 or 4 years ago.   But it has been appropriate to the equally unexpected financial crisis and recession.    Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past.    It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.”  The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s.  But as an economic historian, Bernanke had just the broader perspective that was needed.   Thank heaven he did.

            2)   “Monetary easing under current circumstances has no effect.”  It is true that, with short-term interest rates already near zero for the last two years, further monetary expansion is likely to be of less help than in a normal recession.  (The classic “liquidity trap” has been re-born as the “zero lower bound.”)    But monetary policy can work through other channels besides short-term interest rates.  Seven such mechanisms are: long-term interest rates, expected inflation, the exchange rate, equity prices, real estate prices, commodity prices, and the credit channel.   QE is worth a try, given that the economy is still weak and given the constraints that keep fiscal policy sub-optimal.

            3)  “Monetary ease will lead to inflation.   What we need now, if anything, is monetary tightening.”   This is the view, for example, expressed recently by some conservative economists, including John Taylor.   It seems to me way off base.  With unemployment far above the natural rate, GDP well below potential, and inflation (slightly) below target, it is clear that the Fed’s November 3 decision to ease further  was appropriate.

            4)  “The Fed is firing a volley in a destructive international currency war.”   This is the criticism that has come from some of our trading partners:  in particular, China, Germany and Brazil.   I don’t generally do “My country, right or wrong.”   But my country is right on this one.    Monetary easing is not a beggar-thy-neighbor policy.  The colorful phrase “currency wars“ seems to have confused some people.  The current situation is precisely the point of floating exchange rates:    when some countries feel that their high unemployment calls for monetary expansion (US) at the same time that others feel that their overheating calls for monetary tightening (Brazil, India, Korea, China…), an appreciation of the latter currencies against the former is precisely the way that floating rates accommodate the differences.    This is why Milton Friedman favored floating rates, so that each country could pursue its own desired policies independently.   I realize that the pressure which US monetary easing puts on countries like China to allow appreciation is unwelcome. China is finding it increasingly difficult to cling to its exchange rate target by means of controls on capital inflows and sterilized foreign exchange intervention.   But capital flows are a far more legitimate way to let China feel the pressure than the alternative:  Congressional threats to impose WTO-inconsistent tariffs on Chinese imports if it won’t allow faster appreciation of the yuan.

            I was glad to see that today’s decision by the Federal Open Market Committee to stay the course was unanimous.   The Fed is right not to give in to misguided criticisms.   This is what we have central bank independence for.

Click here for a TV interview on today’s FOMC decision, and inflation & TIPs.

[Comments can be posted on the Belfer site.]

During much of the last decade, U.S. fiscal policy has been procyclical, that is, destabilizing.   We wasted the opportunity of the 2003-07 expansion by running large budget deficits.   As a result, in 2010, Washington now feels constrained by inherited debts to withdraw fiscal stimulus at a time when unemployment is still high.   Fiscal policy in the UK and other European countries has been even more destabilizing over the last decade.  Governments decide to expand when the economy is strong and then contract when it is weak, thereby exacerbating the business cycle.    

Meanwhile, some emerging market and developing countries have learned how to run countercyclical fiscal policy - saving in the boom and easing in the recession - during the same decade that we advanced countries have forgotten how to.    

The frenetic debate at any moment for or against “fiscal conservatism” is artificial.  It is not the right answer always to shrink any more than it is the right answer always to expand.  Americans should take a perspective longer than the annual budget cycle or the bi-annual electoral cycle, let alone the daily news cycle.   When the United States was able to take advantage of the long 1992-2000 boom to eliminate its budget deficit, the key legislation had been enacted in 1990 and 1993.   Similarly, the big deficits of the last ten years were created by the legislation of 2001 and 2003.   Bringing back far-sighted fiscal policy would mean taking steps today to lock in long-term progress toward fiscal responsibility (such as enacting social security reform) but at the same time extending last year’s short-term fiscal stimulus so long as the economy is still weak.

It might help to have ways to insulate fiscal policy from some of the wilder vagaries of politics.    I came away from a conference in Chile recently, impressed anew by that country’s accomplishments.  It has achieved countercyclical fiscal policy over the last ten years by means of some innovative institutions.   Chile has a rule that targets the structural budget balance.  In other words, it can only run a deficit to the extent that GDP and the price of copper are below their long-run trends.  But a structural budget rule is not enough in itself.   Who is to say which deficits are structural and which are temporary?  Chile’s key innovation ten years ago was to vest responsibility for determining the long-run trends in GDP and copper prices in two panels of independent experts.   Why does this matter?   One reason that politicians spend too much in booms is that they convince themselves that deficits are temporary even when they are really structural.  Officials in the US and Europe made overly-optimistic forecasts of future growth rates and tax revenues during the 2001-07 expansion.  Research shows that this is a systematic pattern.  The biased forecasts contributed to unaffordable tax cuts and accelerated spending, which in turn spelled excessive deficits and debts.  Today we are living with the consequences of this procyclicality.

Perhaps we should look South, in order to re-learn how to run countercyclical budgets. 

[For comments, go to SeekingAlpha.]

              The NBER’s Business Cycle Dating Committee, of which I am a member, announced this morning that June 2009 was the trough of the recession that began in December 2007.    It was the longest recession since the 1930s.

              It is the fate of the Committee to be teased mercilessly every time we make one of our formal declarations of a turning point in the economy.   We get it from both directions:    We waited too late to call the end of the recession, or we did it too early.     (Occasionally someone makes both criticisms simultaneously!)   Even The Daily Show got in on the fun this time.

              On the one hand, people say “Who needs the NBER to tell us what we already knew?”    It is true that GDP has been expanding for 5 quarters now, and that most economists have therefore considered the recession over for some time.   But it is not that easy to call the precise trough, for several reasons:  different indicators say different things regarding the precise date of the bottom, data get revised, and we could not have been confident until now that a hypothetical new downturn would count as a second recession instead of a continuation of the first one.    Does the 15-month lag in this announcement seem like a long time?  It took us 18 months to declare the end of the preceding recession (2001).

              On the other hand, people say “It doesn’t feel like the recession is over to me or to people I know.  How can the NBER be so out of touch?”   The main answer, here:  The proposition that the recession is over is only a statement that things are no longer getting worse; it is not a statement that we are back to good times.    The economy still feels bad for good reason:  it is bad.  In particular the unemployment rate is still very high.   But things are much better now than they were 18 months ago, when the economy was in freefall, or in mid-2009, when we were at the bottom of the worst downturn since the Great Depression.  It takes a long time to emerge fully from a hole that deep.  And, to be sure, the current pace of the expansion is disappointingly slow, especially with respect to jobs.  But GDP and employment are, at least, rising.

              The other question that we are asked the most is whether one should worry about a double dip recession.  The NBER does not forecast.  I can speak only for myself.    The possibility of a new downturn is indeed a concern, especially because Washington has been unable to deliver a sensible fiscal response. (A sensible policy in my view would consist of some more stimulus, as in February 2009, designed to maximize bang-for-the-buck, coupled with simultaneous steps to move the long-term fiscal path back toward responsibility, such as social security reform).    But even without an appropriate fiscal response, I am optimistic that we can avoid sliding back into a second outright recession.  More likely, we will have a slow continuation of the current (inadequate) recovery.

Payroll employment peaked in December, and according to numbers released today had declined by 260,000 jobs as of April. (Source: BLS.) Since we have not yet seen a single negative number on GDP growth, this job loss is easily the most tangible statistical evidence we have so far that the much-heralded recession indeed may have started in the first quarter of 2008.

It has been noted that the unemployment rate started out from a low level — averaging 4.6 % in 2007 — so that even after a period of gradual increase, it remains relatively low by historical standards: 5.0% in April. This is still inside the range that has usually been considered by politicians as too low to generate serious discontent (and by central bankers as too low to put downward pressure on wages and prices). But why, then, is there so much popular dissatisfaction with the economy?

One answer is the old “discouraged worker” effect. Workers who stop looking for a job are not counted in the labor force, and so are not counted as unemployed. There is an obvious way to capture this phenomenon. Compare employment to the entire population, rather than only to those who are actively in the work force. The chart does that. (These figures include farm jobs, as in the standard BLS employment ratio.)

The path of the employment/population ratio during the current decade has been remarkable. The steep slide in jobs that began with the 2001 recession continued thereafter, and actually accelerated in late 2002. Finally the freefall leveled out. (The Bush Administration trumpeted the turnabout in terms similar to those it now uses to sell the aftermath of the troop surge in Iraq: the response to an unacceptable casualty rate was to make things worse for a half-year, and thereafter to compare the post-surge rate of casualties to the high-point, rather than to the period that came before.)

Employment did indeed rise between the years 2003 and 2007. But it barely stayed ahead of population growth. It did very little to make up for the decline equal to 2-3% of the population that had taken place during the first two years of the Bush Administration. The labor force participation rate normally rises in a boom, as good labor market conditions lure workers out of homes, schools and retirement. This is certainly what happened during the record expansion of 1992-2000. But it did not happen during the most recent expansion. To the contrary, the labor force participation rate was at a minimum in 2007, even though that year appears to have been the peak of the business cycle. As a result, employment as a share of the population was well below what it had been at the preceding business cycle peak year (2000). The fraction of Americans with jobs shows a decline from 64.7% to 62.6%, which translates into 4.9 million missing jobs ! Little wonder that, as employment once again starts to decline even in absolute terms, workers are unhappy.