There’s heightened nervousness about the next recession and there are signs pointing in both directions.

January 11th, 2019 at 3:34 pm

I can’t turn around without seeing or hearing people worrying more about the next recession.

Google Trends: Web search for “next recession”

Source: Google Trends

My peeps at the Indicator have a nice podcast on the topic. The WSJ points out that more than half of economists they surveyed expect a downturn by 2020, which, in case you live under a rock, the article helpfully notes is an election year.

The reasons for the heightened anxiety are:
–Slower global growth, particularly in China (also Europe and Japan). Remember how Apple’s market cap fell 10 percent in one day a couple of weeks ago. That was on the news that their China sales were down. We’re all connected, man…also, trade war.

–Higher interest rates and the flat yield curve. Interest rates are up, which acts like a brake on growth and they’re up more for short- than long-term rates, meaning the yield curve is flat, though not inverted (inversions provide reliable recession warnings, though they don’t say precisely when).

–High levels of US sovereign and corporate debt could provoke a credit crisis. High private sector debt levels can proceed a deep and sudden credit contraction, and high government debt can lead to the perception of diminished fiscal space, discussed below.

–Overheating risk and the Fed. This has maybe faded in recent weeks as the Fed has sounded pretty dovish of late, while inflation–actual and expected–looks decidedly nonthreatening. But with historically low unemployment and bigger-than-expected job gains, there’s always some nervousness of the return of that 70s show, with inflation taking off and the Fed having to slam on the brakes.

–Trumpian cray-cray. I mentioned the trade war. Then there’s the shutdown. And…how can I say this?…our current leadership fails to inspire confidence in this (or any other) space.

These are all real things, but here’s a realer thing: economists can’t tell you with any authority when the next recession is coming. If you forced me to take a stand, I’d stand with Powell. Heather Long reports the following:

“I don’t see a recession” in 2019, Powell said Thursday in an interview at the Economic Club of Washington, D.C. “The U.S. economy is solid. It has good momentum coming into this year.”

To be clear, the “solid U.S. economy” still leaves too many people and places behind, and real middle-wages, incomes and earnings haven’t been nearly as strong as, say, corporate profitability.

Just to be a contrarian, let me tell you about a few indicators that underscore Powell’s near-term optimism.

First, economist Jan Hatzius from Goldman Sachs has long emphasized the private sector balance sheet (those of us of a certain age recall that the great Keynesian economist Wynne Godley emphasized this metric).  Jan writes that: “…a financial deficit in the private sector—i.e., an excess of private sector spending over private sector income—…makes aggregate demand highly vulnerable to disruptions in asset prices or the supply of credit.”

Well, private balance sheets look pretty good–they’re around their historical average. Hatzius calls this “an unusually benign reading this deep into an expansion” and adds that “it is not only the household sector that runs a surplus but also the nonfinancial corporate sector, which is reassuring given the concerns around leveraged loans and corporate credit more broadly.”

I agree. However, the figure does show that this balance can spike pretty quickly, so here’s some positive indicators to which I’d give more weight: the strong labor market, rising real wages, and their correlation with real consumer spending. The figure below plots the yearly change in real aggregate earnings–real wage*jobs*hrs/wk–for middle-wage workers against consumer spending, which, ftr, is just under 70 percent of US GDP. To be fair, this is a much less forward looking indicator than say, the yield curve, but here’s the punchline: unless you have a story about the US job market heading south in a big way this year, I don’t think you have much of a near-term recession story.

Sources: BEA, BLS

Moreover, my labor market story goes the other way. I suspect unemployment–a lagging indicator–falls further this year and that the combination of strong labor markets and low energy prices leads to decent real wage gains. In fact, just this AM, we learned the real, mid-level hourly wages rose 1.3 percent in 2018, its strongest showing since August 2016.

To be clear, in much of my analysis, I have emphasized the expected slowing of growth later this year as fiscal stimulus fades. But, again, it’s not obvious that this doesn’t mean a return to the pre-stimulus trend growth rate of around 2 percent as opposed to a recession.

Finally, while we just can’t know when and why the next downturn will hit, we can get a sense of whether we’re ready for it (listen to the Indicator link above on this question). I say we’re not (though if we did the stuff in here, we could be). Monetary space may be constrained by an historically low federal funds rate, and if the debt/GDP level is =>80 percent, which may well be the case, history shows that the fiscal authorities, politically constrained by this higher-than-average debt level, tend to do less by way of discretionary, counter-cyclical offsets.

Such austerity would be a terrible mistake, for a lot of reasons. Depending on the depth of the downturn, it’s a great way to consign millions of people and families to unnecessary job and income losses. And such losses, depending on how deep they are, have been shown to leave lasting scars on people well into their post-recession lives. Also, as I wrote yesterday, Blanchard’s new work shows the fiscal and welfare costs of public debt to be far below where the convention debate places them (and in my framework, countercyclical offsets in recession are definitely GD–read the piece).

I’ll continue to heed all the warnings of my fellow tradesmen and women–no question, there are headwinds now that were not upon the land a year ago. But I’ll be more guided by the fact that nobody can time a recession, while anyone who’s paying attention can raise trenchant warnings about whether we’re ready for it, wherever it is.

Blanchard on public debt and interest rates; also: thanks, MMTers!

January 10th, 2019 at 12:58 pm

There’s a deservedly nice bit of buzz about a new paper by tony economist Olivier Blanchard. My WaPo piece today takes you through the argument, along with a heavy dose of my own interpretation, one familiar to OTE readers.

“The key points are disarmingly simple, and they’re ones I have written about before in this column. Part one is this: When a country’s growth rate is higher than the interest rate on its debt, the fiscal costs of sustaining its debt levels are somewhere between zero and low. The reason is that even if the government does not raise taxes to offset its higher debt, the ratio of debt to gross domestic product will decrease rather than explode over time. Part two: For most of the period covered by Blanchard’s research (1950-now in the United States), g>r, i.e., the GDP growth rate has exceeded the interest rate (same with the U.K., the euro area and Japan).”

I then discuss a nuanced aspect of the work. Because private capital accumulation is diminished in higher public debt scenarios, the return on capital investment must also be part of this cost/benefit analysis. In my interpretation, this leads to a conclusion that regardless of how low the interest rate on debt is, we still need to distinguish between the utility of borrowing what I call “good debt” and “bad debt.”

Here, I’d like to briefly discuss two thoughts I left out of the Post piece.

The first is in regard to the political economy implications of Blanchard’s findings. In a better world, these findings would lead fiscal policy makers to think more realistically about public debt. But in the real world, where every idea becomes a weapon in the arsenal of partisan politics, deficits are largely a political, not an economic tool.

R’s shout about them when they rise on the D’s watch and ignore them on their own watch. Because D’s have long been too sensitive to accusations of fiscal profligacy and R’s just don’t care about any of that, this has led to austerity in years when we needed the fiscal stimulus and visa versa now, or what I call “upside-down Keynesianism.” I go through the numbers/evidence here.

I don’t expect Blanchard’s evidence to change these dynamics because they’re not about fiscal costs, they’re about political posturing. But that doesn’t mean nothing will change!

A lot of the fear-mongering and deficit attention disorder is driven by deficit scolds outside of government. The pressure from MMT’ers (my next point), Blanchard’s analysis, similar historical work I cite from Kogan et al, and, most importantly, the lack of crowd-out or other predicted economic distortions from deficits, all make it harder for the austerians to be taken seriously by neutral observers. See, for example, David Leonhardt, a evidence-based columnist known for pitching it down the middle, in today’s NYT.

As I (and Blanchard) argue, this doesn’t mean deficits don’t matter. Again, see my GD/BD discussion. But this feels a bit like the minimum wage debate in the early 1990s when Card and Krueger came out with Myth and Measurement, their path-breaking work disproving the widely assumed connection between minimum wages and pervasive job losses. About 10 years later, the reality of their findings became broadly accept knowledge and the result has been much better policy in this space.

Thus, if progressive/empirical economists keep pushing on this more nuanced, realistic view of public debt, perhaps policy will be smarter in 10 years. Sorry if that’s a wait, but given the stickiness of lame ideas, you either play the long game or no game.

Next, I didn’t say anything about MMT but much of the discussion around the Blanchard buzz makes the correct point that the MMT’ers played an important, admirable role in elevating these issues. I’ve raised some questions about their model and Josh Barro’s new piece provides an excellent take on their perspective at this interesting moment in fiscal thought.

Much of the analysis shows that MMTers are advocating Keynesianism with a few wrinkles, like their argument that if fiscal stimulus does generate overheating, the Congress should reduce price pressures with a tax increase, which leads most of us to ask, “what’s plan B?”

But their relentless hammering against mindless deficit reduction has been a key force in the ongoing, salutary rethink of these relations, for which we should all thank them!

Links referenced in a recent talk

January 6th, 2019 at 12:59 pm

I recently spoke to members of Congress and referenced a number of pieces. Here are the links to those pieces.

What are some ideas for lowering the growth of health costs? See the section starting on pg. 11 of this testimony.

On our lack of investment in quality, affordable pre-K, and how we’re an international outlier in that regard. Look carefully at the 2nd figure–it tells this story well.

On some ideas for progressively raising revenues. Also, see this on a financial transaction tax.

On the need for fiscal stimulus in the next recession, even at “high” levels of the debt/GDP ratio.

On lowering the black/white unemployment gap.

Payrolls up big as a strong jobs report caps a strong year for the US labor market

January 4th, 2019 at 9:37 am

Well, it appears that the US jobs market didn’t get the memo that a recession is just around the corner.

Payrolls rose a very strong 312,000 in December, bringing the full count of jobs added for 2018 up to 2.6 million, the strongest year for job gains since 2015. Unemployment ticked up to 3.9 percent, but largely because more people were drawn into the labor market, as the participation rate ticked up two-tenths to 63.1 percent, its highest level since early 2014, and yet another reminder that the job market has more capacity to expand than many observers heretofore believed. Nominal wage growth accelerated slightly and, at 3.2 percent for all private sector workers and 3.3 percent for mid-level earners, both measures tied cyclical highs. Weekly hours edged up slightly, jobs gains for the prior two months were revised up, and a very high 70 percent of private industries added jobs on net.

In other words, not only is the US labor market holding its own, it’s actually gained momentum in recent months. Moreover–and remarkably–these uniquely strong results are occurring against a backdrop of low, stable inflation, implying that the Federal Reserve could still conceivably pause in their rate-hiking campaign, accommodating job market improvements that are so essential to middle and low-wage workers.

Key findings from today’s report

To boost the underlying signal from the jobs data, our monthly smoother takes 3, 6, and 12-month averages of the monthly job gains from the payroll data. First, note that the bars show relatively high levels of job creation at this stage in the expansion, as many economists believed monthly gains would be slowing by now as the job market neared peak capacity. But at 254,000, the average monthly gain over the past quarter has been slightly higher than the earlier trends.

Tighter labor markets continue to noticeably boost wage growth, as shown in the two figures below. Nominal hourly wages were up 3.2 percent, year-over-year, for all private-sector workers, and 3.3 percent for middle-wage workers. The smoothed, 6-months moving average shows evidence of “wage-Phillips curve” awakening in 2018: low unemployment finally started to correlate with rising pay pressures. As discussed next, thanks largely to low energy prices, I expect real wage growth of over 1 percent for middle wage workers in 2018. While not a particularly high real growth rate in historical terms, it represents an important gain for working families.

Lookback on the 2018 job market relative to earlier years

With today’s report, we can evaluate the 2018 job market in historical context, as in the two tables below. The first focuses on jobs and the second on wages. Annual changes are for December 2017 over December 2018; level variables are for December 2018 (all these values may undergo some revisions).

Payrolls grew by 1.8 percent last year, a comparable, if slightly higher, rate to earlier years in the cycle, with gains of about 220,000 per month. The unemployment rate remains below that of earlier years in the last decade, and 6 percentage points below the almost 10 percent rate at the end of 2009, near the trough of the Great Recession. Another measure of labor slack—the employment rate of prime-age workers—at 79.7 last month, is still climbing back to its pre-recession peak of 80.3 percent reached in January at that year.

The next table offers a longer historical perspective on the growth in the hourly pay of middle-wage workers at business cycle peak years and 2018 (which may or may not turn out to be a peak year). Some key determinants of mid-level wage growth include the pace of inflation, productivity, unemployment, and bargaining power (which is, in turn, related to low unemployment, as well as unions and the depth of government labor standards, like minimum wages).

Thanks to the pressure of tighter labor markets, nominal wage growth picked up over the year, as shown in the figures above. But it remains below that of prior peaks. Part of this relates to lower inflation, and, in fact, real wage growth was faster for mid-level workers last year than in 2016-17, at least based on my forecast for December inflation (which isn’t out yet; my guess is that CPI inflation is up 2 percent, Dec/Dec).

The key lesson is that very tight labor markets generate real gains for working people, even with productivity quite low. Importantly, these gains are occurring in the current economy without generating inflationary pressures, both in actual and in expected inflation. Any economic model that insists the monetary authorities hit the brakes hard to preclude further such gains is clearly out of touch with reality.

Recession ahead?

Amidst this positive labor market news, various economic headwinds have kicked up of late. Highly volatile financial markets, Trump’s trade war, slower growth abroad, and fading fiscal stimulus are leading to some grim forecasts for near-term U.S. growth. Conversely, low unemployment, job gains, and higher real wages can be counted on to boost consumer spending, which is almost 70 percent of the U.S. economy. In other words, the economy faces both headwinds and tailwinds, with the latter reflecting the job-market induced strength of the highly acquisitive American consumer.

The next figure shows this relationship by plotting yearly growth rates of real, aggregate, weekly earnings (jobs times real wages times hours per week) against real, economy-wide consumer spending (not including December’s results). They track each other well, though less so in recessions, when households dip into savings—if they can—to smooth their consumption through down labor markets. Most recently, both series have been steadily tracking 2.5 to 3 percent and my expectation is that this trend will persist, if not strengthen in coming months, as stronger real wage gains support spending.

Source: BLS. BEA, my analysis

However, the headwinds noted above are real and, especially as fiscal stimulus fades later this year, growth will likely slow, as will job gains, threatening the dynamic portrayed in the previous figure. For now–say, over the next 6-12 months–strong consumer spending should provide the US economy with good momentum. But it is important to sustain these gains for as long as possible, as it took a long while for many working households took benefit from the expansion.

Testify! Diving into the weeds on debt, the spending vs. revenue problem, and “revealed preferences.”

December 20th, 2018 at 4:18 pm

I testified today before the House Financial Services Committee at a hearing the Republicans called “The perils of ignoring the national debt.” As I tweeted earlier today, the hearing was delayed a hour because the R’s went off to vote on a tax cut adding another $100 billion to the 10-year debt. That bill is unlikely to get very far in the Senate, but it does raise a somewhat existential question about the urgency of all this hand-wringing about the debt.

Here’s my testimony; see the intro for a summary and bullet points. There are two points I’ll highlight here. First, see the discussion of “revealed preferences.” I hear a lot of chin music from all sides about how much they really want to cut spending, yet they rarely do so, and, to the contrary, are often quick to raise spending on their preferences, many of which, to be clear, I share.

But I was taught to pay a lot more attention to what people do, not what they say, which economists label “revealed preferences.” Thus, I conclude in my testimony that:

Spending and “revealed preferences:” My point in these NDD and defense discussions is that Congress’s “revealed preferences” suggest our deficits are born of an unwillingness to raise the revenue we need to meet the spending we believe is warranted. To label that a “spending problem” is fundamentally inaccurate.

While hearings like this show we can have substantive disagreements on the extent of those needs and spending levels, spending deals don’t sign themselves. This reality, in tandem with the existence of large, persistent deficits and debt, reveals that year upon year, Congressional majorities accept existing spending levels. However, the current Congressional majority has not only been unwilling to raise the revenues necessary to pay for its revealed preferences, it has significantly cut its revenue inflows.

The essence of our fiscal problem is thus neither a revenue problem nor a spending problem. Instead, it is this: Congress has long been unwilling to raise the resources necessary to pay for the institution’s revealed preferences. Given that framing of the problem, policy makers must either reduce Americans’ expectations about the role of government in our economy and their lives or, over the long-term, raise the revenues necessary to meet those expectations.

Next, a quantitative analysis of budget forecasts suggests that the logic of a framing our fiscal imbalance as a spending problem, full stop, is indefensible. I paste that section in below and urge you to take a good look at the Figure 4 (the third figure below). It’s dense, I grant you, but I think it’s persuasive.

Washington, we have a revenue problem

The above observations show the “spending-problem-only” framework to be clearly misguided. In fact, one of my biggest concerns about the impacts of the Republican tax plan is the extent to which it has broken a critical linkage in public finance: that between a full-capacity economy and lower deficits and debt through higher revenue flows. (Because it so heavily favors wealthy households, the other major concern is the extent to which the tax law exacerbates after-tax income inequality.)

Figure 2 below shows that because more economic activity—lower unemployment in the figure—has historically spun off more tax revenue, as the economy has closed in on full capacity, the budget deficit has gotten smaller, and vice versa (deficits are shown as positive shares of GDP). [1] Outside of major wars, and before the 2017 tax law, when economic growth led to more employment and diminished labor market slack, deficits typically came down. In fiscal year 2000, for example, the unemployment rate was 4 percent and the budget was in surplus.

Figure 2

In fact, using data back to the mid-1940s, the average deficit as a share of GDP over every year that the unemployment rate was lower than or equal to 4.5 percent comes to -0.4 percent. If I take last year’s and this year’s deficits (-3.5 and -3.8 percent) out of that average, the result is a small surplus (0.1 percent).

The end of the figure shows just how different our fiscal stance is today and, based on CBO projections, in the future. The unemployment rate is well below 4 percent, but the deficit, also about 4 percent, is far above its average at low unemployment. In fact, a simple regression of the deficit-to-GDP ratio against unemployment predicts a deficit of about 1 percent in FY18, almost 3 percentage points below its actual value.[2]

Is this divergence driven by a negative shock to revenues or a positive shock to spending? CBO data reveal the answer to be a negative revenue shock. The figure below shows that in the summer of 2017, before the tax cuts and spending deal, the budget office predicted that we’d spend 20.5 percent of GDP in 2018, which, as the actual spending bar shows is almost exactly the right number (20.3 percent). However, CBO also thought — remember, this is pre-tax-cut — that we’d collect 17.7 percent of GDP in revenues when the actual share was, as shown, just 16.4 percent. This diminished revenue figure is the key difference between what CBO expected then and what occurred. In fact, the spending share—20.3 percent of GDP—is precisely equal to the 50-year average.

To be clear, the point of this comparison is not to argue that our current spending of about 20 percent of GDP is optimal (though it is “average” in historical terms). Instead, it shows that the jump in the 2018 deficit was a function of the tax cuts leading to diminished revenue collection, an outcome that is especially disappointing given the near-full-capacity economy.

A comparison of CBO long-term projections further underscores the revenue shortfall point. Figure 4 shows CBO’s forecasts for primary outlays (outlays other than interest payments[3]) and revenues from two different vintages of their long-term budget outlook, one from 2010 and the most recent, from 2018. The logic of the “spending problem” case implies projected outlays should be accounting for a higher share of GDP in the 2018 projection, with the projected revenue share either higher or similar to that of the earlier forecast. That is, the “spending problem” scenario should show fiscal gaps being driven by more spending, not less revenues.

In fact, the opposite is the case. Not only are primary outlays lower in the 2018 than the 2010 forecast—by 2 percentage points of GDP, on average, over the forecast period—but revenues in the 2018 budget outlook are much lower than in 2010’s outlook—by 4.5 points, on average. And they would be even lower were Congress to extend the Trump tax cuts. In other words, current law in 2010 (not all of which was followed, to be clear; i.e., the George W. Bush tax cuts did not fully sunset) called for both higher spending and higher revenues than today’s current law. And given that the revenue decline between these two forecasts has been more than twice that, on average, as the primary spending decline, the “spending problem” framework is not defensible.

These are forecasts, but  a longer-term analysis of the actual path of revenues and outlays by Robert Kogan of the Senate Budget Committee staff makes a similar point. Had we kept the Clinton-era tax code in place—meaning no George W. Bush or Trump tax cuts—but let all the spending that occurred since then proceed apace, including the military actions, the Affordable Care Act, and so on, the result would be a debt-to-GDP ratio that is 27 percentage points, or about a third, below where it stands today, about 51 percent instead of 78 percent.[4]

[1] Paul Van de Water, “2017 Tax Law Heightens Need for More Revenues,” Center on Budget and Policy Priorities, November 15, 2018, https://www.cbpp.org/research/federal-tax/2017-tax-law-heightens-need-for-more-revenues#_ftnref16.

[2] The regression runs from 1949 to 2017 with the unemployment rate at time t and with one lag, along with a lag of the dependent variable. All coefficients other than the constant are significant at the p<0.01 level; R-sq=0.81 and DW=1.77.

[3] Primary outlays are an appropriate choice here because the “spending problem” refers to programmatic spending. Consider a revenue increase with unchanged program spending. Thanks to the higher revenues, deficits and debt service would fall, even with no spending cuts. However, for completeness, I show the same figure with total outlays in an appendix.

[4] https://www.washingtonpost.com/news/posteverything/wp/2018/05/29/my-attempt-to-cut-through-the-fog-of-our-fiscal-debate/?utm_term=.52481a56ae76