What is the “natural rate” for u6?

November 23rd, 2015 at 8:04 am

Not the sexiest title, I grant you, but important stuff, nevertheless.

Those of us interested in just how close we are to full employment like to track the more comprehensive “u6” rate, aka, “underemployment.” It includes all the unemployed, but also the millions of involuntary part-timers (IPT)—who are, quite literally, underemployed—plus a small subset of those out of the labor market who might be willing to work if there were more good opportunities available. Especially because IPT has been so elevated in this recovery, and because some special factors, like depressed labor force participation, have led to a downward bias of the unemployment rate, u6 is worth watching closely.

As you see below, u6 rose more in the Great Recession and has fallen faster in the expansion than the official rate.

Unemployment and Underemployment (u6)

Source: BLS

Source: BLS

Now, for reasons I’ll explain, it’s necessary to guesstimate to the “natural rate” of unemployment, i.e., the unemployment rate consistent with stable prices. The Fed thinks it’s about 5% which is where we are now, ergo, they’re getting ready to raise rates.

But I think that these days, it’s better to gauge slack using u6, which last clocked in at 9.8%. But where is that relative to the natural rate of underemployment?

The (justifiably) influential macro team at Goldman Sachs believes that the natural rate for u6, call it u6*, is 9%. That’s about where u6 stood at the end of the last expansion (late 2007) when the official rate was at 5%, so not an unreasonable guess.

OTOH, as you can see in the figure, u6 was around 7% at the end of the 2000s expansion, when the official rate was around 4% (and inflation was perfectly well behaved, ftr). There are reasons to believe the “natural rate” is higher today than it was back then—certainly productivity and thus potential growth are lower now. And, of course, there are good reasons not to truck in this whole “natural rate” business at all; there’s no reliable way to nail it down, it moves around, and economists invariably tend to pitch it too high, at great cost to those who depend on truly full employment.

But here’s why it’s important: the Taylor Rule. This is the rule that says at least one Taylor Swift hit must be on pop radio at any given time (whoops—sorry—just a little whining from a chauffeur whose teenagers insist on controlling the radio). The other Taylor Rule is one of the methods the Fed employs to decide whether the interest rate they control needs to be raised, lowered, or left alone.

There are many variations of Taylor rules, and I’ll let you Google them to your heart’s content. They’re a touch controversial right now because House Republicans are trying to pass legislation to make the Fed follow some version of the rule, a terrible idea that Fed chair Yellen has inveighed against. Like I said, the rule is but one input and there are too many variants to reliably count on it to give anything more than a range of impressionistic answers as to where the Fed funds rate (ffr) should be set.

The rule is just a formula that takes data on inflation and slack and spits out an ffr. If you use the version Yellen describes here in footnote #5, and you plug in u6 instead of the official rate for slack, as I strongly think you should, you have to, as part of the formula, guesstimate u6* (the natural rate for u6).

So that’s what I did, using a few different methods (data available upon request).

1) regress u6 on Levin’s comprehensive slack variable, such that u6*=the intercept term, i.e., underemployment when slack=0.

2) regress u6 on the difference between the unemployment rate and the CBOs natural rate; the intercept is again the natural rate.

3) same as #2 but just plug in 4.5% for CBO’s natural rate, under the assumption that they peg it too damn high.

The table shows the results, using Yellen’s ftnt 5 version of the Taylor rule, and the most recent observation of year/year core PCE inflation (1.3%).

Source: see text

Source: see text

If, like the GS team, you think u6* is 9%, the rule returns 0.17% which is about where the Fed’s likely heading in a few weeks, when they raise the ffr by 25 basis points. If you think u6* is something less than that, as I do, you’d be in less of rush to get started with your “normalization campaign” as the rule says the economy still needs a negative real rate to get back to full employment.

But these differences are small and there are many sensitive assumptions built into the calculations. As I’ve said here re Fed liftoff plans, go ahead and raise a tiny bit if you must. What matters now is the path of future increases which, if we are to get to and stay at truly full employment, should surely be shallow and driven by the extent to which income and wage growth are reaching those who have heretofore been left behind.

President Obama makes an interesting point about economic messaging

November 20th, 2015 at 8:47 am

From a recent interview with the President in GQ:

You can’t separate good policy from the need to bring the American people along and make sure that they know why you’re doing what you’re doing. And that’s particularly true now in this new communications era. I think that we were ahead of the curve in 2008 in social media and the Internet and digital communications. When we came into office, instead of taking some of those lessons, we suddenly adapted ourselves to the White House press room and structures that had been built back in the 1940s and ’50s. As a consequence of those missteps early, we got the policies right, and that’s why the economy now has grown for five and a half straight years, six years, and why unemployment rates have gone from 10 percent to 5.1 percent. But there was a lot of political pain along the way that might not have been necessary.

Accurately diagnosing economic problems is often challenging. Figuring out the right policy prescriptions to treat the diagnosis is also hard, as is effectively and efficiently implementing the fixes.

But on top of all of that, effectively explaining what you’re doing to “the American people,” who, despite that unfortunate phrase, are not a monolith, is especially challenging.

First, if we’re talking about countercyclical policies of the type that the administration implemented in the heart of the Great Recession, there are two strong forces pushing against efforts to sell measures like the Recovery Act. One, people don’t do “counterfactuals”—what economists think would have happened to key variables had we not intervened. The jobless rate was 8.3% in February 2009 when the Recovery Act passed. It climbed to 10% later that year and didn’t fall below 8.3% until early 2012.

The message that “yes, unemployment’s gone up since we launched the stimulus but it would have gone up more absent the intervention” is not one most people are at all willing to entertain.

Two, opposition political forces take it as their job to discredit these actions. Despite evidence to the contrary, they dubbed the Recovery Act the “failed stimulus” pretty much out of the box (no question, Christy Romer and I didn’t help by using the consensus forecast at the time to predict the impact of the Recovery Act on unemployment; ftr, we had the deltas right—the changes in unemployment, jobs, and GDP—but the levels were too optimistic; this was a huge kick in our own goal that played into opponents hands and vastly complicated the messaging; see the offending Figure 1 here, but also see our beloved Endnote 1).

If those factors didn’t pose enough of a messaging challenge, the fact that we were bailing out banks didn’t help. People correctly perceived that the folks who helped get them into the mess were being rescued with taxpayer dollars. I don’t think anyone could sell that to the public.

President Obama’s point is more about the medium than the message. After using social media arguably more successfully than any prior national election, he notes it was largely dropped in favor of old school methods. Could more Twitter have meant less “political pain?”

I don’t know and have no idea how to back out that counterfactual. I tried writing blogs for the Huffington Post (here’s an e.g.), explaining in granular terms the positive impact of the Recovery Act, but I don’t think they reached anyone. The White House has certainly well adapted social media since then, but the economy’s improved and all those countercyclical interventions are way in the past.

He’s right that the policies were effective, and in many ways, that’s the most important message to get out there now, as in this important new paper by economists Alan Blinder and Mark Zandi. There’s another recession out there somewhere and it is essential that we the correct lessons regarding what worked and what didn’t from the last one.

But other than not scoring a win for the other side, I kinda doubt we could have done a much better job selling the policies in real time, even with a bunch more Snapchatting, etc. I’m not letting us off the hook, nor am I suggesting we did everything right; we didn’t. I just think the nature of the moment, the need for the bailouts, and the fact that things were going to get worse before they got better overwhelmed our messaging skills, such as they were.

Models of the minimum wage (for what they’re worth)

November 18th, 2015 at 7:15 am

The recent minimum wage debates among the various campaigns are pretty disconnected from a model of how the damn thing actually works in the real world. In part, that’s a function of campaigns not doing nuance, but it’s also because there is no model that economists agree on as per why the empirical results on minimum wage increases are so different from the predictions of the classical model.

As I’ll show in a moment, that model predicts a lot of unemployment and you just don’t see that following moderate minimum wage increases. To be clear, I’m not arguing you don’t see any job loss. But you don’t see anything like the predictions of minimum-wage opponents: the number of beneficiaries of the increases virtually always far surpasses anyone hurt by them.

Start with the classical, textbook model. Now, as you’ve heard me say before, “all models are wrong; some models are useful.” But when it comes to the minimum wage, this model is both wrong and useless. If you’re in an econ class and your professor presents this model of the minimum wage and nothing more, she is guilty of malpractice.


The X-axis measures employment (N) and wages (W) are on the Y-axis. Demand curves generally slope down, a negative function of the wage rate, and vice-versa for supply curves. The equilibrium wage and employment levels are at the intersection of D and S. Impose a minimum wage above the equilibrium level and workers want to supply more labor than employers demand, so the wage mandate generates unemployment.

Why is this model so off? Staying within the competitive framework, the first variation adds dynamics, showing how a positive demand shock can absorb the wage increase. D_0 is the original demand curve, but Paul Krugman gets elected president and introduces a massive infrastructure program, such that the demand curve moves out to D_1, absorbing the wage increase with no unemployment.

This is, of course, fanciful, but to the extent that higher minimum wages get spent in places where consumer demand is constrained by working poverty, the model may be telling us something about why moderate increases have their intended impact. The same dynamic is likely operative when immigration raises labor supply: the demand the immigrants generate helps to offset their added supply.


Of course, a negative demand shock would have the opposite impact. Yet even when wage increases have been introduced in down economies (e.g., 1991), we’ve not seen large disemployment effects, so this model too is surely incomplete. Also, demand increases can be accompanied by supply increases (I’m holding supply constant in this second figure), and that too will just get you back to the similar, doleful dynamics seen in Figure 1.

[During the 1990s, the minimum wage and the EITC were increased, and welfare reform was introduced. In the context of these first two figures, that might lead you to expect a large supply shock, lowering wages and boosting employment. Except what actually occurred was both low wages and low-wage employment went up significantly. Thus, in the context of these models, supply expanded but demand expanded further. Or, as we say around here: full employment solves a lot of problems.]

Still sticking with the model, we can introduce some ideas into the diagram that comport a bit more with reality. In the low-wage labor market, demand has consistently been found to be highly inelastic, meaning workers/employers are not that responsive in terms of employment to changes in wages (dlog(emp)/dlog(wage)=small number like -0.1 to -0.3, or something…). Let’s assume supply is pretty inelastic too, which at least from the perspective of low-income workers (versus kids of wealthier families) seems plausible, since they’ve gotta work as opposed to choosing whether or not to work.

When you draw inelastic supply and demand curves, you end up predicting a lot less unemployment. Given the confidence intervals (statistical uncertainty) around our econometric estimates, you can see how if this model is more accurate, significant estimates of job loss effects are hard to pull out of the data. Which they are, suggesting this version may well be trying to tell us something about low-wage workers and their employers’ tempered responsiveness to increases in the wage floor.


In some cases, it has been observed that employment increases after the minimum wage is raised. There’s a model for that too, called a monopsony labor market, meaning a job market with one employer (details here; figure shown below). Compared to the models shown thus far, where wages are set at the level of the macroeconomy (vs. the level of the firm), in monopsony, the big employer sets the wage. If she sets it too low, employment and output can be inefficiently low. Since the employer faces an upward-sloping supply curve, when she raises the wage, she pulls more people into work (see the link for the meaning of the other labels in the model).


The monopsony model may sound arcane—the classic example is the one-company coal town—but it may not be too much of a reach to conclude that the low-wage labor market in a given town or city works kind of like this. As the link concludes, “the minimum wage is increasingly effective in improving efficiency, the more the market is controlled by buyers. A minimum wage is increasingly problematic, the more the market is competitive.” The fact that employment has not responded to wage increases as in the competitive market (Figure 1) might confirm your suspicion, as it does mine, that the low-wage labor market is typically not in equilibrium and is dominated by buyers (of labor), like fast-food restaurants, who may well operate in ways that mimic monopsony.

In a Republican debate the other night, Donald Trump, when asked whether the minimum wage should be raised, answered “no” because, he asserted, our problem is that wages are too high. His colleagues generally seemed to agree with him.

The next figure plots this (cockamamie) idea. W_0–the current minimum wage–is too damn high, and is thus restricting job growth. Take it down to the intersection of supply and demand, and you end up with more jobs. But here’s a fun wrinkle: deport 11 million unauthorized immigrants—7 percent of your workforce—and build a wall, thus whacking the heck out of your labor supply (as seen by the inward shift of S_0 to S_1) and the competitive model predicts higher wages but fewer jobs. If the negative supply shock is strong enough, it can fully offset the initial wage loss such that the post-wall wage of W_2 equals the original minimum wage.


This part of the exercise proves that much as you shouldn’t look directly at a solar eclipse, thinking through Trumponomics is ill-advised.

Otherwise, do we learn anything from all this modeling? Most importantly, the competitive model as conventionally drawn is misleading. Economic models vastly simplify the economy, which can yield some insights, such as the dynamic, inelasticity, and monopsony points above. But at end of the day, you really don’t want to push any of these too far. In economics, when the theory doesn’t match the evidence, trust the evidence.

(h/t, Ben S for help with figures.)

Imagine that…candidates actually debating substantive differences on economic policy

November 16th, 2015 at 9:20 am

Of course, Saturday’s debate between the Democratic candidates was initially dominated by foreign policy in the wake of the horrific attacks in Paris.

But when they turned to the economy, there were interesting substantive differences at a level of specificity you don’t often hear in these debates. I add my own few sense [sic] in re Glass-Steagall, the minimum wage, and the importance of who’s on the president’s economics team. Over at WaPo.

One thing I don’t get into was Sen. Sanders claim that “the business model of Wall Street is fraud.”

As you’ll see in the WaPo piece, I’m feelin’ the Bern re the senator’s impulse to thoroughly regulate financial markets. Such ideas, to be clear, hark back not to socialism but to smart economics from Adam (Smith) to Hy Minsky, who recognized that as the business cycle progressed, unregulated markets would eventually systematically underprice risk, inflate a bubble, and screw everything up for the rest of us for awhile, until the “shampoo cycle”–bubble, bust, repeat–can get started again.

But I don’t agree with his sweeping condemnation. And I say that fully understanding that campaign rhetoric often needs to reduce complex ideas down to simple assertions.

The reason this doesn’t work for me is that calling the model fraudulent actually makes it sound too easy to solve when the problem is the vast majority of what goes on in contemporary markets is of course legal. The problem isn’t fraud, it’s waste. It’s rent-seeking and anti-productive activities.

The role of early financial markets was to allocate excess savings that would otherwise sit in vaults not doing much of anything to productive endeavors with the potential to expand the economy’s productive frontier. More recent vintages added potentially useful instruments that allow market participants to hedge investments in ways that offset potential losses in investment A with investment B.

But from the very beginning, “innovators” found ways to speculate that generated temporary ebullience and hid the extent of growing risk. More often than not, the innovators were either a step ahead of the regulators or worse, tapped ideology about the wonder of innovation to drug regulators to fall asleep at their switches, dreaming Greenspanian dreams of self-regulating markets.

Fraud is much more concrete than any of that–think Madoff. Or for that matter, investment banks right before the crisis selling MBS long to clients while they, based on information they possessed in real time, were shorting them. That seemed fraudulent to me and should have been prosecuted. (Not the same thing, but it’s this sort of thing that leads me–and Lily B–to fight for the “conflict of interest” rule.)

There is a critical role for financial markets, for credit, for access to capital, for the ability to build assets through saving and investing. The goal of economic policy in this area must be to get back those fundamentals while blocking the shampoo cycle. I’m not sure yelling “fraud” helps to get us there.