Hysteresis in unemployment

The scatterplot of unemployment with insured unemployment gives visual evidence of the persistence of unemployment and the long term damage done by labor disruptions.  Here is the plot since 1971, first in raw monthly numbers, then in trailing 12 month moving averages.

We can see that unemployment remains elevated after each event.  Unemployment was relatively low during the 1975 disruption.  But, the recovery only lasted 5 years.  When the next disruption hit in 1980, unemployment was still elevated.  Then, the labor market was disrupted again in 1982, and unemployment, relative to insured unemployment, rose far from the normal range.  The labor market stalled in 1985-1986, but a full-scale disruption was avoided, so relative unemployment continued to slowly decline over time.

The next disruption happened in 1992, after a full 10 years of recovery, so the relative level of unemployment had fallen back into the normal range, but was still high.  The following recovery was 11 years long, so that by 2003, the level of unemployment, relative to insured unemployment, had fallen to below the level of the early 1970's.

Normal UE = total UE predicted by short term UE

Then, I think we see two things going on in the disruption of 2009.  First, since the recovery was only 6 years long, relative unemployment hadn't fallen back to its 2003 level, so the level of unemployment was slightly higher than the trajectory it followed in 2003.  Second, pro-cyclical policies - mainly very long-term unemployment insurance - led to an unusual number of reported very long-term unemployed persons.  We can see this in the third graph, where the level of total unemployment is reliably predicted by short term unemployment until the recent disruption.

At this point, the excess unemployment, relative to insured unemployment, is roughly divided in half.  Half of it could be related to the shortened business cycle that has led to a persistent increase in uninsured unemployment, similar to the 1980s, which appears to slowly decline as the business cycle lengthens.  The other half appears to be related to the unique feature of very long-term unemployment, regarding which there is no American precedent with which to anchor our expectations.

Given these factors, and given that exit rates from short and medium term unemployment should now be unaffected by EUI policies, monthly employment reports will have somewhat less importance, going forward.  Regular unemployment is roughly 5.0% now, and should slowly decline to 4.0% or even less if we can manage to maintain the recovery for another, say, 5 years.  The other approx. 0.8% of reported unemployment is very long term, and presumably marginally attached to the labor force.  While it's decline has been fairly linear for 2 to 3 years, at a rate that would burn it off by early 2016, its further decline and the destination of the workers who are leaving the category, may be difficult to track and may be only tangentially related to other factors at work in the economy.

I may focus less on monthly employment as a result.

Quick Follow-up on Inefficient Market Hypothesis (IMH)

Following on my earlier post, where I propose that the lack of reliable excess returns is not that dependent on efficiency, here is a short hand for levels of market efficiency.  These are roughly in order from contexts with the least amount of available excess returns to contexts with the most available excess returns.:


Strong EMH (prices reflect all public and private information)

Nobody can earn excess returns.

Semi-Strong EMH (prices reflect all public information)

Only insiders can earn excess returns.

 Weak EMH (prices are independent of past prices)

Excess returns without inside information are possible, but aren't persistent.

Weak IMH (investors are occasionally nearly universally unreasonable)

Persistent non-insider excess returns are only available in the (unlikely) event that you aren't bonkers.

Semi-Strong IMH (there are occasionally broad social pressures against being reasonable)

Persistent non-insider excess returns are available if you are willing to be frequently embarrassed and demonized.

Strong IMH (legal enforcement of inefficiency)

Persistent non-insider excess returns are available where there are an insufficient number of unregulated potential marginal investors.

In practice, strong IMH is widely available, but vulnerable to regulatory shocks.  Semi-strong IMH is widely available, but requires a decent amount of skill and clinical depression.  Weak IMH and weak EMH are difficult to distinguish from one another in practice.  Most punditry, including my own, and trading is from the presumed point of view of Weak IMH, but in hindsight is usually a confirmation of Weak or Semi-Strong EMH.  Even where investors, like Warren Buffett or Charlie Munger, spend a lifetime operating in something that looks like Weak IMH, there isn't enough evidence to clearly settle the issue.  Of course, if IMH is operative, who would we depend on to confirm it?

You should invest passively because markets are INefficient.

In a comment on my mini-rant the other day, pkd mentioned the trend among the intelligentsia of referring to our current era as "late capitalism", discussing capitalism as if its long-expected demise has finally arrived.  Stagnation, inequality, unsustainability...these are the concerns of the day.

It really is amazing how regularly backward human intuition is regarding emergent systems, particularly in financial and economic matters.  The internet, together with wireless telecommunications and computers themselves, is arguably the most awesome non-organic development ever to grace the face of the earth.  For the most part, it was developed, created, and disseminated to even the most destitute parts of the world in the time it takes a Western child to reach adulthood.  It is a revolution, it's universal, and it happened in the blink of an eye.

So, today a teenager can develop a piece of software that spreads across the globe, and become an instant billionaire because millions of people voluntarily remit to her some small portion of its value.  The rest of us, meanwhile, bathe in a sea of abundance and opportunity that was unimaginable before.  Why, I'm bathing in it right now, as I share my thoughts with you via my blog.  It's a cornucopia, much of which is provided at no direct charge, with (literally) immeasurable value.

And, our intuition sees this newfound wealth and this sea of immeasurable services, and screams "Stagnation! Inequality!"  We literally could not be more wrong.  And it comes so naturally.  No wonder the God of the Old Testament was always so angry.  We really are insufferable.  And, many people say, "You know what got us out of the Great Depression?  World War II.  Sometimes the  cure for stagnation (like living through this dark era when the internet was developed) and for inequality (says Picketty) is a good old fashioned war."  I'm not making this up.  This is a thing.  A very common belief.  Maybe the typical belief.

Anyway, this got me to thinking about the Efficient Market Hypothesis.  Emergent systems like modern markets are so effective at coordinating effort that it usually takes a peculiar cultural or regulatory obstacle to keep economic activity from dynamically moving in the right direction.  In unencumbered trading markets, for prices to fail to efficiently reflect costs, risks, and opportunities, we really have to be nearly universally out of our minds.  And, yet, as human beings, we are quite clearly capable of just that.  Evolution can bumble along without a bit of intention or forethought, and make you an opposable thumb just when you need it.  Monkeys throwing darts could do a decent job managing your portfolio.  But, human beings, we can burn witches or bleed the sick for centuries without having a doubt.  Observe a big enough group of us, and we will always underperform the monkey with the dart.

So, here's the thing.  We normally say markets are pretty efficient, so just about everyone should invest passively.  We talk about weak, semi-strong, or strong efficiency.  In any case, the idea is that prices probably already reflect any marginal information you are likely to have.

I am going to suggest another form of EMH.  I'll call it Weak Inefficiency.  If, as a group, we are so bonkers about something that even the incredible mechanism of dynamic markets can't pull the price to its efficient place, then each additional trader is likely pushing the price away from efficiency.  So, yeah, most prices are probably reflective of rationally applied information.  So, you should invest passively.  But, if prices are wrong, then run like crazy from that market.  You are probably out of your mind.  If markets are inefficient, you better believe you should invest passively.

And, if they are inefficient, you might be crawling out of your skin, dying to trade.  You might be absolutely certain of yourself, even as you are bass ackwards wrong.  When you feel that way, you might just be correct - inasmuch as the market will be inefficient.  And yet, then, more than ever, you better be passive.

In fact, we can probably describe the IMH with its own weak, semi-strong, and strong forms.

Weak IMH - voluntary inanity
Semi-Strong IMH - inanity enforced culturally or through unorganized force
Strong IMH - inanity through organized force

The libertarian project really mostly boils down to pushing things back from strong IMH to weak IMH.  Marge Simpson probably gave us the slogan for IMH after she failed to cancel the Itchy and Scratchy Show.  "I guess one person can make a difference, but most of the time they probably shouldn't."

Follow-up

Brief Preview of November Employment

Continued unemployment claims continue their steep decline, even as they reach record lows.  I don't have a lot of detail to add this month.  A further decline in the unemployment rate again this month seems likely, especially considering that last month barely missed 5.7%.


My employment forecasts from early in the year seem to be coming true, and yet forward interest rates have plummeted.  Did anyone manage to forecast unemployment at the end of 2014 heading to the mid-5's while the 10 year treasury sits at 3.0%?

Meanwhile, in December 2013, the FOMC projected 4Q 2014 unemployment at 6.3%-6.6%, continuing their pattern of being 1 year behind the actual change in unemployment (the 4Q 2015 projection was 5.8%-6.1%), and the median FOMC Fed Funds Rate projection for the end of 2015 was 0.75%.  By the September 2014 meeting, they still forecasted 5.9%-6.0% for 4Q 2014 and 5.4%-5.6% for 2015, continuing their pattern of being 1 year behind.  But, now their Fed Funds Rate projection for the end of 2015 was 1.375%.  Fed Funds projections from the coming meeting will be interesting to see.

As for the unemployment rate in November, the question seems like it will again be, does it fall a little or a lot?  Eventually, insured unemployment will level out, and then we will have to wait and see if the excess relative unemployment persists.  But, as long as insured unemployment continues to decline so strongly, there is no historical precedent for unemployment not to follow.

Villains have incredible power to make us stupid.

At Slate, in a review of a book by Harvard historian Sven Beckert, Eric Herschthal, a Ph.D. candidate in History at Columbia University, makes a startling, if obvious, confession:

Less than a decade ago, a historian interested in the rise of capitalism would have a difficult time finding a job in a history department. The closest thing scholars wrote about capitalism was called labor history, the story of the working class. Almost no one bothered writing about the flip side, elite capitalists; to do so suggested sympathy for the enemy. The people who took capitalism seriously became economists (or bankers). Filling the void were popular accounts that celebrated the brilliance of tycoons like Andrew Carnegie and the Rothschilds, or perhaps the genius of the Industrial Revolution’s inventors—think Eli Whitney and the cotton gin. If anything like “the history of capitalism” existed, it exalted entrepreneurs and inventors, extolled the efficiency of the factory and the free market, and suggested that the whole system thrived only in the absence of a regulatory state.

Then came the Great Recession of 2008...The truth is that no one knows what “the history of capitalism” is because its history is just now being written. But if there is any indication of what it might look like, it appears in Sven Beckert’s remarkable and unsettling new book, Empire of Cotton: A Global History....Beckert, a recently tenured history professor at Harvard, has also decided to bring back the elite. But they’re cast, now, in a far harsher light.

Thank goodness we have arrived at a time where the presupposition of capitalists as villains is in vogue, so that academic historians can now remove the protective shield from their eyes and dare to observe them.  And, are you shocked to know what they find?  Herschthal's conclusion:

But the history of the downtrodden has been told, even if it remains incomplete. We need new histories that explain how the system that came to oppress them—in a word, capitalism— emerged in the first place, with all the inequalities, wealth, and violence that it produced. Beckert’s version will not be the final word in this new history of capitalism, but it is an exceptional start. 

Academic historians join a long history of human studies.  My back of the envelope estimate is that 95% of human studies have revolved around the moral superiority of one's god, clan, ethnicity, race, political faction, gender, sexual orientation, etc.  Libraries are filled with the tomes of those who came before us - scholars who spent their lives becoming experts about the befoulment of their chosen villains.

It's a sort of example of the make-work bias - the idea that value is proportional to the amount of work required.  But, the problem is that effort in the intellectual pursuit of villains is waste.  Worse than waste, it increases our confidence and our misinformation - partners in crime against wisdom.

So, coincidentally along with the development of capitalism, each generation looks back on the generations before and sees that their working conditions were ghastly, relative to our own.  Those working conditions were enforced by "elite capitalists".  This is a fact that is undeniable.  And, thus, clearly the evidence confirms that capitalism and capitalists are the villain.  And, given this terrible and undeniable history, we must look forward, and cage this "unfettered" capitalism, lest the capitalists continue their pillage.  If you doubt any of this, consider the pre-capitalism laborer.  Few pre-capitalism laborers ever looked back at their ancestors and saw ghastly working conditions relative to their own.  This is a problem we can clearly place at the feet of capitalists.  (To be more clear, the previous ghastly conditions are the fault of capitalists.  The improvements came from the reformers.  This is also a fact that cannot be denied.  The reformers are right there at the front of the parade.  You can't miss them.  Herschthal didn't.  He has eyes through which to see.  He is a historian, which I am not, as I have been unable to view the past without sympathy for the historians' enemy.)

And, thus, Herschthal can write from within a culture where there is a concept of "at-will employment", which Wikipedia defines as:

a term used in U.S. labor law for contractual relationships in which an employee can be dismissed by an employer for any reason (that is, without having to establish "just cause" for termination), and without warning. (emphasis in original)

Note that this term applies exclusively to employers.  We have no term for at-will employment, as applied to employees, because the notion is so universal that it would be redundant.  And, writing from within this culture - this culture that is defined by capitalism and in which "at-will employment" is in every way (vis-a-vis one's employer, one's family, etc.) assumed to be a right of labor, contrary to essentially all past human experience - Herschthal can pen this review indicting capitalism for appropriating the institution of slavery.  Yes, the institution of slavery, which dates to the early development of agriculture and just happened to decline on the heals of the industrial revolution.

Herschthal is, I am sure, armed with reams of knowledge which could demolish my criticism in any debate.  He could number the angels dancing of the head of this pin with remarkable aptitude, I have no doubt.  It is to our benefit that he identified the villain in the first paragraph, which should save lazy folks like me a lot of work.

How Stock Options Inflate Payout Ratios

Imagine a firm with a price to book ratio of 1, worth $100 million, with $100 million in revenues, 10% profit margin ($10 million per year) and a 50% payout ratio.  Each year, owners receive $5 in dividends, and the firm reinvests $5 million, so that the following year, the firm is worth $105 million, etc.

Now, imagine that the firm replaces $1 million of cash wages with $1 million worth of stock options.  Let's say that, on average, when those options are exercised, employees receive $5 million worth of stock, but only pay $4 million for it.  And, let's assume the firm has a policy of purchasing the shares on the open market when those options are exercised.  So, in a typical year, the firm will repurchase $5 million dollars worth of shares in order to distribute stock to employees through the stock option program.

Note, the firm still has $100 million in revenues, $10 million in profit ($11 million in profit from operating cash flows minus $1 million in GAAP expense from the stock options), and $5 million in dividends.  And they still reinvest $5 million into the business ($11 million in profit from operating cash flows, minus $5 million dividends, minus $5 million in buybacks, plus $4 million from employee option exercises).

But, now, they have a 100% payout ratio instead of a 50% payout ratio - just by replacing 1% of market cap. with stock options in lieu of cash wages.  But true profit and profit retention remain unchanged.

PS.  I use the antidilution stock buyback here for consistency in the example, but the options cause the gross payout ratio to be inflated regardless of the buyback policy.  When the option is exercised, the firm receives cash equal to the strike price of the optioned shares.  This is a capital inflow from the employee.  The exercise of the options mean that, ipso facto, the firm had higher capital inflows than would be inferred from gross capital distributions.

	Firm with all cash wages	Firm with Stock Options
Cash Profit	$10	$11
Options Expense	$0	$1
Net Profit	$10	$10
Less: Dividends	$5	$5
Less Buybacks	$0	$5
Operating Retained Cash	$5	$0
Add Stock Sales	$0	$4
Add back Option Accrual	$0	$1
Total Retained Cash	$5	$5
Total Gross Distributions	50%	100%
Total Net Distributions	50%	50%

Not a good sign

While the employment market has been strong, credit has been showing weakness after initially showing strength when QE3 first started tapering.  Part of the problem, in my opinion, is that the Fed didn't commit to a full recovery in household real estate equity, relative to mortgage debt.  That, in addition to pro-cyclical regulatory sentiment, has put a stranglehold on real estate credit markets.  The recent decline in cash buyers may be related to the end of QE monetary accommodation.

So, my question is, is momentum in labor and production strong enough to keep markets growing while real estate markets continue to present a liquidity problem.

The first graph here shows Commercial and Industrial Loans and Closed End Residential Real Estate Loans since before the recession.  We can see here how both seemed to accelerate at the beginning of the QE3 taper.

But, the second graph is a close up view of recent weekly changes.  Closed End Residential Real Estate has not only flattened.  It is clearly declining and is now back to levels not seen since March.  And C&I Loans look like they may be leveling off also.

The FHFA has announced plans to lighten up on some regulations of securitized mortgages.  But the loans shown in the graph are loans owned by the banks.  The path we are seeing here is not a positive scenario.  And, 5 year inflation expectations from TIPS is still down around 1.4%.

On the bright side, inflation seems to have firmed up in the last couple of months.  I have been watching CPI less Food, Energy, and Shelter.  It has rebounded after going into negative territory in July and August.

Higher Education Subsidies are extremely regressive

From Twitter:

N.B. Under a signalling model of education, higher education subsidies will lower the wages of lower skilled workers.
— Garett Jones (@GarettJones) November 19, 2014

Bryan Caplan, who is working on a new book about education that should be very interesting, has also commented on this issue a lot.  I would take it even further that Garett.

1) As he mentions, students who don't attend college see lower wages because they lack the credentials that are more widely distributed.

2) For students who are incentivized to go to college, but don't graduate, the subsidy will be associated with immediate missed wages and work experience, and more debt from the portion of their education expenses that was not subsidized.

3) The only students truly subsidized are the students who do graduate.  And, they will tend to have higher lifetime earnings than the students who are net losers from the subsidies.

See Caplan's post, linked above, regarding graduation rates.

Further, there is no market failure here.  There are huge private resources devoted to distributing scholarships by need and merit.  The students that Caplan would encourage to attend college have many private options.  The effect of public funds on opportunities for students is likely harmful for many reasons.

1) It leads to increased tuitions over time.

2) It introduces student selection criteria into the marketplace of grants, loans, and subsidies that are likely to be less reliable than the existing private selection processes.

3) The additional students selected into college attendance because of public subsidies will end up taking some of the private funding sources that could have been used by students who would have graduated.  According to Caplan's data in the link, among all but the highest quartile of high school graduates, as measured by math scores, about 40% of high school graduates attend but do not graduate from college.


There is a lot of concern, across the political spectrum, for the high level of publicly subsidized student loans.  High default rates are definitive evidence of the lack of reliability in student selection among these subsidies and loans.  This is a case where the effect of public spending on national welfare could very likely be negative.  The spending hurts us, not least of which those of us who can least afford it.  We should stop it.

From the "We are the 100%" file: Sticky Wages and Sticky Fed Funds Rate

Scott Sumner has a great post at econlog.  The words were flowing from my penny pencil today, so I thought I'd copy & paste a comment I left there.  But, I encourage you to read Scott's post.

---------------

Great post.
I think this is related to another illusion - that rising wages are inflationary. If Fed policy is sticky, then it will be pro-cyclical, and Fed policy will lead to inflation when a strong economy leads to rising real wages and interest rates.
The illusion is bolstered by the cognitive illusion of narrative thinking, where we imagine that employers and employees are in a negotiating battle and that rising wages are a result of employees having a stronger hand in negotiations.
But, rising wages aren't associated with falling profits.
But, this also is related to an illusion. Since profits are not sticky, they are the first measure to fall when a correction comes. When they begin to fall, it will naturally happen at the cyclical high point of wage growth and profit. So, if one is inclined toward believing the negotiating narrative, the empirical evidence will seem clear as a bell. Don't you see? Whenever real wages are growing at their highest, profits fall.
The narrative says that when a worker has readily available other options, he can go to his supervisor and demand a raise. This is why rising wages are associated with low unemployment.
But, the negotiation is a red herring. The real effect in that picture is that the worker has other opportunities, and that they are willing and able to move out of their current job into a job that captures more of their productive potential. It's the movement that creates the rising wage, not the negotiation. And, this is obvious in the JOLTS data.
This and a thousand other effects where frictions that keep labor from flowing freely to its best use are what keep real wage growth down when unemployment is high. Everybody is better off without the frictions. So, we see high real interest rates, high profits, and growing real wages together. The correlation of these sources of income is so overwhelming through business cycles, it's incredible that it is so universally misunderstood.
This is why it is so infuriating to me to see the "1% vs. 99%" rhetoric and the "corporations love to see high unemployment" rhetoric. Humanity has a special ability to use divisiveness in the service of ignorance. This is a case where the unifying truth is right in front of our noses, and so many people just aren't going to accept it.

Mass Transit

Tyler Cowen linked to a story about some new bullet trains in Japan that will travel almost as fast as airplanes.

A commenter at Tyler's post pointed out that the Japanese rail system is run by private firms.  Here is a Wikipedia page about them.

Seoul also has a very nice subway system which is operated privately.

By far the largest mass transit system in the United States is also largely run by private, competitive firms - Southwest, United, Delta, etc.

It's a sad commentary on the present condition of our electorate and our governance that mass transit is generally explicitly assumed to be public, even though we all utilize private mass transit frequently.  How strange is it that in the United States - the supposed beacon of laissez-faire sensibilities, the international leader of disruptive and innovative technological industries - we can't even seem to imagine the private funding and operation of industries and institutions where such has been the case for decades in many parts of the developed world?