Might more inflation be good for the US and Europe? This column looks at the housing market in the US and argues that, with houses dropping in price, buyers are playing a waiting game. And as buyers keep delaying, the price drops further. Given the importance of property in many economies, the knock-on effects are severe. Yet one way to break this vicious cycle is with inflation.

The eloquent advocacy for moderate inflation at times of peril goes back to Irving Fisher’s seminal paper on the debt deflation:

“In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this, in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either via laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.” Fisher (1933)

This visionary paragraph remains fresh today, particularly at times when the global crisis showed the perils of debt deflation in the US from 2008, and in Europe from 2010. The residential housing market in the US is a prime example of the acidic power of housing deflation.

The key theoretical point is here:

The option-value approach to durable goods implies that housing price deflation and low sales are intertwined. When the odds for housing deflation remain high, households have the incentive to delay purchase, even if they have good access to financing. The zero bound on the nominal interest rate implies that low interest rates may not offset the exposure to capital losses due to expected housing deflation. This configuration may lead to a housing market trap – households engage in a waiting game, delay their purchase, and thereby induce yet faster housing deflation, probably provoking other households to delay their purchase. This in turn pushes more houses to be ‘underwater’, leading to more foreclosures, more fire sales, and so forth.

The social cost of degrading neighbourhoods, where deeper foreclosures reduce the value of other houses, is by now visible in the worst affected states in the US. These dynamics validate the notion of ‘fire-sale externalities’, as well as Fisher’s observation “liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better.” The laissez faire bankruptcy way of dealing with housing adjustment turned out to be highly inefficient in the US residential market.

This leaves Fisher’s ‘reflation’ option as a viable policy to shorten the painful debt deflation in the US. The logic is simple – moderate inflation for several years would terminate at an earlier juncture the buyer’s ‘waiting game’ in the housing market. Once the deflationary dynamics end, the pent-up demand for houses will be released. The timing game will switch from waiting to ‘rush to buy’. Chances are that this will signal the end of the housing slump, and will invigorate construction.

Our argument applies to certain key countries within the Euro area as much or perhaps even more than it does to the United States. We consider in particular Spain, which as shown in Figure 3 of the VoxEU column has experienced less of an adjustment thus far.

This argument augments the point that Jeffry Frieden and I have made in our Foreign Policy piece on conditional inflation targeting, and which we will expand upon in a forthcoming Milken Institute Review article. See also other proponents here.

(1) p^gas_t = 0.514 + 0.719 × f^gas_t-1 + u_t

Adj-R² = 0.97; SER = 0.034; DW = 1.90; smpl = 2005M11-2012M03; n = 77

Using this relationship, and the futures prices as of April 19, one can infer the path of future gasoline prices, and for May 13. I show the result in Figure 1:

The total notional exposure of all of JP Morgan's trades has been estimated to be $79 trillion. That's "trillion", with a "T", from a company with an equity value of $140 billion, and falling quickly.

Paul Krugman suggests that in the case of the trades by the London Whale, JP Morgan "was just engaging in financial tricks of little or no social value". One could argue that the role of leveraged bets through derivatives is to allow those who really know what the value of the underlying security should be to help guide the market to that correct valuation. But if you're making your bet with somebody else's money, where the deal is you get the upside and somebody else gets the downside, those leveraged bets aren't so likely to be in the public's interest.

In any case, we would want to weigh any potential social benefits of such trades against their possible social costs. Is JP Morgan "too big to fail"? I think so. A recent paper by Stanford Professor Darrell Duffie highlights an unresolved weakness in the U.S. financial system centered on the tri-party repo market. This is a key mechanism whereby institutions with funds to lend overnight, such as money market funds, provide funds to those with short-term borrowing needs, namely dealer banks who are prepared to pledge securities as collateral for a one-day loan. Each day something like $100 billion in such short-term lending is intermediated by two clearing banks (JP Morgan Chase and Bank of New York Mellon). Dealer banks deposit securities as collateral with the clearing bank in exchange for a one-day loan, which funds the clearing bank in turn receives later that day from the ultimate lender.

Source: Duffie (2012).

Duffie believes the system is inherently unstable, as dealer banks depend crucially on the ability and willingness of the clearing banks to provide short-term financing each new day:

A dealer whose solvency or liquidity come into question may be unable to find cash lenders that are willing to roll over a sufficient quantity of its repos. In that case, concerns over a dealer's liquidity might be self-fulfilling. The dealer could fail, or its securities might need to be liquidated in a fire sale, or both....

A fire sale of a dealer's securities caused by the dealer's inability to roll over its repo financing on a given day could temporarily depress the prices of some of the affected classes of securities, particularly those securities that lack transparency or whose credit- worthiness depends on the stability of the financial sector. This could have spillover effects to other dealers and more broadly.

Between the unwinding of the previous day's repos and the roll into the next day's repos, money market funds and other cash investors claims are in the form of demand deposits at the clearing bank. In extreme scenarios and in the absence of sufficient transparency, cash investors could become concerned that a clearing bank could be destabilized by its intra-day secured-lending exposure to a dealer. A run of these intra-day demand deposits could indeed destabilize the balance sheet of a clearing bank in the worst case.

Here is Duffie's recommendation for how to make the tri-party clearing system more stable:

Given the systemic importance of tri-party clearing agents, and given their high fixed costs and additional economies of scale, tri-party repo clearing services for U.S. dealers and cash investors should probably operate through a dedicated regulated utility. Although this would likely increase operating costs for market participants, it would enable investment in more advanced clearing technology and financial expertise, allowing greater resilience of the tri-party repo market in the face of financial shocks such as the default of a major dealer. The moral hazard associated with lending of last resort to a dedicated utility is much reduced relative to the case of a financial institution with a wide scope of risk-taking activities.

If nothing else, this week's news should remind us that more needs to be done to ensure financial stability and that the incentives of private participants align with the public's best interests.

Gov. Scott Walker recommitted Saturday to his pledge to create 250,000 private-sector jobs by 2015, a promise all the more difficult to achieve since he first made it because of anemic job growth during his tenure.

As of March, private employment is 34,000 below the October 2011 forecasted level.

Several individuals have pointed out difficulties with the state level CES based employment series. Tim Duy, Joshua Lehner, and reader Tom have helped me understand the tentative nature of the CES-based numbes. They pointed me to the contrasting figures coming from the Quarterly Census of Employment and Wages, which suggest private employment would have continued to rise through September 2011 (the extent of QCEW data). However, interestingly, over that same period, the household series suggests sideways movement in overall employment.

Should employment be re-benchmarked up, the subsequent trend in recorded private employment would still put employment below the forecast from the October 2011 Economic Outlook.*

^* Procedure: Seasonally adjusting the QCEW data, then using a regression estimated over 2009M06-2011M06 to extrapolate 2011M07-M09, then adding recorded changes in private employment from CES over the 2011M10-2012M03 period.

Update, 5:25pm Pacific

Here is a graph with the implied path of private employment, given Governor Walker's 250,000 net private jobs objective.

Update, 5/13, 3:35pm Pacific Open question: why has the Wisconsin measured labor force shrunk (0.2%) while the US labor force has increased a percentage point? An interesting observation to keep in mind when looking at the WI unemployment rate.

Update, 5/15 8pm Pacific: Rumor has it that the Walker Administration will release their own employment series. [1] [2], based on other indicators. Interesting fact: Wisconsin ranked 50th out of 50 in 2011Q3-2011Q4 personal income growth. [3] (Table 6)

A filmmaker released a video Thursday that shows Gov. Scott Walker saying he would use "divide and conquer" as a strategy against unions.

In the video shot on Jan. 18, 2011 - shortly before Walker's controversial budget-repair bill was introduced and spawned mass protests - Hendricks asked the governor whether he could make Wisconsin a "completely red state, and work on these unions, and become a right-to-work" state. The Republican donor was referring to right-to-work laws, which prohibit private-sector unions from compelling workers to pay union dues if the workers choose not to belong to the union.

Walker replied that his "first step" would be "to divide and conquer" through his budget-adjustment bill, which curtailed most collective bargaining for most public employee unions.

...

"So for us," the governor continues, "the base we get for that is the fact that we've got - budgetarily we can't afford not to. If we have collective bargaining agreements in place, there's no way not only the state but local governments can balance things out. ... That opens the door once we do that. That's your bigger problem right there."

...

Walker co-sponsored right-to-work legislation in 1993 as a freshman in the state Assembly, but as governor has consistently downplayed seeking any restrictions on private unions in public statements. [emphasis added -- MDC]

And so we now have further documentation: "[rescinding collective bargaining] doesn't save any [money]".

In Tuesday’s NYT column, entitled “The Structural Revolution”, David Brooks writes:

[I] ... believe the core problems are structural, not cyclical. The recession grew out of and exposed long-term flaws in the economy. Fixing these structural problems should be the order of the day, not papering over them with more debt.

...

... we structuralists do not believe that the level of government spending is the main factor in determining how fast an economy grows. If that were true, then Greece, Britain and France would have the best economies on earth. (The so-called European austerity is partly mythical.) We believe that the creativity, skill and productivity of the work force matter most, and the openness of the system they inhabit.

I wonder if Mr. Brooks has ever taken a course in macroeconomics. Almost every intermediate macroeconomics textbook I know of uses a Solow growth model to determine long run growth, and a Keynesian type model for the short run, so I don’t understand this simple dichotomization.

I think there should be a rule that anybody who writes about macroeconomics should be forced to read a macroeconomics textbook; even if Mr. Brooks had read Barro’s textbook, at least he’d understand under what he was criticizing was a straw man.

Here is the CBO’s assessment of the structural and cyclical components of GDP and of unemployment.

By these measures, most of the deviations are “cyclical”. There is a structural aspect, of course. The CBO’s measures take into account trends in capital stock, labor force, and multifactor productivity. If that ain’t structural, I don’t know what is.

The CBO’s assessment of the natural rate of unemployment, including the recent measures of short term natural rate, highlights the fact that structural does not necessarily mean long-lived, nor does it necessarily mean immune to measures implemented to address cyclical weakness. These measures include extended unemployment insurance, etc.

In fact, maybe it would be useful to quote from CBO’s Budget and Economic Outlook, released at the end of January 2012 (p.35-36):

Cyclical and Structural Unemployment. In CBO’s view, most of the 3.5 percentage-point rise in the unemployment rate since the onset of the recession can be directly attributed to a cyclical decline in the demand for goods and services, and hence for workers. However, CBO estimates that part of that rise—roughly 1 percentage point—reflects structural factors associated with the recession but not directly linked to the current level of aggregate demand. Those structural factors include a mismatch between the requirements of existing job openings and the characteristics of job seekers, including their skills and locations; the lasting effect of long-term unemployment on individual workers’ ability to find and hold a job; and the effect of extended unemployment insurance benefits on incentives to continue searching for work (as opposed to either accepting a job offer or dropping out of the labor force). Although quantifying the relative importance of these factors is quite difficult, CBO estimates that in late 2011 the rate of unemployment attributable to sources other than the current level of demand for goods and services—the so-called natural rate of unemployment—was about 6 percent, up from about 5 percent before the recession. In CBO’s projections, most of the effect of those structural factors on the unemployment rate fades by 2022.

Roughly half of the 1 percentage-point rise in unemployment that CBO attributes to structural factors reflects mismatches between the skills and locations of available unemployed workers and the needs of employers, CBO estimates. One important source of such mismatches is the decline in demand for construction workers that followed the collapse of the housing market. The effect of mismatches on the unemployment rate is projected to diminish gradually over the next five years—as people acquire new skills and, in some cases, relocate to faster growing regions and as some older workers who lost their jobs during the recession leave the labor force.

About a quarter of the 1 percentage-point increase due to structural factors can be attributed to the effects that extended unemployment insurance benefits have had on the supply of labor. Such benefits induced some unemployed people to search for work less intensively or to reject unsatisfactory job offers. The benefits also encouraged some unemployed people who would otherwise have stopped looking for a job and dropped out of the labor force to stay in it to remain eligible for benefits. If extended unemployment insurance benefits expire on February 29, as scheduled under current law, those effects will dissipate by the summer of 2012.

The remaining roughly one-quarter of a percentage point reflects the difficulties that the long-term unemployed (people who have gone without a job for at least six months) face in finding work. Such workers may encounter difficulties resulting from the stigma attached to long-term unemployment—that is, employers’ perception that the long-term unemployed would be low quality workers—and from the erosion of their skills while they are unemployed. As a result, some workers who have been unemployed for a long time, especially those displaced from a long-tenured job, are likely to have trouble landing another stable job. Consequently, they could remain unemployed for an extended period; moreover, even after they are reemployed, many will remain more vulnerable than before to additional future spells of unemployment. As a factor boosting unemployment, such difficulties for the long-term unemployed will, in CBO’s view, increase in importance over the next two years (as some people who are currently out of work stay out of work longer) and then persist for several more years, before gradually diminishing but not completely disappearing by 2022.

Emphasis added -- MDC. This means a majority of the increase in unemployment is not "structural" in the sense that Mr. Brooks uses the term.

(By the way, I know there will be a bunch of commenters who claim the CBO’s approach is flawed – usually without understanding how those measures are constructed – but I find it telling that alternative approaches say using DSGEs and assuming monopolistic competition – obtain similar measures of the natural rate [1].)

Experts concur that most of the unemployment we see is cyclical in nature, and even a large component of the increase in “structural” unemployment is policy-driven. From the summary of the SF Fed’s recent conference on unemployment, by Neumark and Valletta:

The recent San Francisco Federal Reserve Bank conference on workforce skills examined labor market changes that may have accelerated during the Great Recession. These changes may have increased mismatches between employer needs and worker skills. In general, we find that this doesn’t appear to be the case. Estimates of the extent of skill mismatches in recent years indicate that it has been limited and is likely to dissipate. Moreover, the conference’s research presentations and a panel of workforce development specialists did not identify a noticeable increase in mismatches in recent years. Thus, concerns about growing skill mismatches may be overblown. On the other hand, successful integration of low-skilled workers into the workforce represents a continuing problem. Conference participants offered useful ideas on how to meet this challenge, stressing the roles of community colleges and well-designed training programs.

The conference website is here. But I think it might be too much to ask Mr. Brooks to read more broadly, given his predisposition to spout data-free assertions. See for instance this post on Mr. Brooks’ earlier column on long term unemployment. From Mr. Brooks' column:

There are probably more idle men now than at any time since the Great Depression, and this time the problem is mostly structural, not cyclical. These men will find it hard to attract spouses. Many will pick up habits that have a corrosive cultural influence on those around them. The country will not benefit from their potential abilities.

This is a big problem. It can’t be addressed through the sort of short-term Keynesian stimulus some on the left are still fantasizing about. It can’t be solved by simply reducing the size of government, as some on the right imagine.

And as I wrote before:

While surely there is a structural component, Brooks is making the common mistake of equating long term unemployment with structural unemployment. As discussed in this post, the two are related, but the bulk of the current unemployment is cyclical in nature.

My final observation: in the neoclassical synthesis, potential output is a function of the capital stock, the labor stock, and multifactor productivity, i.e., Y^Pot = AF(K,L), where A is MFP, K is capital, L is labor. K is the sum of private and public capital. Augmentation of public capital is primarily due to investment in infrastructure. I believe many critics of the ARRA pointed to investment in infrastructure as a problem, while many (including in the Administration) have asked for more investment in infrastructure. This makes me think that a lot of those of us who Mr. Brooks calls "cyclicalists" have indeed been thinking long and hard about structural factors.

As I've asked before, would it kill columnists who write about macro to read a textbook (even a neoclassically oriented one like Barro, although I use Blanchard in my intermediate macro courses).

From Whip Up Inflation Now:

[We need] inflation -- just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

We believe that now is the time to act, as the US recovery sputters along, and the austerity-based approach in the Eurozone shows a need for revision. Higher inflation would serve to erode real debt, both private and public; it would also ease the adjustment of relative prices and wages, as an alternative to internal devaluation via nominal price/wage changes. Both US and eurozone inflation rates are relatively low right now.

Furthermore, we can act because inflationary expectations are anchored at low rates. Two year ahead inflationary expectations expectations for the US and the eurozone are both low.

Now, as Jim has pointed out, merely raising a target inflation rate (or declaring a nominal GDP target) does not mean that the mechanics are straightforward. But my personal view is that, the costs of enduring years of high unemployment is too high, relative to the costs of exceeding target inflation, especially if it is made clear that the target increase is conditional on the state of the economy.

From BusinessWeek:

[The Census Bureau, BEA and BLS] have always had to fight for more funding. Now they may have to fight just to keep their budgets intact. As part of $19 billion in nondefense discretionary cuts in Paul Ryan’s (R-Wis.) budget—recently passed by the House of Representatives—the agencies are likely to get less funding.

The Senate is unlikely to embrace the Ryan budget in its entirety. Yet specific proposals show what the House has in mind. The House Committee on Appropriations recently proposed cutting the Census budget to $878 million, $10 million below its current budget and $91 million less than the bureau’s request for the next fiscal year. Included in the committee number is a $20 million cut in funding for this year’s Economic Census, considered the foundation of U.S. economic statistics.

Some people argue that trying to track the economy is a waste of money as the bureaucrats will just manipulate the data to (e.g., Ricardo in his DickF incarnation in 2009). From the article:

Some believe the Census Bureau does too much already. “They waste a share of their budget on studies that no one actually uses,” says Chris Edwards, an economist with the Cato Institute, who cites periodic surveys on such items as the total hog count in the U.S. to prove his point. “A lot of that could be done by the private sector.”

For the rest of us who think it's important to know what is happening in the world, I think there are clear dangers of shortchanging statistical agencies [1].

Update, 9pm: I would be remiss in my duties if I didn't mention the latest Economic Report of the President contains several "Data Watch" boxes, highlighting the data acquisition and analytical issues facing the Nation. From Data Watch 2-1:

as the U.S. economy continues to evolve, the work of accurately measuring service activity grows accordingly. Despite recent innovations in the collection of primary source data, there are still conceptual issues pertaining to the appraisal and definition of services that remain unresolved. As an example, improvements in health care have contributed to longer life spans and better quality of life, but there is not a consensus about how to value and incorporate these benefits in a national income accounting framework. Similarly, industries such as finance largely produce intangible outputs that are difficult even to identify, much less quantify. Furthermore, although estimates of international trade in services are now more detailed than was the case before the 1980s, the statistics still could and should be improved. Data on the prices of traded services are extremely limited, and even the most disaggregated data collected by the BEA on services extend to only 36 categories, in contrast to thousands of categories for manufactured goods. Continued research and investment in the development of data on services are needed to ensure timely and accurate measurement of the U.S. economy.

Second, I pointed out that the direct stimulative effects of a debt maturity swap were decidedly minor.

The conclusion I draw from these two observations is that we might have to push on this lever extremely hard to get anything accomplished, and that pushing on the lever is not without its own dangers. My position is therefore that the Fed is correct in viewing this particular tool as one that should be used with caution.

Now for some of the responses. Brad DeLong observes that although Federal Reserve deposits at the moment are essentially equivalent to short-term Treasury obligations, once we get away from the liquidity trap they will not be. Insofar as some of today's created reserves turn into M1 instead of T-bills at that future date, Brad argues, the time path would be more stimulative and, through an expectations effect, that could make a difference today. This is in fact my view as well, and one of the reasons why I insist that the main mechanism by which large-scale asset purchases could make a difference is not through their direct mechanical consequences for interest rates, but instead comes from their value in sending a credible signal for future Fed policy. And that's why I think the main task for the Fed is not to decide how much LSAP we need, but instead to articulate a clear framework within which those measures are implemented that is also mindful of the particular fiscal management challenges that these policies tie us into. I suggested that the current policy, which I read as not allowing inflation to fall below 2%, works well for both objectives.

Scott Sumner is dismayed at my focus on the concrete steps the Fed would need to take to implement more stimulus. Scott is a strong advocate of the view that if the Fed were simply to announce a particular target, everything would fall in place to make sure it happens. For clarification, I fully agree with Scott and Brad that it would be possible for the Fed to achieve a higher inflation rate than 2%. My concern is with the robustness of the particular strategies for implementing such an objective. In particular, the fiscal management problem I am referring to is one of a rapid flight from dollars and loss of confidence in the Fed and Treasury. As I explained in my original post, this is the exact opposite of deflation. A strong Fed commitment to avoid deflation should not provoke market fears about the ability of the Treasury and Fed to manage their short-term liabilities. The question on which I and some of the Fed's critics may differ is whether there is a similar robustness to the Fed's announcing that what they're trying to produce is, say, 3.5% inflation. My fear is that the practical instruments available to the Fed are too blunt, and the stability of the expectations equilibrium too tenuous, for us to be confident that the Fed could manage a multi-trillion dollar balance sheet if financial participants develop sudden doubts about how it will play out.

Notwithstanding, I agree that there is room for the Fed to look for a more expansionary objective. To repeat my earlier conclusion:

Perhaps there is a clear way to communicate an alternative, more ambitious goal, such as keeping nominal GDP growth above 5%, or temporarily focusing on getting unemployment down to 7%. If articulated narrowly and with some caution, these might allow the Fed to do more while still preserving confidence in what I have described as the logistics of managing potentially volatile short-term government debt.

But unlike many of my fellow academics, I worry about those logistics and am convinced that it is a mistake to ask too much from monetary policy.

In fact, over the last 21 or so years, one has to go back to the Clinton administrations to find such numbers.

Oh, and by the way, unemployment has been at or below 4% only 11 times in the past 40 years (essentially at the end of the Clinton Administration).

Figures 1 and 2 confirm that employment growth appears to be decelerating. However, it is interesting that the household series adjusted to conform to the NFP series continues to register 1.6 million additional employed, as compared to the official NFP series. Note that the former series is a research series, developed in response to conservative economists criticisms of the official series. The household survey is smaller than the establishment, so the sampling error is about four times as large as that of the establishment survey. Further, the household series has to be adjusted for population controls (although the establishment series has to be benchmarked using data on UI tax records).

Governor Romney has stated that employment growth should average about 500,000 after such a recession [1] This job growth has occurred exactly 16 times since 1939 (the sample available); the last time it occurred was May 2010. It never occurred during the administrations of the G.W. Bush. September 1997 (during the Clinton administrations) was the previous episode. (see also [2]).

Figure 3 highlights the fact that total hours worked are rising faster than private sector employment (which is in turn rising faster than nonfarm payroll employment).

Private sector employment now exceeds levels of 2009M01, while aggregate hours worked exceeds by 1.9% (in log terms).

Finally, note that the monthly (not benchmark) revisions have been upward. With revisions to the February and March data, average employment growth is 207 thousand in the first four months, as compared to 210 thousand, from the first three months indicated in the March release.

None of the foregoing should detract from the main point: we need faster employment growth. And that goal is within our power. Certainly, if government employment rolls had not decreased by 15,000, NFP would have risen by more in a mechanical sense. But in a deeper economic sense, we hould have had yet more had states not been slashing the rolls of K-12 teachers and other educational staff. Other measures, here and (citing the CBO) here.

More coverage: [WSJ RTE/Sparshott], [WSJ RTE/Izzo], [WSJ RTE/Shah], [Calculated Risk], [Delong], [Thoma], [NYT/Leonhardt], [NYT/Norris], and [FreeExchange/Ip].

I found it notable that UK growth has been so weak ever since the implementation of the austerity program. In some ways, it’s "textbook". Figure 1 shows growth in log differences since 2009.

UK growth compares poorly to US growth

I was slightly surprised that the UK growth had lagged so much against US growth, given that obstructionism in the US political system had prevented implementation of additional pro-growth policies. But the current policy framework in the UK seems even more anti-growth than that in the US. Of course, (unlike Professor Ed Lazear), I recognize the fact that growth in the wake of financial crises is on average slower than those not accompanied by such crises. With a larger proportion of UK GDP involved in financial activities, one might expect extra headwinds.

Nonetheless, it's clear the contractionary fiscal policy has not attained the objectives sought. According the IMF's Article IV report from 2011, FY2009/10 structural budget balance, was -5.3%. The FY10/11 budget balance, under the new government, was -4.5%. The programmed (cyclically adjusted) balances in FY11/12, FY12/13, FY13/14 were -3.2%, -2.0%, and -0.6%, respectively (and into surplus in subsequent years!) according to the March 2011 budget. Most reasonable models would predict contraction and that's what we get.

Austerity in a (relatively) small, open economy is still not expansionary

The UK economy is about one sixth the size of the US evaluated at current exchange rates. If there was a country where the expansionary fiscal contraction scenario could play out, it would be there.

And yet, with a pound some 20% depreciated (log terms) below levels at the beginning of 2007, the UK economy has struggled to exceed zero growth. I predicted back in November the UK would go into official recession, and here we are. It is no wonder that the troubled economies of the euro zone, lacking the exchange rate shock absorber, and operating at the zero interest rate bound, should be slipping deeper into recession. In other words, expansionary fiscal contractions might be little more than a curiousum, much more a fevered fantasy of the Republican members of the Joint Economic Committee and Paul Ryan than anything else. (See also Simon Wren-Lewis on why expansionary fiscal contraction is unlikely to work in the UK context.)

The implications for the US

Now let's consider a fiscal framework that entails spending reductions relative to baseline, at close to the zero interest bound, and without much room for dollar depreciation. That scenario would be closely mimicked by programs such as the Ryan budget plan (unless one believed in some implausibly high elasticities as in the Heritage Foundation's "analysis" of last year's incarnation [1] [2] [3]).

I think the fact that fiscal drag is greater now is not surprising given that the share of fiscal consolidation coming from spending cuts is rising. This is shown in Figure 4, from the IMF's Article IV report (p. 35).

So, we too can make the current US recovery worse than that of the Great Depression; just implement a front loaded fiscal contraction, heavy on spending cuts. Furthermore, in order to maximize the contractionary impact, harass the monetary authorities to tighten policy by inciting fears of high inflation (à la Rep. Paul Ryan), when year-on-year inflation as measured by the personal consumption expenditure deflator is 2.1%.

(More on the UK, from Interfluidity, which stresses the Neoclassical synthesis vs. New Keynesian vs. Post-Keynesian interpretations. I believe the data are not puzzling from an open economy perspective but that might reflect my training; deficient aggregate demand and relatively high inflation can occur when there is a large imported share in GDP.)

The primary tool available at the moment is large-scale asset purchases, in which for example the Fed buys longer term Treasury securities with newly created reserves. These reserves are simply accounts banks hold at the Fed, which funds the banks could redeem for cash or use to buy an asset from somebody else any time they wished. From the point of view of the bank that holds those reserves, they are an asset very similar to short-term T-bills, being highly liquid and paying a very low interest rate. I think it is most accurate to think of large-scale asset purchases as the government shortening slightly the maturity structure of its outstanding debt, leaving the public holding fewer long-term bonds and more reserves. There are a number of recent academic studies that have evaluated the potential effects of such an operation, which generally conclude that massive purchases could modestly reduce long-term interest rates and thus potentially provide some stimulus to aggregate demand. But note well that the Treasury could achieve pretty much the same effect if it were to do less of its borrowing with 10-year bonds and more of its borrowing with 3-month bills.

So a natural question is, why aren't the above academics taking aim not at the Fed but instead at the Treasury for issuing so much long-term debt in preference to short-term debt in the first place? If we phrase the question this way, the answers should be obvious. First, as noted by University of Chicago Professor John Cochrane, once you spell out exactly what the operation consists of, it's hard to expect huge economic benefits of large-scale asset purchases:

of all the stories you've heard why unemployment is stubbornly high, how plausible is this: "The main problem is the maturity structure of debt. If only Treasury had issued $600 billion more bills and not all these 5 year notes, unemployment wouldn't be so high. It's a good thing the Fed can undo this mistake."

Maybe it would help a little if the Treasury did more of its borrowing short-term, but who could possibly expect that to be a panacea?

Second and more importantly, suppose the same academics were to descend on the Treasury in force, insisting that the government rely more heavily on short-term borrowing. Let's say, to take a dramatic example, we propose to move the entire $10+ trillion in current publicly held debt, along with each month's additional new net borrowing, into 4-week bills. Couldn't we all agree that such a move would recklessly endanger the government's ability to manage its weekly debt financing? Sure, at the moment, it might be possible to find $10 trillion in buyers each month. But conditions and sentiments can easily change, and would be particularly likely to do so if the refinancing logistics were as inherently vulnerable as exclusive reliance on short-term financing would render them. The U.S. isn't Greece, these academics insist, and I agree-- at the moment, we're not. But that's a result of the situations we allow ourselves to be placed in, not an immutable law of nature.

And reserves are an even more volatile form of government borrowing than Treasury bills. Deposits with the Federal Reserve are a liability of the Fed that can be redeemed immediately at will rather than having to wait 4 weeks to decide whether to roll the debt over again. But, some may argue, reserves are different in that they aren't destroyed by private sector decisions. If I decide I'd rather have, say, yuan or gold instead of my dollars, I can use the reserves to make that purchase. But although I've gotten rid of my reserves, the bank of the person who sold me the yuan or gold now has the reserves instead, and maybe they don't want them either. Equilibrium is restored by prices of goods and assets adjusting until people in fact want to hold the reserves after all, for example, I get so few yuan or so little gold for each dollar that I figure I might as well hold the dollars.

One tool for ensuring that the supply of reserves equals the demand would be for the Fed to raise the interest rate it pays on reserves. This would encourage banks to continue to hold the reserves, and is exactly the same kind of option that would be available to the Treasury if buyers balked at rolling over its debt. The Fed could try to persuade banks to hold reserves by raising the interest paid on them, the Treasury could try to persuade lenders to participate in the auction by raising the interest paid on T-bills. The problem is, if investors lose faith in the refinancing logistics themselves, the outcome in either case could turn out to be quite a high rate of interest and a chaotic, highly destructive process.

I think that's why most of us would agree that it would not be a good idea for the entire U.S. debt to be solely in the form of 4-week T-bills or deposits with the Federal Reserve.

And it's why I also believe that large-scale asset purchases can not, by themselves, be viewed as a solution to the current disappointingly slow U.S. economic growth.

My view is that instead large-scale asset purchases are most effective when used as a communication tool by the Fed, as a concrete follow-up action the Fed could implement in order to achieve certain stated goals. The task then is to identify what those goals are, communicate them credibly to the public, and count on large-scale asset purchases as the Fed's big stick.

And the way I see current U.S. monetary policy is exactly as Bernanke defended it at a recent press conference. I believe the Fed has effectively and credibly communicated that it is not going to allow the U.S. to repeat Japan's experience of deflation or extremely low inflation. Deflation is the exact opposite of the potentially chaotic flight from dollars that I described above, and deflation would unquestionably be counterproductive for the U.S. By drawing a line at keeping inflation above 2%, I think the Fed can use its limited available mechanical tools in a credible way to achieve an appropriate goal.

Perhaps there is a clear way to communicate an alternative, more ambitious goal, such as keeping nominal GDP growth above 5%, or temporarily focusing on getting unemployment down to 7%. If articulated narrowly and with some caution, these might allow the Fed to do more while still preserving confidence in what I have described as the logistics of managing potentially volatile short-term government debt.

But unlike many of my fellow academics, I worry about those logistics and am convinced that it is a mistake to ask too much from monetary policy.

Walker warned that job losses might again ramp up in Wisconsin if either Barrett or Falk are elected in the June 5 recall...

Wisconsin's lackluster performance since 2011M01 is discussed further in this post. (Tim Duy reminds me that the accuracy of state establishment series has decline recently, so one has to be cautious about over-interpreting recent trends; nonetheless all employment indicators put Wisconsin in a poor light relative to the US overall, including civilian employment.)

Note the divergence in private and total nonfarm payroll employment. This occurs because government (primarily local) employment has been reduced.

Teacher employment is one category that has fallen substantially [1]. In other news, the Walker Administration is planning to award $765 thousand in bonuses to selected government workers in a newly initiated program. [2]

I will venture to say that we should not put too much credence in Governor Walker's forecasts, given his previous record of employment forecasts, including the 250,000 jobs to be created.[3]

Update 1 May, 11am Pacific: Here is additional data on year-on-year change (in log differences, so interpretable as annual growth rates) in employment in local education.

But I think it's worth emphasizing what's been happening in two sectors that play a critical role in most business cycles. Housing contributed 0.4 percentage points to the 2.2% Q1 growth, and autos an additional 0.7 percentage points. These two categories usually make a big contribution both to the drop in GDP during a recession as well as to the rebound usually seen in the early recovery phase. For example, in the 2007:Q4-2009:Q2 recession, real GDP fell on average at a 2.7% annual rate, with autos and housing accounting for about half of this decline all by themselves.

Contributions to the growth rate of real GDP, 1947:Q2 to 2012:Q1. Top panel: growth rate of real GDP (annual rate). Middle panel: contribution to first panel of motor vehicles and parts. Bottom panel: contribution of residential fixed investment. Shaded areas represent dates of economic recessions as determined by the National Bureau of Economic Research. Data source: BEA Table 1.5.2.

One of the unusual features of the recent data is that these two key sectors contributed very little to the first two years of the recovery, with autos only adding 0.1 percentage point to the average annual GDP growth over 2009:Q3-2011:Q3 and housing actually exerting a very slight drag. However, the last 6 months have been closer to the typical pattern, with autos contributing 0.8% and housing 0.3%.

Moreover, further growth in these sectors from here does not require any pent-up demand. If sales simply get back to historical replacement rates and meeting population growth, it would be a huge improvement over where we are right now.

Contributions to the level of GDP, 1947:Q1 to 2012:Q1. Top panel: nominal spending on motor vehicles and parts as a percentage of nominal GDP. Bottom panel: residential fixed investment as a percentage of nominal GDP. Blue lines represent historical averages. Data source: BEA Table 1.5.5.

The slow pace of GDP growth continues to disappoint, particularly for the 12.7 million Americans actively looking for jobs and still unable to find them. On the other hand, the U.S. is unquestionably better off than would be the case had the September prediction of the Economic Cycle Research Institute that the U.S. was about to enter another recession proved to be accurate. The latest GDP report brings our Econbrowser Recession Indicator Index down to 4.0%. For purposes of calculating this number, we allow one quarter for data revision and trend recognition, so the latest value, although it uses today's released GDP numbers, is actually an assessment of where the economy was as of the end of the last quarter of 2011. The index would have to rise above 67% before our algorithm would declare that the U.S. had entered a new recession.

GDP-based recession indicator index. The plotted value for each date is based solely on information as it would have been publicly available and reported as of one quarter after the indicated date, with 2011:Q4 the last date shown on the graph. Shaded regions represent dates of NBER recessions, which were not used in any way in constructing the index, and which were sometimes not reported until two years after the date.

Not a recession, though of course we are all hoping for something much better than what we have so far. For other takes, see Phil Izzo, Karl Smith, and the always indispensable Calculated Risk.