DRI-135 for week of 1-4-15: Flexible Wages and Prices: Economic Shock Absorbers

An Access Advertising EconBrief:

Flexible Wages and Prices: Economic Shock Absorbers

At the same times that free markets are becoming an endangered species in our daily lives, they enjoy a lively literary existence. The latest stimulating exercise in free-market thought is The Forgotten Depression: 1921 – The Crash That Cured Itself. The author is James Grant, well-known in financial circles as editor/publisher of “Grant’s Interest Rate Observer.” For over thirty years, Grant has cast a skeptical eye on the monetary manipulations of governments and central banks. Now he casts his gimlet gaze backward on economic history. The result is electrifying.

The Recession/Depression of 1920-1921

The U.S. recession of 1920-1921 is familiar to students of business cycles and few others. It was a legacy of World War I. Back then, governments tended to finance wars through money creation. Invariably this led to inflation. In the U.S., the last days of the war and its immediate aftermath were boom times. As usual – when the boom was the artifact of money creation – the boom went bust.

Grant recounts the bust in harrowing detail.  In 1921, industrial production fell by 31.6%, a staggering datum when we recall that the U.S. was becoming the world’s leading manufacturer. (The President’s Conference on Unemployment reported in 1929 that 1921 was the only year after 1899 in which industrial production had declined.) Gross national product (today we would cite gross domestic product; neither statistic was actually calculated at that time) fell about 24% in between 1920 and 1921 in nominal dollars, or 9% when account is taken of price changes. (Grant compares this to the figures for the “Great Recession” of 2007-2009, which were 2.4% and 4.3%, respectively.) Corporate profits nosedived commensurately. Stocks plummeted; the Dow Jones Industrial average fell by 46.6% between the cyclical peak of November, 1919 and trough of August, 1921. According to Grant, “the U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression),” over 36% within 12 months. Unemployment rose dramatically to a level of some 4,270,000 in 1921 – and included even the President of General Motors, Billy Durant. (As the price of GM’s shares fell, he augmented his already-sizable shareholdings by buying on margin – ending up flat broke and out of a job.) Although the Department of Labor did not calculate an “unemployment rate” at that time, Grant estimates the nonfarm labor force at 27,989,000, which would have made the simplest measure of the unemployment rate 15.3%. (That is, it would have undoubtedly included labor-force dropouts and part-time workers who preferred full-time employment.)

A telling indicator of the dark mood enveloping the nation was passage of the Quota Act, the first step on the road to systematic federal limitation of foreign immigration into the U.S. The quota was fixed at 3% of foreign nationals present in each of the 48 states as of 1910. That year evidently reflected nostalgia for pre-war conditions since the then-popular agricultural agitation for farm-price “parity” sought to peg prices to levels at that same time.

In the Great Recession and accompanying financial panic of 2008 and subsequently, we had global warming and tsunamis in Japan and Indonesia to distract us. In 1920-1921, Prohibition had already shut down the legal liquor business, shuttering bars and nightclubs. A worldwide flu pandemic had killed hundreds of thousands. The Black Sox had thrown the 1919 World Series at the behest of gamblers.

The foregoing seems to make a strong prima facie case that the recession of 1920 turned into the depression of 1921. That was the judgment of the general public and contemporary commentators. Herbert Hoover, Secretary of Commerce under Republican President Warren G. Harding, who followed wartime President Woodrow Wilson in 1920, compiled many of the statistics Grant cites while chairman of the President’s Conference on Unemployment. He concurred with that judgment. So did the founder of the study of business cycles, the famous institutional economist Wesley C. Mitchell, who influenced colleagues as various and eminent as Thorstein Veblen, Milton Friedman, F. A. Hayek and John Kenneth Galbraith. Mitchell referred to “…the boom of 1919, the crisis of 1920 and the depression of 1921 [that] followed the patterns of earlier cycles.”

By today’s lights, the stage was set for a gigantic wave of federal-government intervention, a gargantuan stimulus program. Failing that, economists would have us believe, the economy would sink like a stone into a pit of economic depression from which it would likely never emerge.

What actually happened in 1921, however, was entirely different.

The Depression That Didn’t Materialize

We may well wonder what might have happened if the Democrats had retained control of the White House and Congress. Woodrow Wilson and his advisors (notably his personal secretary, Joseph Tumulty) had greatly advanced the project of big government begun by Progressive Republicans Theodore Roosevelt and William Howard Taft. During World War I, the Wilson administration seized control of the railroads, the telephone companies and the telegraph companies. It levied wage and price controls. The spirit of the Wilson administration’s efforts is best characterized by the statement of the Chief Price Controller of the War Industries Board, Robert Brookings. “I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.” Of course, Mr. Brookings was not actually himself buying the gunpowder; the government was only representing the taxpayers (of whom Mr. Brookings was presumably one). And their attitude toward taxpayers was displayed by the administration’s transformation of an income tax initiated at insignificant levels in 1913 and to a marginal rate of 77% (!!) on incomes exceeding $1 million.

But Wilson’s obsession with the League of Nations and his 14 points for international governance had not only ruined his health, it had ruined his party’s standing with the electorate. In 1920, Republican Warren G. Harding was elected President. (The Republicans had already gained substantial Congressional majorities in the off-year elections of 1918.) Except for Hoover, the Harding circle of advisors was comprised largely of policy skeptics – people who felt there was nothing to be done in the face of an economic downturn but wait it out. After all, the U.S. had endured exactly this same phenomenon of economic boom, financial panic and economic bust before in 1812, 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. The U.S. economy had not remained mired in depression; it had emerged from all these recessions – or, in the case of 1873, a depression. If the 19th-century system of free markets were to be faulted, it would not be for failure to lift itself out of recession or depression, but for repeatedly re-entering the cycle of boom and bust.

There was no Federal Reserve to flood the economy with liquidity or peg interest rates at artificially low levels or institute a “zero interest-rate policy.” Indeed, the rules of the gold-standard “game” called for the Federal Reserve to raise interest rates to stem the inflation that still raged in the aftermath of World War I. Had it not done so, a gold outflow might theoretically have drained the U.S. dry.  The Fed did just that, and interest rates hovered around 8% for the duration. Deliberate deficit spending as an economic corrective would have been viewed as madness. As Grant put it, “laissez faire had its last hurrah in 1921.”

What was the result?

In the various individual industries, prices and wages and output fell like a stone. Auto production fell by 23%. General Motors, as previously noted, was particularly hard hit. It went from selling 52,000 vehicles per month to selling 13,000 to 6,150 in the space of seven months. Some $85 million in inventory was eventually written off in losses.

Hourly manufacturing wages fell by 22%. Average disposable income in agriculture, which comprised just under 20% of the economy, fell by over 55%. Bankruptcies overall tripled to nearly 20,000 over the two years ending in 1921. In Kansas City, MO, a haberdashery shop run by Harry Truman and Eddie Jacobson held out through 1920 before finally folding in 1921. The resulting personal bankruptcy and debt plagued the partners for years. Truman evaded it by taking a job as judge of the Jackson County Court, where his salary was secure against liens. But his bank accounts were periodically raided by bill collectors for years until 1935, when he was able to buy up the remaining debt at a devalued price.

In late 1920, Ford Motor Co. cut the price of its Model T by 25%. GM at first resisted price cuts but eventually followed suit. Farmers, who as individuals had no control over the price of their products, had little choice but to cut costs and increase productivity – increasing output was an individual’s only way to increase income. When all or most farmers succeeded, this produced lower prices. How much lower? Grant: “In the second half of [1920], the average price of 10 leading crops fell by 57 percent.” But how much more food can humans eat; how many more clothes can they wear? Since the price- and income-elasticities of demand for agricultural goods were less than one, this meant that agricultural revenue and incomes fell.

As noted by Wesley Mitchell, the U.S. slump was not unique but rather part of a global depression that began as a series of commodity-price crashes in Japan, the U.K., France, Italy, Germany, India, Canada, Sweden, the Netherlands and Australia. It encompassed commodities including pig iron, beef, hemlock, Portland cement, bricks, coal, crude oil and cotton.

Banks that had speculative commodity positions were caught short. Among these was the largest bank in the U.S., National City Bank, which had loaned extensively to finance the sugar industry in Cuba. Sugar prices were brought down in the commodity crash and brought the bank down with them. That is, the bank would have failed had it not received sweetheart loans from the Federal Reserve.

Today, the crash of prices would be called “deflation.” So it was called then and with much more precision. Today, deflation can mean anything from the kind of nosediving general price level seen in 1920-1921 to relatively stable prices to mild inflation – in short, any general level of prices that does not rise fast enough to suit a commentator.

But there was apparently general acknowledgment that deflation was occurring in the depression of 1921. Yet few people apart from economists found that ominous. And for good reason. Because after some 18 months of panic, recession and depression – the U.S. economy recovered. Just as it had done 14 times previously.

 

It didn’t merely recover. It roared back to life. President Harding died suddenly in 1923, but under President Coolidge the U.S. economy experienced the “Roaring 20s.” This was an economic boom fueled by low tax rates and high productivity, the likes of which would not be seen again until the 1980s. It was characterized by innovation and investment. Unfortunately, in the latter stages, the Federal Reserve forgot the lessons of 1921 and increases the money supply to “keep the price level stable” and prevent deflation in the face of the wave of innovation and productivity increases. This helped to usher in the Great Depression, along with numerous policy errors by the Hoover and Roosevelt administrations.

Economists like Keynes, Irving Fisher and Gustav Cassel were dumbfounded. They had expected deflation to flatten the U.S. economy like a pancake, increasing the real value of debts owed by debtor classes and discouraging consumers from spending in the expectation that prices would fall in the future. Not.

There was no economic stimulus. No TARP, no ZIRP, no QE. No wartime controls. No meddlesome regulation a la Theodore Roosevelt, Taft and Wilson. The Harding administration and the Fed left the economy alone to readjust and – mirabile dictu – it readjusted. In spite of the massive deflation or, much more likely, because of it.

The (Forgotten) Classical Theory of Flexible Wages and Prices

James Grant wants us to believe that this outcome was no accident. The book jacket for the Forgotten Depression bills it as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007-9 recession,” which “proposes ‘less is more’ with respect to federal intervention.”

His argument is almost entirely empirical and very heavily oriented to the 1920-1921 depression. That is deliberate; he cites the 14 previous cyclical contractions but focuses on this one for obvious reasons. It was the last time that free markets were given the opportunity to cure a depression; both Herbert Hoover and Franklin Roosevelt supervised heavy, continual interference with markets from 1929 through 1941. We have much better data on the 1920-21 episode than, say, the 1873 depression.

Readers may wonder, though, whether there is underlying logical support for the result achieved by the deflation of 1921. Can the chorus of economists advocating stimulative policy today really be wrong?

Prior to 1936, the policy chorus was even louder. Amazing as it now seems, it advocated the stance taken by Harding et al. Classical economists propounded the theory of flexible wages and prices as an antidote to recession and depression. And, without stating it in rigorous fashion, that is the theory that Grant is following in his book.

Using the language of modern macroeconomics, the problems posed by cyclical downturns are unemployment due to a sudden decline in aggregate (effective) demand for goods and services. The decline in aggregate demand causes declines in demand for all or most goods; the decline in demand for goods causes declines in demand for all or most types of labor. As a first approximation, this produces surpluses of goods and labor. The surplus of labor is defined as unemployment.

The classical economists pointed out that, while the shock of a decline in aggregate demand could cause temporary dislocations such as unsold goods and unemployment, this was not a permanent condition. Flexible wages and prices could, like the shock absorbers on an automobile, absorb the shock of the decline in aggregate demand and return the economy to stability.

Any surplus creates an incentive for sellers to lower price and buyers to increase purchases. As long as the surplus persists, the downward pressure on price will remain. And as the price (or wage) falls toward the new market-clearing point, the amount produced and sold (or the amount of labor offered and purchases) will increase once more.

Flexibility of wages and prices is really a two-part process. Part one works to clear the surpluses created by the initial decline in aggregate demand. In labor markets, this serves to preserve the incomes of workers who remain willing to work at the now-lower market wage. If they were unemployed, they would have no wage, but working at a lower wage gives them a lower nominal income than before. That is only part of this initial process, though. Prices in product markets are decreasing alongside the declining wages. In principle, fully flexible prices and wages would mean that even though the nominal incomes of workers would decline, their real incomes would be restored by the decline of all prices in equal proportion. If your wage falls by (say) 20%, declines in all prices by 20% should leave you able to purchase the same quantities of goods and services as before.

The emphasis on real magnitudes rather than nominal magnitudes gives rise to the name given to the second part of this process. It is called the real-balance effect. It was named by the classical economist A. C. Pigou and refined by later macroeconomist Don Patinkin.

When John Maynard Keynes wrote his General Theory of Employment Interest and Income in 1936, he attacked classical economists by attacking the concepts of flexible wages and prices. First, he attacked their feasibility. Then, he attacked their desirability.

Flexible wages were not observed in reality because workers would not consent to downward revisions in wages, Keynes maintained. Did Keynes really believe that workers preferred to be unemployed and earn zero wages at a relatively high market wage rather than work and earn a lower market wage? Well, he said that workers oriented their thinking toward the nominal wage rather than the real wage and thus did not perceive that they had regained their former position with lower prices and a lower wage. (This became known as the fallacy of money illusion.) His followers spent decades trying to explain what he really meant or revising his words or simply ignoring his actual words. (It should be noted, however, that Keynes was English and trade unions exerted vastly greater influence on prevailing wage levels in England that they did in the U.S. for at least the first three-quarters of the 20th century. This may well have biased Keynes’ thinking.)

Keynes also decried the assumption of flexible prices for various reasons, some of which continue to sway economists today. The upshot is that macroeconomics has lost touch with the principles of price flexibility. Even though Keynes’ criticisms of the classical economists and the price system were discredited in strict theory, they were accepted de facto by macroeconomists because it was felt that flexible wages and prices would take too long to work, while macroeconomic policy could be formulated and deployed relatively quickly. Why make people undergo the misery of unemployment and insolvency when we can relieve their anxiety quickly and compassionately by passing laws drafted by macroeconomists on the President’s Council of Economic Advisors?

Let’s Compare

Thanks to James Grant, we now have an empirical basis for comparison between policy regimes. In 1920-1921, the old-fashioned classical medicine of deflation, flexible wages and prices and the real-balance effect took 18 months to turn a panic, recession and depression into a rip-roaring recovery that lasted 8 years.

Fast forward to December, 2007. The recession has begun. Unfortunately, it is not detected until September, 2008, when the financial panic begins. The stimulus package is not passed until January, 2009 – barely in time for the official end of the recession in June, 2009. Whoops – unemployment is still around 10% and remains stubbornly high until 2013. Moreover, it only declines because Americans have left the labor force in numbers not seen for over thirty years. The recovery, such as it is, is so anemic as to hardly merit the name – and it is now over 7 years since the onset of recession in December, 2007.

 

It is no good complaining that the stimulus package was not large enough because we are comparing it with a case in which the authorities did nothing – or rather, did nothing stimulative, since their interest-rate increase should properly be termed contractionary. That is exactly what macroeconomists call it when referring to Federal Reserve policy in the 1930s, during the Great Depression, when they blame Fed policy and high interest rates for prolonging the Depression. Shouldn’t they instead be blaming the continual series of government interventions by the Fed and the federal government under Herbert Hoover and Franklin Roosevelt? And we didn’t even count the stimulus package introduced by the Bush administration, which came and went without making a ripple in term of economic effect.

Economists Are Lousy Accident Investigators 

For nearly a century, the economics profession has accused free markets of possessing faulty shock absorbers; namely, inflexible wages and prices. When it comes to economic history, economists are obviously lousy accident investigators. They have never developed a theory of business cycles but have instead assumed a decline in aggregate demand without asking why it occurred. In figurative terms, they have assumed the cause of the “accident” (the recession or the depression). Then they have made a further assumption that the failure of the “vehicle’s” (the economy’s) automatic guidance system to prevent (or mitigate) the accident was due to “faulty shock absorbers” (inflexible wages and prices).

Would an accident investigator fail to visit the scene of the accident? The economics profession has largely failed to investigate the flexibility of wages and prices even in the Great Depression, let alone the thirty-odd other economic contractions chronicled by the National Bureau of Economic Research. The work of researchers like Murray Rothbard, Vedder and Galloway, Benjamin Anderson and Harris Warren overturns the mainstream presumption of free-market failure.

The biggest empirical failure of all is one ignored by Grant; namely, the failure to demonstrate policy success. If macroeconomic policy worked as advertised, then we would not have recessions in the first place and could reliably end them once they began. In fact, we still have cyclical downturns and cannot use policy to end them and macroeconomists can point to no policy successes to bolster their case.

Now we have this case study by James Grant that provides meticulous proof that deflation – full-blooded, deep-throated, hell-for-leather deflation in no uncertain terms – put a prompt, efficacious end to what must be called an economic depression.

Combine this with the 40-year-long research project conducted on Keynesian theory, culminating in its final discrediting by the early 1980s. Throw in the existence of the Austrian Business Cycle Theory, which combines the monetary theory of Ludwig von Mises and interest-rate theory of Knut Wicksell with the dynamic synthesis developed by F. A. Hayek. This theory cannot be called complete because it lacks a fully worked out capital theory to complete the integration of monetary and value theory. (We might think of this as the economic version of the Unified Field Theory in the natural sciences.) But an incomplete valid theory beats a discredited theory every time.

In other words, free-market economics has an explanation for why the accident repeatedly happens and why its effects can be mitigated by the economy’s automatic guidance mechanism without the need for policy action by government. It also explains why the policy actions are ineffective at both remedial and preventive action in the field of accidents.

James Grant’s book will take its place in the pantheon of economic history as the outstanding case study to date of a self-curing depression.

DRI-315 for week of 9-22-13: What Has Happened to the Labor Market?

An Access Advertising EconBrief:

What Has Happened to the Labor Market?

The performance of the labor market should be gauged using multiple indices, but is commonly judged by only one. The unemployment rate currently stands at 7.3%, having fallen from a cyclical height of almost 10%. Although that may seem like sizable progress, 7.3% unemployment is unheard of almost four-and-a-half years into a cyclical recovery. Even more startling is the swan-dive done by labor-market participation, which has declined to its lowest point since 1978. These data coincide with repeated extensions in unemployment-benefit tenure and increased enrollments in the food-stamp (SNAP) program. SNAP now provides food to about one in seven American families.

Taken together, these facts suggest an ominous change in the U.S. labor market. The Wall Street Journal recently brought that change into sharper focus by interviewing a leading expert-participant in the labor market.

Bob Funk owns Express Employment Services, headquartered in Oklahoma City, OK. EES is the fifth-largest employment agency in the country, with annual sales of $2.5 billion and 60 franchises scattered across the land. Funk estimates that EES will place about a half-million applicants in jobs over the coming year. Clearly, he has a vested interest, but that cuts both ways – his financial stake in the market hones his perceptions all the more keenly. And he cuts to the bone in his analysis of what is wrong with the U.S. labor market.

The Great Shift

Like many an interviewee, Funk is promoting a product in which he has a personal interest. EES will soon release a study called “The Great Shift,” which sounds the alarm about the deterioration of the U.S. labor market. Few men are better qualified to pronounce on this topic than Funk, whose company places both blue- and white-collar workers ranging from the lowest level maintenance worker to hard-hat construction workers to high-level executives.

In the simplest terms, the U.S. labor market is morphing from a market that works well into one that fails or works poorly. Many forces are bleeding the life out of the U.S. labor market. In the interview, Funk and interviewer Steve Moore highlight the most pernicious of these.

Loss of work ethic. “In my 40-some years in this business,” Funk declares, “the biggest change I’ve witnessed is the erosion of the American work ethic. It just isn’t there today like it used to be.” If this sounds suspiciously familiar, perhaps that is because it echoes the lament of every older man – successful or not – pining for lost youth. That is probably why it has not fired the imagination of the public at large.

But business owners have no trouble connecting with Funk’s message. Funk’s list of the specific attributes necessary to success on the job – being on time, taking a conscientious approach to the job, treating every task seriously and being willing to do anything including work overtime – will light a fire of recognition in the eyes of every employer who reads it.

According to Journal interviewer Stephen Moore, Funk “thinks the notion of the ‘dead-end job’ is poisonous because it shuts down all sense of possibility and ambition…If low-level employees show a willingness to work hard,” Funk maintains that “most employers will gladly train them with the skills to fill higher-paying jobs.” Neither Funk nor Moore trouble to explain why employers would be so generous, but the point is worth developing. Contrary to the impression created by politicians and the news media, most job training occurs on the job rather than in academic and vocational institutions. Since the employer will have to train anybody who fills a higher-paying position anyway, it will generally be easier and cheaper to train an internal candidate rather than import one who must be wholly indoctrinated into company procedures. But any employer wants a trainee whose can-do attitude, enthusiasm and demonstrated productivity make the investment in training odds-on to succeed. That’s why holders of so-called “dead-end” jobs can actually have a leg up on outside applicants, and why so many of the rich and famous got started at the entry level.

Alas, as Moore puts it, Funk “fears that too many of the young millennials who come knocking on his door view a paycheck as a kind of entitlement, not something to be earned. He is also concerned that the trendy concept of ‘life-balancing’ is putting work second behind leisure.”

Some readers will find this jaundiced picture too one-sided. Surely there must be some people who see openings for hard work as an opportunity for economic advancement and personal improvement. Sure enough, Funk unhesitatingly identifies just such a class of go-getters. “I guess I’m a little prejudiced to the immigrants and especially Hispanics,” Funk admits. (Note the refreshing use of the word “prejudiced” in its correct, non-pejorative sense.) “They have an amazing work ethic. They don’t want handouts and are grateful to have a job. Our company has a great success rate with these workers.” Moore, who has decades of interaction with academic and government economists, observes grimly that “this focus on work effort is seldom, if ever, discussed by policy makers or labor economists when they ponder what to do about unemployment. To most liberals, the very topic is taboo and is disparaged as blaming the economy’s victims.” Moore tactfully refrains from pointing out that the benefits of immigration, too, are taboo among mainstream conservatives; they see only a camera-negative vision of immigrants as criminal, disease-ridden, welfare-sucking, invasive forces of destruction.

The relative attractions of subsidized leisure. When Moore pressed Funk “to explain what Washington can do to get Americans back on the job,” Funk replied that “the first step would be to start shrinking the ‘vast social welfare state programs that have become a substitute for work. There’s a prevalent attitude of this generation of workers that the government will always be there to take care of them.'” Funk mentions unemployment benefits, health care and food stamps as examples of welfare-state subsidies that kill the incentive to take entry-level jobs, but he reserves special condemnation for the Social Security disability program.

Funk considers disability, which now serves some 14 million recipients, the most-abused federal-government program. EES has discovered that over half of the disability claims filed by its workers are fraudulent, he claims. When the company challenges claims in court, “we win over 90% [of the time].”

Government regulation. Funk characterizes the Affordable Care Act (ObamaCare) as “an absolute boon for my business.” Why? The legislation requires businesses with 50 or more full-time employees to provide health care for their employees. ObamaCare defines “full-time” employment as 30 hours (!) or more per week. This has led to the already-notorious business categories known as “49ers” (businesses that cap their full-time employment at 49 workers) and “29ers” (businesses that cap their employee work week at 29 hours). “Firms are just very reluctant to hire full-time workers,” Funk says. “So they are taking on more temporary help, which is what we do.” While ObamaCare is statutory law, it will be implemented by an executive agency, the IRS. Its provisions have the substance of regulation and legislators were acting exactly as regulators do when they passed it. Indeed, the overwhelming public opposition to the bill gives it even more of the substance of regulatory fiat.

As Moore notes, “the hundreds of thousands of temporary workers [Funk] places in jobs are EEC employees. He pays their salary, benefits and payroll taxes and the firms that hire the workers reimburse EEC for those costs plus a commission. This feature of the temporary-worker industry allows companies trying to fill job openings to do so in a way that sidesteps ObamaCare’s mandates. After an on-the-job trial of several months, companies often offer the workers permanent positions.”

The function now performed by Funk’s temp agency was formerly performed routinely by business firms themselves without need for a middleman. Workers were hired under terms called “probation,” which stated that if the relationship did not prove mutually satisfactory they would be discharged. But the federal government overlaid the employer-worker relationship with so many “protections” ostensibly designed to promote worker security that businesses couldn’t discharge workers who didn’t work out without running the risk of a lawsuit. And a lawsuit was sure to result in either a settlement or a trial; either way the business would incur a significant cost. So businesses simply stopped hiring. Workers became more “secure,” all right – if they already had a job. But workers looking for a job became less secure, because businesses no longer had the choice of hiring on a hunch with the fallback option of discharging the worker if the hire didn’t work out. Apparently most people lost sight of the fact that the probationary period also gives a worker the same chance to try the job on for size. (The implicit stance behind government labor-market regulation seems to be that “fairness” demands gross asymmetry – employers must meet tremendous obligations while workers enjoy lots of “rights.” This implies that fairness and freedom are incompatible.) This is still another of the many ways in which government itself contributes to higher and longer unemployment through its own policies.

Fund adds “the problem isn’t just ObamaCare, though. It’s the entire assault on employers coming out of Washington – everything from the EEOC to the Dodd-Frank monstrosity. Employers are living in a state of fear.” One terrorized industry not mentioned by either Funk or Moore has been trucking, where the Department of Transportation has launched a veritable war on employment. DOT has revamped its regulatory modus operandi in favor of a statistical data base that has turned veteran drivers with previously spotless driving records into risky or even prohibitive employees. Frequent agency threats to require expensive health diagnostic checks for sleep apnea have cast a pall over the profession. DOT’s long delays in making up its mind on allowable hours of service for truckers left the industry hanging. And trucking firms have also felt the sting of the agency’s new regulatory scheme. Truck drivers already feel the breeze of a sword of Damocles swinging over their head, in the form of technological obsolescence impending due to eventual development of self-driving vehicles. The federal government acts as if duty-bound to beat technology to the punch by driving truckers out of the industry first.

The jobs mismatch. At one time, it was conventional thinking that an increase in job openings would lead to a decrease in unemployment and an increase in employment. The stunning exit of workers from the labor force has played hob with convention; the unemployment rate has fallen at the same time that the volume of employment has also declined sharply. When we probe for the reasons behind the out-migration of workers, the most striking datum is the mismatch between the types of workers sought and those now unemployed or no longer looking for work. When an unemployed worker’s job-search efforts are repeatedly met with rejection, surrender becomes easier to understand.

Funk claims that EES usually has around 20,000 jobs that it can’t fill owing to a lack of qualified applicants. Moore lists the most sought-after fields as “accounting (thanks to Dodd-Frank’s huge expansion of paperwork), information technology, manufacturing-robotics programming, welding and engineering. He’s mystified why EES has so much trouble filling thousands of information-technology jobs when so many young, working-age adults are computer literate.”

The idea of a mismatch between available job-seekers and available jobs has been around for at least a century. In economics textbooks, it is called “structural unemployment.” If the number of unfilled jobs is exactly equal to the number of unfulfilled job-seekers, this might mean that employer and employee just haven’t gotten together yet. But if this condition persists for a long while, this suggests that job and job-seeker are somehow incompatible. At first glance, this seems like the sort of problem that might arise in a modern economy due to the absence of central economic planning by government. After all, how do we know that the “right” number of engineers, accountants and welders will be trained and packed off to the labor market? Doesn’t this require rational planning by somebody – or bodies – who can see the whole “big picture” on a gigantic planning board?

It turns out that free markets are supremely qualified to handle this sort of problem because only free markets can transmit the information about the kind and quantity of jobs needed to the precise people who can help to solve the problem – namely, the would-be engineers, accountants, welders, et al. And the problems of matching are far too big to be solved by central planners – not merely too big, but too subtle and complex, as much a matter of subjective perceptions as objective information. That is why private for-profit agencies like EES, which exploit both the incentives and the information offered by the price system, outperform the state employment agencies.

The persistence of imbalances, whether structural or frictional, implies that prices are not being allowed to do their job. In the low-skilled segment of the market, the minimum wage is the longtime culprit. Recent increases in both the federal and state minimum wages would be bad enough under any circumstances, but in this climate they constitute criminal economic-policy malpractice. At the executive level, the recurring attempts to legislate CEO pay do nothing to improve the welfare of consumers but do hinder the workings of the market for executive talent.

It is the middle of the labor market that has suffered most conspicuously, and acutely, from meddlesome non-market forces. In order to get and hold a job as an accountant, engineer or IT specialist, fluency in mathematics is an absolute prerequisite. (Mere numeracy no longer suffices in accounting, since today’s accountant must command enough computer-related expertise to service his clientele.) The only thing American schools teach worse than mathematics is reading, which is another prerequisite for most high-end jobs. In contrast, foreign students tend to be well versed in mathematics, which explains the agitation to make visas available to high-skilled immigrants.  The educational deficit may not explain the entire skills deficit, but it is surely the beginning of wisdom on the issue.

The long-running failure of American public schools. Public-school reform in America now enters its second century. The breath of fresh competitive air blown in by charter schools and vouchers has brought the first genuine, effective reform to K-12 education. But the education establishment dies hard. With the death of the old telecommunications monopolies, teacher’s unions are the leading political force in many statehouses. The stubborn persistence of labor-market imbalances in math-, reading- and computer-skilled jobs has its corollary in the stubborn persistence of the political power of teachers’ unions.

How do teachers’ unions hurt educational performance? They are structured to favor incumbent teachers over newcomers, which means that they insist upon seniority as the basis for pay and advancement rather than actual teaching productivity. Even worse, it means that the tenure system reigns unchallenged. “Teacher is by far the most corrupt social institution in our time,” Funk flatly declares. “It doesn’t reward excellence or weed out bad teachers.”

Contrast tenure with the rule of free markets, in which business failure is penalized by financial failure. Success is rewarded with high(er) profits, which encourages entry of new firms and imitation by other businesses. All this is utter anathema to public schools, which abhor failure and exit by a public school – unless the school district itself decrees it for cost reasons, of course. There is no particular, automatic reward for successful teaching performance – in particular, no immediate and unequivocal financial reward for good teachers. (Indeed, in higher education it is axiomatic that good teachers usually fail to achieve tenure because they spend too much time concentrating on teaching and not enough worrying about the “research” that will lead to tenure.)

While it is true that change is finally coming, it proceeds at a glacial pace because it moves along the choked roadway marked “politics” rather than the speedy autobahn of free markets. Unions dictate the terms on which vouchers are allowed to exist (if at all) and operate; they dictate the funds allocated to charter schools. This is akin to running a poultry farm by appointing the fox foreman and letting him control access to the chicken house.

What Does This Pattern Remind You Of?

When we put the pieces of this labor-market pattern together, they form a familiar picture. For decades, Europe has produced the same picture: dreadful work ethic, open-handed government subsidies killing off the incentive to take entry-level jobs or work at all, smothering government regulation, declining academic performance, powerful unions blocking reform, increasing mismatch between available jobs and worker skills. Not only that, but the Continent’s long-running virus of sluggish growth and high unemployment has recently spread to the U.S.

Most ominous of all is the serial banking and financial crises experienced by countries within the Eurozone. They began with tiny, insignificant little Greece, whose troubles couldn’t possibly be big enough to harm anybody else. Besides, Greece was an outlier, an exception. Its people were exceptionally lazy, its banks horribly inept, its regulation unusually lax – or so the party line ran among the commentators and mainstream news media.

Soon, though, the financial woe spread to Portugal, Spain and Italy. France began to look shaky. Every few months a new crisis flared up. Each time, finance ministers and heads of state appeared to assure us that this new fix has achieved financial peace in our time – until the next crisis. And then came recession – again.

For years, the American labor movement has been holding up Europe as its model. Incredible as this may seem, labor leaders have pooh-poohed the high rates of unemployment and low rates of economic growth in Europe. They have maintained that people in Europe were happier than Americans. They were more secure. Wasn’t this worth putting up with a little more unemployment, a little less material wealth? Goods and services weren’t all that important, were they, when stacked up against the really important values in life?

Lately, though, we haven’t heard much of this rhetoric. Partly this was because riots and discord in Europe were blatantly at odds with the party line about the bovine placidity and content of the populace there. Partly it was because the American Left was now peddling a new party line about the rapine and plunder of the 99% by the 1%, and they needed to extend this paradigm internationally in order to demonize the phenomenon of globalization. And it’s pretty hard to harmonize the picture of happiness with one of rape and plunder.

The real importance of our growing resemblance to Europe, however, is that is raises the specter that we will follow in their financial footsteps. The mainstream news media has a history of disregarding the views of men like Bob Funk. But the carbon-copy example of Europe lends a chilling credence to his views. It happened there and is still happening there, which makes it that much tougher to pretend that it can’t happen here.

DRI-330 for week of 10-14-12: The 7.8% Unemployment-Rate Controversy

An Access Advertising EconBrief:

The 7.8% Unemployment-Rate Controversy

On October 5, 2012, the Bureau of Labor Statistics released estimates on employment and unemployment in the United States for the month of September. BLS does this every month, and these data are usually a source of interest but only rarely a source of controversy. This release was different.

The Bureau announced that its estimate of unemployment had fallen to 7.8% from its previous level of 8.1%. This came as a big surprise to economic forecasters and analysts, who had expected the rate to remain the same or even rise. The source of controversy was the magnitude of the decrease and its rationale.

The unemployment rate itself is estimated using a survey of roughly 60,000 U.S. households. The results of that survey have been quite volatile in recent years – last month, for example, they showed a seasonally adjusted decline of 119,000 in the number of those working. But the September survey estimated an increase of 870,000 employed. This was a staggering result – the largest total in this category since January, 1990 (1,251,000) and June, 1983 (991,000). (Two larger totals were attained earlier in the millennium, but BLS adjustments in the data make these totals non-comparable with others.)

This was the kind of increase in employment normally associated with rip-roaring growth in economic activity. In June, 1983, for example, annualized growth in GDP was 9.3%. In January, 1990, it was 4.2%. But here in 2012 it is a puny 1.3%. This seeming paradox raised suspicions in the minds of some people.

Much has been made during President Obama’s tenure that no U.S. president has ever been reelected with an unemployment rate above 8%. Conservative talk-radio host Rush Limbaugh went so far as to predict that the Obama administration would somehow contrive to bring reported unemployment down below 8% prior to the election – implying that deception might be involved.

In the face of the decline in the reported unemployment rate, former CEO of General Electric Jack Welch sent a text message to friends in which he directly accused the Obama administration (whom he characterized as “Chicago guys”) of somehow manipulating data to produce this result.

Tons of ink and reams of paper are consumed writing about markets and their misfortunes. Virtually nothing is said about the collection, preparation and presentation of economic data. This time is ripe for that discussion.

Political Theater vs. Political Economy

The brouhaha over the BLS’ handling of this data release is ironic. While clear wrongdoing occurred, it has been virtually ignored throughout the controversy. Public debate has instead focused on a hypothesized conspiracy to invent or distort data, to “cook the books.” As is so often the case, battle lines have been drawn along political lines. Meanwhile, the news media has been perfectly willing to dramatize the conflict as an exercise in political theater while ignoring the underlying issues of political economy.

The BLS, and particularly Director Hilda Solis, plays a key role in the drama, but that role has been miscast by both political factions. The right wing has cast the agency as accomplice and co-conspirator. Defenders of the administration have portrayed the BLS as staffed by politically independent professionals, completely devoid of political sentiment and as behaviorally pure as Ivory Snow.

In reality, the agency is a branch of the “permanent government,” the bureaucracy that keeps rolling along like Old Man River through Democrat and Republican administrations alike. Its only inherent goal is to maintain its existence, size and power. Ms. Solis is a political appointee, named by President Obama in 2009. As such, she has divided loyalties.

As political appointee, she owes her position to the President. The temptation to hew her actions and public pronouncements toward the positions of the administration is ever-present. This would be true regardless of her personal sympathies, but since presidents usually choose department heads whose views dovetail with their own, the sympathies of a director typically reinforce the incentive to side with the administration.

But as chief administrative officer of a federal bureaucracy, she is the only person capable of steering that agency away from its normal self-serving goals and toward the objective of serving the broad general interest. As far as the American public is concerned, that is her only valid function – to steer the agency between the Scylla of toadying to the administration and the Charybdis of bureaucratic inertia.

In this case, Hilda Solis failed miserably. That is the wrongdoing – indeed, the tragedy – of the 7.8% unemployment controversy.

Friday Morning, 8AM, October 5, 2012

On the morning of the announcement, Ms. Solis was presented with the statistical reports prepared by her staff. In order to contrast what she should have done with what she actually did, we must take a critical look at those reports. The BLS takes two surveys of employment that attract widespread public attention.

Its payroll survey uses payroll records of 60,000 businesses to estimate new hires during the target month. The results of this survey tend to be relatively stable. The September report not only presented results for that month but also upward revisions for the previous months of July and August. Payroll jobs for July were revised up to 181,000; the August estimate was revised up to 142,000. The September estimate was a job gain of 114,000.

The first thing to notice about this survey is the downward trend. This, combined with the fact that unemployment has long been considered a lagging indicator, influenced the expectations of many economists who expected the September unemployment rate to rise slightly. While there is no general agreement among economists, it would be fair to state that 142,000 jobs is close to a tipping point when it comes to lowering the unemployment rate – it is either barely adequate to nudge unemployment down or not quite enough, depending on how responsive one finds the labor force to be.

The 114,000 jobs chalked up in September, though, are not enough to make a dent. That is why the result of the other employment survey, the telephone survey of households conducted by BLS, created such a stir.

The household survey purported to locate a total of 873,000 new jobholders in September. Of these, some 582,000 were supposedly part-time jobs. The fact that this total had been exceeded only twice since 1983 – and both times when the economy was growing at elevated rates – made many anti-administration partisans doubt the veracity of the figures.

These job numbers were not only dubious on their face. They were also blatantly at odds with everything else we knew or conjectured about the state of the economy. Growth had begun the year promisingly but had stalled and slowed to an annualized pace of 1.3% in the second quarter. World trade slowed. Recession loomed in Europe.

Some good news tempered the general mood of gloom, but it was measured. Consumer confidence rose somewhat, perhaps buoyed by a stock market rally – but the rally was dampened. Labor force participation increased after steady decreases – but the increase was slight.

In order to believe in the veracity of the household survey’s jobs estimate, we would have to believe that the labor market had suddenly, inexplicably become the leading indicator for a roaring expansion that as yet had no other harbinger – that the household survey was telling us the truth while all other indices were lying, or at least keeping mum.

Historically, the household survey was known to be volatile. The previous month, August, it had recorded an estimated job loss of 119,000. Thus, the variance between the two surveys was still three times greater in September.

The only reasonable conclusion seemed to be that the household survey was wrong. “Wrong” doesn’t mean faked or fraudulent. It doesn’t mean that BLS employees didn’t make the survey calls, or didn’t record the answers correctly. It certainly doesn’t mean that somebody hid the results in the dead of night or bribed the BLS to suppress them.

All experienced economic forecasters and statisticians know that formulating estimates from sample data is far from an exact science. It is like dining out every night – sooner or later you’re going to get hold of something dreadful that needs to be purged. And that is exactly what statistics textbooks advise students to do with obviously aberrant values in a data set – omit them.

The argument for omission is fairly straightforward. The most basic type of statistical estimation technical, called linear regression, tries in effect to draw a straight line through a collection of data points for the purpose of estimating the course future data will follow. The line is an attempt to capture the central tendency of the data. Including a wildly aberrant value will pull that line off course and make the future estimation process less accurate.

What BLS Director Solis Should Have Done

For practical reasons, it may be difficult or impossible to simply cancel or postpone the release of the household survey and associated unemployment rate. This is an eagerly awaited statistic that is followed closely by analysts throughout the world. Regardless of any good reasons advanced for cancellation or postponement, such an unusual procedure would itself be suspect – people would wonder what the authorities were hiding.

Of course, that argument cuts both ways. The world isn’t waiting breathlessly in order to receive estimates that are worthless or downright misleading. Then there is the little matter of a Presidential election that probably won’t – but just might – turn on the result of these estimates.

What Hilda Solis should have done is: 1. order a double-check of all relevant figures and calculations in the household survey; 2. assuming the results check out, announce at the press conference that the data release contains survey data and a consequent estimate that defy common sense; 3. advise the general public that no weighty conclusions be drawn from the suspect estimates, since they are unsound; 4. invite all interested parties to inspect the Bureau’s data, methods, calculations and results.

She should have done this because the purpose of government is to aid and inform the American public, not to serve the political interests of any administration or the economic interests of bureaucrats. By presenting the data but warning the public, she would be telling the truth, the whole truth and nothing but the truth. She would be allowing anybody who still wanted to accept the figures to do so, but at their own risk. And she would be putting everybody else on notice. She would be behaving the same way as a fiduciary – a professional who has the legal duty to put the client’s welfare above all else. That duty covers both commissions and omissions; it is the obligation to place the full range of professional expertise at the service of the client. In this case, the client is the American people.

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What Hilda Solis Actually Did

What Hilda Solis actually did was to release the household survey and unemployment-rate estimate without warning the public. Indeed, she not only refused to supplement the data release with a warning – she passed up opportunities in subsequent interviews. An interviewer from Bloomberg questioned her three times about the dubiety of the 7.8% unemployment rate and the 870,000 job gain in the household survey. She defended the household survey, citing job gains among 16-24 year-olds. At no time did she back away from or otherwise express reservations about the household survey.

Ms. Solis’s act had the effect of inviting the public to take the dubious household-survey results at face value. Some people did that. Others were shocked by the extremity of the 870,000 job-gain and 7.8% unemployment-rate figures. Still others were outraged by what seemed altogether too fortuitous a coincidence – that a bureau in the Department of Labor, long dominated by the Democratic left wing, would produce a wildly extreme employment report favoring a labor-union-supported Democratic incumbent on the eve of a presidential election.

But the people in the best position to evaluate the report were professional economists and forecasters. Here is a representative selection of their characterization of the two disputed estimates – the 870,000 September job gain and the 7.8% unemployment rate: “”Must be an anomaly;” “statistical anomaly;” “just a fluke;” “statistical quirk;” “implausible;” “almost certainly a statistical fluke;” “huge statistical outlier on the upside;” “not reality;” “an aberration.”

All of these comments came from respected economists, forecasters and consultants. One of them is a former director of the Congressional Budget Office. Some of them are known to be supporters of the Obama administration. None are rabid anti-administration partisans. Clearly, they all knew statistical salmonella when they saw it. Yet none of these people criticized Director Solis’ decision to release the estimates without warning or qualification.

The Harm Caused by the BLS Acts of Omission

The news media covered the issue as an exercise in political theater. They pitted right-wing claims of conspiracy against indignant denials and claims of pristine innocence on the left. When the conspiracy angle petered out for lack of evidence, the story died.

The real harm caused by BLS wrongdoing is much more mundane, but more hurtful than any partisan conspiracy. It concerns the day-to-day functioning of government, not the crimes of individuals. The unemployment rate is used by analysts throughout the world as a barometer and index of the U.S. economy. Investment company owners and fund managers use it to calibrate the timing of investments. Financial planners use it to manage their clients’ money. Large corporations use it to gauge the direction of consumer demand. Commercial and investment bankers use it; business and economic forecasters use it; employment agencies and corporate headhunters use it. Even small businesses use it.

All these people suffer when information disseminated by the federal government turns out to be disinformation. When people discover that they have been fooled, they will take the index less seriously in the future. As a result, their job performance will suffer. And their cynicism about government and the rule of law cannot help but harden – after all, they are already suffering their fourth year of being fed false information about interest rates by the Federal Reserve. The Fed’s QE series of government and private securities purchases is openly and deliberately designed to hold interest rates artificially low by increasing the supply of money. Interest rates are even more ubiquitously used and useful than government economic data.

The Enablers

The people best equipped to understand the abdication of professional responsibility by Hilda Solis and the BLS are the premier economists, forecasters and statisticians. They know that the household survey’s September estimates should have been released – if at all – with a stern caution to the general public. This is directly analogous to the warning labels that government regulators require private businesses to stick on products that present a potential hazard to consumers. The 7.8% unemployment-rate and 870,000 job-gain estimates were no less hazardous to the financial, intellectual and political health of the American public.

The quoted comments above demonstrate that these financial experts recognized this danger quite well. But while they noted it in casual asides and obiter dicta, they refused to take the obvious next step. They refused to call Director Solis and BLS to account. They refused to alert the American people to the true nature of the wrongdoing. They refused to limit the damage done. And they lost the opportunity to deter future episodes of misconduct.

The 7.8% Solution

The real wrongdoing in the 7.8% unemployment-rate controversy stems from negligent omission, not active conspiracy. It is patent in the reactions of professional economists and forecasters. The permanent government was derelict in its responsibility to aid and inform the American public. Instead, it catered to political and/or bureaucratic interests. That is not the kind of dramatic, theatrical conspiracy that attracts the attention of news media. But the failure of day-to-day government to do its job grinds down our living standards, morale and respect for law.