This is a highly overrated index. It is merely a survey of purchasing managers. It is a diffusion index, which means that it reflects the number of people saying conditions are better compared to the number saying conditions are worse. It does not weight for size of the firm, or for the degree of better/worse. It can therefore underestimate conditions if there is a great deal of strength in a few firms. The data have thus not been either a good forecasting tool or a good read on current conditions during this business cycle. It must be recognized that the index is not hard data of any kind, but simply a survey that provides broad indications of trends.

Obviously any report can be overrated if interpreted in the wrong way. One way this report seems to be over used and misinterpreted is by relative changes in the index instead of considering the “breakevens” in practice. For example if the headline ISM index drops by 6 points it is significantly more important if it drops from above 50 to below 50 than if the index drops from the 60s to 50s range. The first signifying a reversal of growth and the second a slowing of the growth rate which might actually be good. That is, instead of an overheated economy with growing number of bottlenecks it may signify a stable growth trajectory.

Since the reports are based on sentiment, then it is true that biases are a big factor to consider but that is also its strength as we are trying to have forward looking indicators of the strength and direction of the overall economy, and this should always be taken along with a look at the “Non-manufacturing ISM” reports also. While it may not be as good at forecasting as Briefing.com may desire, it has provided us clues as to what is not likely to happen. For example, they have not so far indicated a double-dip recession. Inflation for a while has been a concern but that trend has reversed and most indicators show a “slowing economy”. It is also worth pointing out that perceptions create reality and what people’s sentiment is now about the future is likely to be created in reality.

But it is an important consideration that the index is not weighted by size of firm or the degree of sentiment. Since the reports have been around for a long time {since 1931}, changing the reports now may not be a good idea but it might be nice to have “weighted scores” versus the standard unweighted scores. On some of the individual indicators, they indicate not only the breakdown of the industries that are expanding, contracting and staying the same, but also percentages of firms responding in the three categories. This can help indicate broad expansion or more narrowed. With these things in mind let us proceed to the latest reports.

ISM Reports:
Overall the reports are positive but most definitely no indication of an overheating economy. The links used in this portion of the post are:
1. ISM – Media Release: July 2010 Manufacturing ISM Report On Business®
2. Econoday Report: ISM Mfg Index August 2, 2010
3. ISM – Media Release: July 2010 Non-Manufacturing ISM Report On Business®
4. Econoday Report: ISM Non-Mfg Index August 4, 2010

Both headline indexes were solidly in positive territory with manufacturing {PMI} at 55.5 and non-manufacturing {NMI} at 54.3 which signified 12 months of positive growth for the PMI and positive growth for the 2010 year for NMI. The PMI went down by .7%, but the NMI increased by .5% which showed signs of convergence in the economy, that is slow but steady growth. What may be more significant is that both indexes were above consensus at 54 for PMI and 53 for NMI. NMI was even above the range of 52.8 to 54.0, while PMI was at the top of the consensus range of 52.5 to 55.5. Overall the experts had expected a slower growth rate for July. The respondent statements for the most part on the manufacturing was down and could signify an even slower growth in the future with Fabricated Metal Products respondent being the one positive voice. The non-manufacturing on the other hand was mostly positive or lukewarm at worst.

One significant aspect that has changed in the reports since the June reports is that “Commodities in Short Supply” for both sectors is reporting shortages, while last month no shortages were reported. The non-manufacturing shortages seem of little consequence but manufacturing stated that “Capacitors; Electrical Components; and Titanium Dioxide” were in short supply. Already, the list of commodities with rising prices is getting longer and it has greater numbers in the parentheses (number of consecutive months of rising prices). Under neoclassical economics of supply and demand, shortages would indicate greater price pressures to clear the market and some of those commodities already show signs of rising prices. Either way these “bottlenecks” could create a drag on the economy. While sectoral rising {or declining} prices signify to the market to adjust, if too many or too rigid of constraints could prevent the necessary adjustments in the economy. Arguably the labor markets are indicating rigidity in a variety of ways including labor migration has been muted partially because of the housing crisis.

That brings us to the issues of price changes as respondents stated and ultimately the issues of Inflationistas And Deflationistas. After the dramatic drop in the price index of manufacturing by 20 points in the June report, the index rose slightly {.5%} and was still significantly above 50 at 57.5. The non manufacturing price index continued its downward trend by dropping 1.1% to 52.7 which is still above the 50% mark and indicating rising prices overall. The downward trend started in April with an index high of 64.7. One significant difference in the two reports is that breath of the price changes. The industry groups are about par {manufacturing 10-3, non-manufacturing 9-4 for increases and decreases respectively}, but the percentage break down by respondents shows that under 50% are experiencing same price levels for manufacturing and over 70% for non-manufacturing. Thus a much larger percentage are not affected by changing prices in non-manufacturing. Even if the trend continues in non-manufacturing for lower prices as it dips below 50%, it will be narrowly focused and less likely to cause a cascading deflationary spiral. Either way, there should be little concern for both inflation or deflation according these numbers.

This does not stop talk from the “deflationistas”. Paul Krugman, as the easiest target around, gives us his back of napkin analysis at Trending Toward Deflation with the chart below. First, trending is a very tricky science and as such he presents no supporting information to help his arguments. Secondly, he does not provide any historical data to show that a trend as such would continue through the zero point of completely stable prices. While, I think that such a point is highly unstable and would be more like a knife edge, I am just not certain that momentum would work so easily to create an economy of deflation from long term inflation. I think there has to be an impetus for such transitions. For example, rapid increases in technology or productivity could bring on deflation but that is hardly happening at the present time.

New orders slowed abruptly in July, in what is the key headline of the Institute For Supply Management report. New orders fell to 53.5, still above 50 to indicate month-to-month growth but down five points from June to indicate a significantly slower rate of growth. The 53.5 reading is the lowest since the manufacturing sector emerged from recession this time last year. Backlog orders also slowed, to 54.5 for a 2-1/2 point decline and its lowest reading since December.

That was the introductory paragraph from Econoday for the manufacturing sectors. It is one of the reasons for looking beyond just the headline numbers as this could signify even slower growth in the preceding quarters or possibly a double dip recession. But on the positive side the non-manufacturing increased by 2.3% to 56.7 and overall the non-manufacturing had a good report as Econoday stated:

This report is a big positive given the prospect from prior reports for gradual slowing. The double dip is still on hold.

One of the positive aspects of the report on non-manufacturing sectors was employment, as it edged above the 50 mark again, which was twice in 3 months. This signifying that there is no trend but at least treading water. For the 8th consecutive month the employment index for manufacturing was above 50% {positive job growth} at 58.6% which was a rise of 0.8%.

Can Exports dig Us out of this Recession?
Last month, the manufacturing import and export indexes were roughly the same levels with imports slightly higher. This has reversed this month as exports edged higher at 56.5% {+0.5} and imports dropping 4% points to 52.5%. While the non-manufacturing sectors {services} has less effect on balance of trade, the report still was positive as new export orders surged ahead of the break even of 50% with a 4 point gain to a total of 52%, and import index staying below 50 at the same rate as last month of 48%.

Those are certainly positive signs for the question posed above and it is certainly possible. It is a question that I have been asking on this blog for quite some time. Now, it looks like the Democrats and especially Obama also think this might be the answer, as this article from the Washington Post talks about at New Democratic strategy for creating jobs focuses on a boost in manufacturing. But the Democrats have the obstacle of their base not being so keen on “free trade” and more trade agreements. Luckily, I have not heard any more news on Obama’s pledge to renegotiate the NAFTA treaty. The Wall Street Journal blog stated the union opposition in the following manner, “Even if the White House may see the benefit of more bilateral trade deals, the administration risks losing support from a core supporter–unions–if it presses forward on a raft of FTAs.” at Trade Deals {are} Vital to Meet Obama’s Export Goal. The opening paragraphs also frame the issues in the following manner.

U.S. trade and business groups are skeptical the U.S. can double exports without the Obama administration signing a raft of new free trade agreements.

Although President Barack Obama’s administration is pushing ahead with a South Korean FTA, officials say their strategy focuses less on bilateral deals and more on boosting exports through promotion and more rigorous enforcement of trade rules.

While I fully support any endeavor at expanding trade, I seriously doubt and are skeptical about those two initiatives will do much good. First, all countries are “promoting” export trade and we are already in many ways. Demonizing businesses and claiming that we subsidize outsourcing of jobs is not likely to promote exports also. Secondly, not likely to win friends and influence people {countries} by taking them to the teacher and complaining about them. Trading partners are not likely to give us more without us also giving up something also. Talking is not likely to lead to spontaneous open markets for US manufacturing.

Adam Ozimek thinks it is more like trying to bring back
Glory days. It should be apparent that the US is a post industrial society and we are not going back but that does not mean that exports and thus manufacturing can not lead the way to economic recovery. Three international economists from the Centre for Economic Policy Research {VOX} ask the question Can the US raise employment with more exports?. Their paper is based on standard economic theories which even from the opening their statement provides the framework for their analysis.

Can increasing US exports create US jobs? Manufactures dominate US exports, but US manufacturing employment is declining. This column suggests that increased US exports are unlikely to lead to dramatic manufacturing employment gains, but employment in related services sectors may improve.

The US economy has shifted from production to services.

They do a good job providing some thoughts on the reasons service sectors may benefit more from increases in manufacturing output than actually the manufacturing employment. But let me expand their ideas and bring up 3 reasons that support their contentions.
1. Using simple Keynesian models, any autonomous spending will produce a rippling effect on the economy through the multiplier effect. Increased investment in manufacturing has the same initial effect than an exogenous spending increase by government, but can provide more long term growth potentials.
2. Spillover effects on different sectors of the economy can increase productivity in other sectors and expand their respective output levels. The economists discuss these issues within the framework of upstream and downstream sectors of the economy to manufacturing. While spillovers are a general phenomenon, the more exact economic concept occurring here is linkages. Overall manufacturing tends to have the most “linkages” to other sectors of the economy, and thus they are the easy and most likely candidate for development policies. The economists show how this effect is dramatic with their graph on employment in the three economic segments with manufacturing and its upstream and downstream linkages.

3. As productivity in the manufacturing {also farming and resource extraction} sectors increases, this raises the GDP and thus per capita GDP. There is a strong correlation between higher productivity in manufacturing and the average workers pay. The authors provide another important correlation in stating the following.

It is also worth noting that previous research has found that the share of services as an input to a country’s manufacturing exports is significantly correlated with the country’s per capita income (Francois and Woerz 2008).

That is basically self evident, that as more value is added to the end products then income increases. Either theory points out that instead of dreading the demise of the manufacturing job, we should praise the rise in productivity as ultimately we all benefit from this. Most praise the productivity of the American farmer and this same should go for the manufacturers of the US.

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Headline Numbers of ISM Report On Business®.
The PMI index {manufacturing index} was reported as 56.2% and NMI (non-manufacturing index/composite index) was reported as 53.8%.   Both numbers missed Market Watch’s Economic Calendar consensus numbers with ISM Manufacturing consensus at 59% and Non-Manufacturing at 55.3%.   Econoday reports ISM Mfg Index as 59 consensus and the range as 57.6 to 59.7 and ISM Non-Mfg Index as 55 consensus and the range as 53.5 to 56 which indicates that only non-manufacturing fell within the range of consensus.

Both reports are remarkably similar in that the composite chart is marked most prominently in “Slower” under the rate of change. The indexes and indicators are mostly growing but are growing at a slower pace.   Considering the number of months of trending growth especially in the manufacturing report, this slow-down could just be head winds slowing progress or just a small hill that will easily reverse and accelerate the growth in future months.   I am just not certain that the slow-down is worth wringing hands over, but could easily frighten the equity markets as they appear to have done prior to this past week.   Econoday notes the possible reaction from markets.

Today’s report is not good news for the stock market which may continue to discount economic slowing for the months ahead.   Today’s report will also increase talk that new rounds of government stimulus may be in order.

Not sure another stimulus is a prudent move at least at this time. I also want to quote from both reports on the recent cooling episode.

Peak growth may have already come and gone, a worry of the global markets and indicated by the ISM’s June report on non-manufacturing.
…
The acceleration in manufacturing cooled but only slightly in June, according to the Institute for Supply Management’s composite index which slowed to 56.2 from May’s very strong 59.7.

Details, Details, Details.
The one number that was a relief for trending lower was price, which was noted in both reports. Prices for both the manufacturing and services industries are still increasing but at a slower pace with the drop significant in both reports. Manufacturing had the biggest drop from May’s 77.5 to June’s 57 and non-manufacturing dropped 60.6 to 53.8 respectively and from April’s high of 64.7.   The manufacturing price index was a sudden drop off and was reported that it was mostly due to stable fuel and energy prices while non-manufacturing is seeing a more stable trend line over the past 3 months with more firms experiencing lower prices and lesser firms experiencing higher prices. At least in this indicator, a slowing of growth is a welcome sign especially considering the high index numbers the reports have shown this year.

Probably the one most disappointing number in both reports was the employment index for non-manufacturing that reversed trends for growth and began “contracting” to 49.7 from 50.4 with the index treading water right around the 50 mark for most of the year. But we also should note that the percentage of respondents with higher employment is greater than the respondents with lower employment and the report notes that 8 industries reported increased employment while 7 reported decreased employment.

Employment in manufacturing maintained its very positive index at 57.8 which was 2 percentage lower than what was reported for May. Mish’s Global Economic Trend Analysis considers the reports pessimistic at best and that the non-manufacturing report is more important considering the economy is more concentrated in services sectors. But growth in employment does not necessarily have to come from the prominent sector. The US and most high income countries are in a post-industrial age so it is right we are not going back to the manufacturing society as our parents and grandparents experienced but manufacturing could lead the way to greater investments and thus economic growth.

The New York Times has a piece that could put a wrench in reducing unemployment in the manufacturing sector Factories Ready to Hire, but Skilled Workers Scarce. Even with so many manufacturing workers out of work there is still a “mismatch between the kind of skilled workers needed and the ranks of the unemployed.” From other reports young people are also unwilling to make manufacturing their career choices and has left the US with an aging but skilled work force without much of a younger class of workers. I can understand their desire to avoid uncertain long term job prospects. Who would want to learn CNC machines if that is suddenly outsourced or becomes obsolete as these skills are not very transferable.

The difficult choices we have as a nation is how to transfer our skill sets and endowments to a future “undiscovered country”. What actions now will result in an optimal solution for now and the millions of unemployed and the future workers? One way is to “prime the pump” with simple Keynesian stimulus and another is to look for structural rigidities in the economy that prevent transitions from one set of economic factors to another. One such tool for transition is immigration. I believe that the industrial revolution would have been more difficult in the US without immigrants. Immigration has also allowed our economy to structurally change through the decades and thus to greater economic growth.

With that in mind, it becomes obvious that plans such as those pointed out by the Wall Street Journal at Global Recession Led to Stricter Immigration Rules is not sound economic thought. Even if other countries decide that limiting freedom of labor to move around, does not indicate that we should follow the same path. Just as long term capital is more productive if allowed to find the most productive places, free flow of human capital will increase productivity. Just as the New York Times article talked about the mismatch, some of that skills and human capital could be imported. Reducing backlogs in employments in certain areas which will increase investment spending and thus create exogenous increases in absorption into the economy. The exact result that is desired from another stimulus package. The authors of the report from the Federal Reserve Bank of Dallas note this in the following statement.

“These could impede countries’ ability to recruit workers in sectors vital to their recovery and long-run economic growth,” the authors say.

What portents do the reports hold?
New orders for both manufacturing and non-manufacturing slowed but were both in growth territory at a strong 58.5 and 54.4 respectively. Manufacturing is just a reversal of the lofty last two months both at 65.7 but non-manufacturing is showing a slowing trend since March from a high of 62.3.

New export orders for the manufacturing sector remained strong at 56 even with a drop of 6 points from last month. Imports remained the same level at 56.5 for manufacturing while non-manufacturing imports dropped to 48. This contraction {under 50} in non-manufacturing imports has also shown up on the new export orders at the same 48. This is one area that manufacturing is more important than non-manufacturing as goods and commodities are still the biggest segment of international trade.

On a side note, I have maintained that construction is not likely to be the impetus to economic recovery {aside from possible Federal stimulus in roads, etc} and so this report on U.S. Office Vacancy Rate at 17 year high indicates that office construction is not likely to change in the near future. Industrial and retail spaces are also on the rise. HT to Paul Krugman at More On Low Business Investment for graph below.

Where is the 3rd depression as the title indicated?
Paul Krugman is actually predicting The Third Depression. As we see from the ISM reports nothing seems to indicate that going forward and we should continue modest growth for the foreseeable future. He is right that unemployment is at too high of levels and if that is the basis for describing the current situation as a depression then it might also be worth considering. He is also right that inflation is not something that should be overblown and that we still face possibilities of deflation as the Capital Spectator noted at DEFLATION RISK IS STILL RISING.

But unlikely that the austerity measures enacted will eliminate all deficits. The IMF and most austerity programs just try to lower the level of debt as a percentage of GDP over time. Thus, this still leaves room for fiscal stimulus, but not on such a grand scale. The question to consider is whether there is marginally reducing benefits from fiscal stimulus. The case example is Japan and not sure anyone can say that more stimulus would have achieved faster growth rates in the 90s and the 00s. Even Krugman at the time questioned Japan’s fiscal policies and noted the following at TIME ON THE CROSS: CAN FISCAL STIMULUS SAVE JAPAN?

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Many have stated that “deficits” do not matter and that is correct in a Keynesian world as the deficits are compensated by surpluses in expanding years. And as we know that is rarely invoked as the drive toward 0 unemployment is unabated in politics. At some time though debt overhang is a concern and needs to be addressed. Also with larger and larger resources in the hands of the Federal Government then it stands to reason that less is available for individuals and businesses to invest and grow the economy. Does too large of central government prevent transitions to the undiscovered country? And does this also create structural rigidity which prevents flexibility of an economy that allows this transition in time?

At the beginning of the year, I predicted unemployment would not go significantly below 9% and just recently the IMF seems to be saying a similar tune as noted at Market Watch, IMF says U.S. on mend but job rate to stay high.

The U.S. economic recovery is becoming increasingly well-established but the unemployment rate will stay above 9% through 2011, according to a report from the International Monetary Fund released Thursday. The U.S. economy and financial system have made great strides in recovering from the Great Recession, but more work needs to be done, the IMF said. “The outlook has improved in tandem with the recovery, but remaining household and financial balance sheet weaknesses –along with elevated unemployment — are likely to continue to restrain private spending,” the IMF said. Important parts of the banking system remain vulnerable to shocks, even though the financial reform legislation would make major steps to close gaps in the regulatory system, the agency said. The European debt crisis has tipped risks to the downside because of potential financial market disturbance, the IMF said.

That is one number I hope we are wrong about in the positive direction and that the unemployment rate will go down sooner. I close with one more link worth reading about what the IMF has recently said and what they suggested for the USA at U.S. economy recovering well but risks remain.

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…

It is easy to see that all the countries shown in the graph will surpass the 60% debt to GDP ratio and are fast approaching the 100% mark if they have not already surpassed it. The 60% debt ratio was a mandate for all economic and monetary union (EMU) countries and clearly no one is abiding by that rule. Whether debt levels of 60 or 100 is too much is an empirical question that I am not aware of the answer and of course based on the structure of each economy the level of debt that is sustainable might be different for each country. For example, a country with a reserve currency that is used widely to facilitate trade would theoretically have a higher potential debt ceiling limit (Hint: US).

According to Mail Online, Britain might also be vulnerable to the fiscal problems the PIIGS are experiencing at the article Britain’s public finances declared ‘vulnerable’ thanks to bulging budget deficit. But unlike the PIIGS, UK has a flexible currency and can adjust its monetary base nearly at will. Dean Baker provides a blog post noting the differences between inside the Eurozone and outside using Hungary as the example at Hungary, Which Was Saved by Not Being in the Euro, Lectures Greece on the Virtues of the Euro, and the NYT Doesn’t Notice. The ironic point is that Dean Baker did not mention George Soros from the NYT article as also being not very cognizant of the differences as Soros is a foreign currency trader {er, manipulator} he should definitely be more knowledgeable.

Graphic of sovereign risk ranking for selected countries of Europe from Mail Online.

Convergence, coordination and structural rigidity problems in the Eurozone.
Paul Krugman again provides us with some interesting insights into the problems with the PIIGS. He makes similar points as Dean Baker but uses Spain as the example. His theme was that Europe was not ready for a monetary union and was rushed into it by “policy elites” at his NYTs article The Making of a Euromess. From reading the history of the EMU, I am not sure how anyone can conclude that it was rushed in any way. Krugman supports this contention because of the problems in Spain, but he fails to show how any more time could have helped. In fact, the longer the time that the individual nation states were integrating then the more likely some unexpected event will prevent integration as happened to Britain as a result of Soros and others that broke the Bank of England.

Dismantling the euro or opting out of the Eurozone and would not necessarily cause “the mother of all financial crises” according to Barry Eichengreen. The process could and would probably unwind as easily as it was created and maybe a lot less painful. But dismantling is a small possibility as most countries are enjoying the benefits of the Eurozone and many are willing to pay the the high price to join. The question forward is how to make it more beneficial to all participants-over the long term. This is where Krugman provides some useful guidance by contrasting the structural components of the USA as having a stronger central government (i.e. federal government) and the Eurozone with the nations set up as states but lacking the organization that can readily redistribute capital.

Krugman also shows the structural rigidity of the economy that is preventing the “free movement of people, goods, services, and capital” which is a tenet of the EU laws. A central government could in fact push through measures to make sure free movements occur and root out structural rigidities. In addition to this important function, it would also avoid the isolation paradox that each country is not willing to be the first to declare financial support. For example, Der Spiegel leaked a story about the German finance minister willingness to provide 20% of the bailout money. That amount of money is based on Germany being the largest economy in the EU and it provides around 20% of the European Central Banks (ECB) capital. But most recently, the EU, and Germany deny Greek bailout plans. I truly doubt that they have no plans. Only bad managers do not get contingency plans in place before crunch time.

Convergence of economies that are closely tied together economically can be another indicator of structural rigidity, that is, higher convergence (lack of divergence) indicates low levels of structural rigidity. Convergence does not mean a “race to the bottom” but by a process by which low income areas catch up to the higher income areas through higher growth rates. According to economists Sylvester Eijffinger and Edin Mujagic at The Euro’s Final Countdown?, the Eurozone is actually experiencing increasing divergence of the economies based the factors of “unit labor costs, productivity, and fiscal deficits and government debt” which in turn leads to a “convergence” of incomes if the factors are converging. Greek finance minister George Papaconstantinou summarized the situation by stating the following, “For a common currency area to work you need a convergence of economic policy …or else you need compensation flows between member states”. This again leads back to the need for a centralized government much as our Federal Government facilitates.

Andrew Willis suggests the answer may entail greater economic coordination among EU member states at Greek drama heightens debate on economic co-ordination. But coordination can only get so far in solving the structural problems. It may actually cause the problems to get worst especially concerning the debt problems. What the Eurozone has become is one big prisoner’s dilemma. Everyone has a reason to “cheat” but not much incentive to make sure the other nations are following the rules, thus it has been manifested in Greece and it’s falsifying and misleading its debt and deficit levels. This again points to the need for a federal bureaucracy under a representative government to insure the rules are followed and that shared resources are not unduly squandered.

For a breakdown of the concept of “coordination”, I turn to Keith Pilbeam, International Finance, second edition. Pilbeam provides a “hiearchy of coordination” which he lists as: 1. exchange of information, 2. acceptance of mutually consistent policies, and 3. joint action. If the present system of coordination collapsed already due to fraudulent data about Greece’s debt and deficit levels then how can the other steps be achieved? If the coordination breaks down even on the first phase, then how can it get to truly socially beneficial outcomes? For the most part, the policies have appeared to be mutually consistent as no nation has decided to severely cut back real spending but that is mostly due to ideological underpinnings of Keynesian economics. The joint action does not seem to be taking place and appears more ad hoc than a concerted effort to solve their mutually identifiable policy goals and in this case full employment is one.

Looking at a Spurious Correlation between self employment levels and Fiscal soundness?
What initially got me interested in the most recent turn of events and the macroeconomic issues that went along with it came from reading a short informational report from the Center for Economic and Policy Research at An International Comparison of Small Business Employment. The graph below instantly had me thinking about the correlation between self employment rates and fiscal/financial soundness for an economy.

Of course correlation does not indicate causality, but there may be structural factors that lead to bad outcomes with excessive amounts of self-employed individuals. One aspect that might be playing out here is that the tax base might be too narrow. One of the first things that the IMF pushes for when dealing with developing countries is to try to broaden the tax base. High tax revenues that are sector specific {e.g. agriculture} can be very distorting to the market and provide suboptimal social outcomes. Self-employment incomes may be distortionary as income may be hidden or transferred and thus avoiding the full burden of the tax bite. That question along with selection bias for respondents would take more specific knowledge about each country’s laws and regulations.

Investment Implications and Possibilities.
Seeking Alpha provides three suggestions for Hedging PIIGS Risk with ETFs. The first is to directly purchase a CDS of the PIIGS. The spreads are now greater than the BRICS, which is simply amazing and maybe a signal that the market is expecting more shoes to drop. The second method is based on the assumption that the contagion effect from the PIIGS will bring down the euro and cause even slower growth in the Eurozone. The trend line for the past 3 months is showing continued strengthening of the US dollar and after February 10th has shown continuation of that trend. The third suggestion is to short ETFs for the specific PIIG countries. One place to find specific ETFs by country is to start with the “HeatMaps” at XTF and drill down on the menus to find more specific details.

Bill Ralls, CFA, Senior Vice President at Fidelity, labels the current crisis as a Greek Debt Drama, Act I. Ralls thinks the drama could result in even more weakening of the euro and no matter what happens the road to recovery will be like a Greek marathon, “stamina and grit will be required as the global economy heads down the long, bumpy path of recovery.” This seems to imply that the Eurozone will continue to be a sick puppy. Whether this leads to more hot money flows into the US and increased fear of emerging markets in general is anyone’s guess. The one aspect that I take exception with Ralls is he correlates Greece as similar to a US state and in this case Massachusetts. Krugman and others have provided information as how the individual states are still not like Eurozone member states. Thus the contagion effect and the lack of effective mechanisms to deal with the problems is increasing uncertainty in the markets. For example, when the rumors about Germany’s willingness to bail out Greece the headline from the AP read as Optimism in Greece inspires market.

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One of the factors that could in fact determine this outcome between a W or V recovery has to do with some moral questions. In the New York Times article No Help in Sight, More Homeowners Walk Away David Steitfeld quotes homeonwner Benjamin Koellmann:

Most of all, though, he struggles with the ethical question.

“I took a loan on an asset that I didn’t see was overvalued,” he said. “As much as I would like my bank to pay for that mistake, why should it?”

Another post at the Calculated Risk blog (Tanta on Let’s Talk about Walking Away) criticizes some of the reporting on the “walk away” home owners and provides some good insights into these concepts of home foreclosures. Part of this moral dilemma arises from the fact that mortgages in the USA are non-recourse loans, unlike a car loan. If you turn in your keys and walk away from a car loan the bank can sell the vehicle and still collect, or try to collect, from you the balance still owed, including interest. In a housing loan the bank can-not go after the buyer for any difference between what is owed and the proceeds of the sale. Morgan Housel at Motley Fool asks the question “Could This Prevent Another Housing Blowup?” His thesis is that if the US (like most countries) reverted to “full-recourse” housing loans, then it is less likely that will form. He compares changes in housing prices in the US and Australia to illustrate the point. In this scenario, we would also not face the moral questions that we as a nation are discussing now.

Matt Koppenheffer, also at Motley Fool, provides a counter-intuitive argument that underwater homeowners should in fact make strategic defaults on their mortgages, and he introduces the subject by asking tactfully “Why Are Homeowners Idiots?”

Why don’t they walk away?
An interesting quirk of economics is that the dismal science generally assumes that all agents in an economy work in their own best interest. But this doesn’t always happen in real life.

The mortgage crisis is a case in point. For many of the underwater homeowners in today’s market, paying down their mortgage isn’t really in their best financial interest. Particularly in states like Arizona — where mortgages are nonrecourse, meaning the lender can’t go after any of the homeowner’s assets other than the property itself — it makes little sense to continue paying a large mortgage on a devalued house when comparable rental rates are far below the monthly mortgage payment.

The answer to the headline question is that housing is more than just an investment and thus consumers are not “profit maximizers” and do not act always in “their best financial interest” but according to the dismal science are “utility maximizers”. Thus staying in a home maybe better for the family than moving away from the familiarity of the neighborhood as well as the amenities of home ownership. This is where morality comes in that individuals also have a desire to be “good citizens” and to abide by the customs and practices of the community he/she chooses to live in. When those standards change then a vicious cycle can form as this passage from Mish’s Global Economic Trend Analysis post entitled Will “Walk Aways”; Increase Discretionary Spending? shows.

After reading your work, I began to examine the attitudes of my neighborhood. The first foreclosure was one of those borderline families you often write about. They were in over their heads and couldn’t afford the house they were living in. Most likely mortgage reset. In any event, the scuttlebutt around the neighborhood was one of scorn, shame, and embarrassment. No thought was given to the negative impact to the value of all our homes in this subdivision. With each subsequent “pre-foreclosure,” people’s attitudes softened about their ex-neighbors. Gone was the Scarlet F; it was replaced with empathy, understanding, and even compassion. Maybe the attitudes have changed because people now realize that the value of their homes have fallen off a cliff. They don’t have time to shame their ex-neighbors when they are worrying about their wealth is being vaporized or a $400 natural gas bill or car payment or the kids or whatever.

Now, I understand that this is one neighborhood in one small town in the Midwest. I also know this is anecdotal evidence. But as I have learned covering retail stocks for so many years: I trust my eyes and common sense and ignore people with a vested interest in the outcome of a situation. My eyes and common sense tell me that times are changing. It has become more socially acceptable to walk away from your house. If one of my neighbors walked away today, most of the remaining neighbors would shrug their shoulders, say that’s too bad and move on. I will be looking for the next phase of this shift in attitude, when remaining homeowners think or say I wish that was me moving—getting out from this 3,000 square foot rock that has ruined me financially.

Matt Koppenheffer provides more reasons for why underwater homeowners should in fact walk away from their debts in another tactful article entitled “Why We Care About Idiot Homeowners?” After presenting a good analysis of formation of a vicious cycle in housing under the banner of “Adding fuel to the flames”, he presents the counter arguments starting with the point we will just be delaying the inevitable. But, that in fact, maybe what the market needs now-a “bank holiday” or a cooling off period. Markets can overshoot the equilibrium price which some define as “animal spirits”. Momentum players try to ride the wave as long as possible and even George Soros used something similar when overshooting the equilibrium exchange rate prices to make money. But the problem is that overshooting can be just as harmful for efficient allocation of resources in an economy as undershooting the equilibrium price. And of course, high social costs may develop, as was the case of collapse of the British Pound.

While some homeowners do in fact need to move, surely not all underwater homeowners need to move now. The situation that precipitated the need to move could just as easily change again for the family. Preemptively defaulting can only lead to overshooting equilibrium price and creating a vicious cycle of declining home prices.

If mortgages were not nonrecourse, then the investment decision would not be based at all on the equity of the asset but in fact would ignore sunk costs and only focus on which direction the asset is likely to follow or in other words whether it will gain in value or decrease. So I am not sure the distinction has merit when considering this as strictly as an asset under reasonable moral guidelines.

Matt does provide some guidance as to what may be the equilibrium prices of housing stock by noting average home sales as a multiple of average annual rental rates based on the historical average of 14.6. While it is true that the multiple is higher still, I think this piece of information is while interesting it does account for sufficiently for changes in how home ownership is valued. That is, the benefits from home ownership may be higher now than historically and also interest rates are bound to affect this ratio especially with the very low rates now. A better gauge, for determining if housing prices are out of normal range, is provided by Morgan Housel at This Is Killing Housing Prices. Morgan created his own index based on a price-to-income ratio. From 1987 to 2000 the index was close to the index date of 1987 at 1. But since 2000 when it was back to the starting index of 1, it rose to a high of 1.64 in 2007 and now has dropped to 1.04 in 2009. I suspect even here there is some room to fall further but a lot less than the approximately 19% suggested by Matt’s numbers.
What does this all mean?
As Calculated Risk noted, we do not have enough data to get a good enough model for understanding what is going on in the housing market, but, whatever happens, if what is acceptable changes then all bets are off on how low the housing market may go. Matt states that “homeowners living in houses that are vastly underwater is a problem for the housing market”. This is not correct as these are issues dealing strictly with private consumption. The social costs come into play if all the underwater home owners (as well as the banks holding properties off the market) decide to sell in the short term and that is when we can see the animal spirits come alive.

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The Institute for Supply Management said Monday that its closely watched PMI rose to 58.4 from 54.9 in December, hitting its highest point since the 58.5 touched in August 2004.

What’ more, the latest report was full of encouraging news for the sector; the all-important new orders index rose to 65.9 from 64.8 the month before, employment rose to 53.3 from 50.2; and production jumped to 66.2 from 59.7. Backlogs also jumped by a substantial six percentage points, to 56.

“This month’s report provides significant assurance that the manufacturing sector is in recovery,” said. Norbert Ore, chair of the ISM’s Manufacturing Business Survey Committee. “Both the new orders and production indexes are above 60%, indicating strong current and future performance for manufacturing. This month, 13 of 18 industries reported growth, up from nine industries last month, and this is a good indication that the impact of the recovery is expanding.”

Most definitely, very positive news and better than I had expected. Some points worth noting are:
* It is worth pointing out that in addition to the employment index increasing significantly to the positive side it also reversed having more more respondents stating that they are losing jobs.
* In last month’s report I noted that 17% were gaining employment and 18% were losing employment and January’s report was 15% higher and 12% lower and the breakdown by industries were 7 up and 6 down.
* Last month in my blog post, I noted that import index was expanding at a faster rate than exports, but that trend has reversed and the export index rose to 58.5 which was a rise of 4 points and imports index rose by a lesser amount of 1.5 point to 56.5 points.

FoxBusiness states the rise in the inflation index as “one sobering sign” and that seems to be an understatement. Not only did the price index rise almost 14% (61.5 to 70), it was over the last months increase of around 8.5% which was of concern to me at the time. The ISM report also noted that only 4% of respondents stated price declines and 44% said prices increased. That is clearly a dramatic shift in respondents price changes especially since just in November the ratio of respondents that faced decreasing prices was one for every 2 facing increases and now the ratio is 1 to 11. The ISM report also quoted a respondent stating, “Commodity prices are moving up again.” (Printing & Related Support Activities). It looks like the Fed may have to consider these data points also and an obvious reason for some dissension in the ranks of the FOMC members.

MarketWatch had a forecast of 56 and the Econoday Report stated the consensus was 55 and the range was 54 to 57. Econoday also notes an important point about producer prices and whether “feed through” of inflation can and will happen.

However, indications on the output side, not available in this report, are pointing to no pricing power yet for finished goods. Today’s report is very strong and points to a V-recovery for the manufacturing sector, a sector all through the second half of last year that was at the center of economic recovery.

Non-manufacturing Report.
Both MarketWatch and Econoday noted that the consensus for the Non-Manufacturing ISM Report On Business® at 51 and the range that Econoday provided was 49 to 52 with the report filing it at 50.5 percentage points. Naturally I was surprised to learn that Services index returns to growth ISM’s nonmanufacturing gauge rises to 50.5% as my last blog post stated the nonmaufacturing was 50.1 of the last report and also signifying an expansion. It seems that revisions are not publicized as well as should be and even the Econoday link above notes the 50.1 of the prior report.

But even with that change, it still is not much to shout about.
* New orders were up signaling future growth possibilities.
* Employment is still anemic at well below 50 at 44.6 percentage points.
* Although the index is positive there are only 4 industries in growth and 11 in contraction which makes for uneven growth and not as broad based as desired.
* While not as high of index points as the price index for manufacturing, the price index for non-manufacturing is still high at 61.2 which was a rise of 1.6 from the previous report.
* Respondents were also quoted as saying that this was an issue going forward as in these responses:

“Commodity prices are starting to rise. We will be trying to mitigate inflationary price trends through longer contracts and value engineering.” (Accommodation & Food Services)

“The recent unexpected rise in fuel prices, with no apparent justification, is cause for concern.” (Public Administration)

What does this all mean?
Inflation while still not resulting in rising costs for consumers is being felt on main street. At least some inflation is better than deflation over the long term as witnessed by the lost decades of the Japanese economy. Manufacturing is looking good but non-manufacturing is still anemic even with massive government stimulus as well as the Fed providing more liquidity to the credit markets than nearly any time in history. I still have some doubts about the housing markets and hope to cover those issues in the next blog post.

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And most certainly there were inflation nutters as well as stagflation hawks (vultures more like it) who were predicting rising inflation levels.  But for the most part these were based just on headline inflation (food and fuels rising faster than normal).  When pressed for details, the nutters came around to talking about M3 monetary aggregate. Let me illustrate with a few paragraphs from Nutting’s article:

In a glorious bit of timing, the Federal Reserve is expected to cut interest rates on Tuesday for a third straight meeting, just days before government data are released showing some of the highest inflation rates in decades.

That’s all you need to know about the Fed’s balance of risks: Policymakers are much more worried about the illiquid credit markets and the possible hit that the credit squeeze could have on the economy than they are about the risks of inflation breaking out.

“Don’t look now, but while we’re in the midst of an easing cycle, the U.S. is facing a 4% inflation rate,” wrote Avery Shenfeld, an economist for CIBC World Markets. “But for now, none of this matters, as both bonds and the Fed are focused on the credit crunch and its growth threat.”

The economic data have been weak, but not disastrous, since October’s meeting, when the Fed signaled that it thought it was done cutting rates. It’s not the immediate economic situation that’s brought the Fed back into the game of cutting rates, it’s the horrendous condition in the credit markets, which are arguably worse off now than they were in August.

“The Fed is expected to reduce rates in response to evidence of very sluggish fourth quarter growth, and further stresses in the credit markets,” wrote Brian Bethune and Nigel Gault, U.S. economist for Global Insight.

In hindsight, we have seen that the inflation fears were unjustified.  In fact, the overall health of the economy has been sluggish due in part to credit markets ceasing up. During that time, I kept trying to get a grasp on how inflation was going to start the vicious cycle and what was going to unmoor low inflationary expectations. That was a quandary I could not resolve, so I concluded that inflation was going to be low and somewhat stable for the core CPI. That does not mean that inflation could rear its ugly head as the Fed has been flooding the economy with trillions of dollars resulting in excess reserves in balance sheets of banks.  That’s one reason I take seriously the general price level rises in the ISM reports, paying special attention to how many sectors/industries are experiencing rising price for inputs (including labor costs).

Joseph Lazzaro reached similar conclusions in his article entitled Ignore the circling inflation hawks (April 5, 2009).  He concluded “The real danger to the U.S. economy for at least the next two years, and probably well into 2012, is deflation, not inflation.”

Humble Pie for All

But in all humbleness, the severity of the housing crisis and the general contagion effect on other credit markets was beyond what I considered possible. Without a complete breakdown of the housing markets and analysis of the buyers as well as the originators of the loans, I still considered that housing stock is more than a simple investment decision, but rather a utility producing product for the consuming household. Thus, once a family becomes a homeowner and puts that first coat of fresh paint on the walls, the house is more than just a place to sleep. Even if the mortgage is under water, what will make a family — one that can make the mortgage payments — suddenly decide that renting from someone else is in their best interests?  That was basically my question at the time.

Hawks of a Different Stripe

Another attention-grabbing headline from that time period is at MarketWatch entitled “Brazilian supermodel’s wake-up call to U.S. ‘Pay me in euros’ underlines ills of our ‘happy conspiracy’ of greed“.  Putting aside that the supermodel is simply looking out for own self interest,  as everyone is — which some label as greed –  let me quote two paragraphs relevant to the headline:

And it’ll ripple around the globe: The dollar’s already lost 34% of its value since 2001. Can it get worse? Yes says Giselle Bundchen, a $30 million-a-year Brazilian supermodel who is demanding Pantene, an American cosmetic company, pay her in euros not dollars.

Why? As Bloomberg News put it, the dollar can “only depreciate because Americans … are living beyond their means.” What irony, a model delivers an economic policy warning with more punch than all the currency threats from Iran, Venezuela and China. Gisele’s lucky. She’s bailing out of the “happy conspiracy.” You can’t.

She may just consider that getting paid in a currency should be less about politics and more about personal consumption. It makes more sense that she would desire to be paid in currencies that she plans on using for her consumption.

In my first post on this blog, Deconstucting the Fed’s ‘Optimism Among Uncertainty’, I noted that the US currency had increased in value by 16.4% over a year’s time. Seems that abandoning the dollar was not the smartest move for maximizing returns. Even Warren Buffet has lost money by shorting the dollar to the tune of around one billion.  Just to remind ourselves, here’s a graph of the US dollar over the past couple of years:

That’s all fine and good but what about going forward?

Sometimes I am asked how the labor market will trend in the next year or so, and most of the time, I defer the question as beyond my scope of study. But this time I will answer.   I think headline unemployment percentage will slowly creep down over the next year to 9% and continue on that trend for the next couple of years. That is still too high {IMHO} but it seems obvious that rates in the low 4 percentage range is a long time off even in the most rosy of forecasts.

Monetary policy has been “pedal to the metal” for at least a year and started in earnest about the time of the first article sited above in December 2007. That policy has had plenty of time to have its full effect, and the Obama stimulus will continue to distribute funds this year as well as just the automatic stabilizers in the fiscal budgetary process. Exports are increasing and the dollar is trending down to support these export markets, even if U.S. trade gap widens {in November}. Credit markets should open up as expectations rise and just the end of a normal business cycle should propel the US economy forward. There is still the possibility that fear rising the levels of uncertainty and overall risks could damper the recovery when politics gets in the way of good economic sense, but with an election cycle coming soon then maybe not too much damage will be done by then.

No more lost decades?

So this makes me optimistic that we will not have another lost decade, as Eric Fry states in Another Lost Decade?

Despite an abysmal 10-years of zero wealth creation and zero job growth, betting on a second consecutive Lost Decade seems like a bad wager. And yet, it happened in Japan…

Let me close with a graph of job growth, by decade, published in the Washington Post, that says it all about our “Lost Decade”:

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That being said what news has driven the markets?
David Brown in the latest ‘What the Market Wants’ entitled Market Opens New Year with a Bang stated the following:

The news fueling the market, while not sensational, has been steadily positive. My favorite was the ISM last week, a full point above consensus at 55.9 and 2.5 points above its previous reading. Consumer confidence, while just meeting expectations at 52.9 last week, was well above the previous reading of 49.5. Best of all, I suppose, was last week’s initial jobless claims of 432,000, which was the lowest level in some time and well below the expected 460,000 and the previous reading of 452,000. PMI was also positive while construction spending and retail sales were just okay. No real disappointments here.

Like noted above, the December 2009 Manufacturing ISM Report On Business® was positive and was continuing with its streak of increasing output in manufacturing for the 5th consecutive month and 8th consecutive for the overall economy. The positive thing to note on the first table of the ISM report is all the “faster” rates of change which is noted in 10 out of the 13 indicators. Which is positive except for two exceptions. The first is the price index rising to 61.5 up from 55 in November. I am not sure at what point do we need to worry about this translating into inflation but it should be noted that there is a lot more industries that are experiencing higher prices and the net for the index was 23 seeing higher prices. Still the Fed is saying that slow recovery still most likely scenario. But more importantly than the headline is the part from the article stating:

There was a sharp divide among officials about the forecast for inflation longer-term. The argument was so intense that the discussion about the price outlook continued long after the formal vote on policy, which usually signals the end of the closed-door gatherings.

They are obviously seeing some signs of inflation as the ISM report may suggest. The second rate of change that should be of interest is that while export index is still positive at 54.5 which indicated the rate of change is slowing, the imports index rate of change is rated as faster for jumping from 51.5 to 55. But since both are expanding then it may not be enough to worry about.

While the employment index went up to 52 up from 50.8 and the rate of change is faster, I still see that the gainers are battling with the losers. The industries that are gaining is 7 and the losers are 8. And the net percentage is -1. This signifies that the ones with employment increases are increasing at a faster rate than the industries in declining employment. Will this group still be able to keep up with expansion? In a way this is sort of expected as some industries expand and some contract but there is a lot in the middle ground that could be expanding employment also if we are to see job recovery this year. But I must say that the surprise was new orders jumped more than 5 points to 65.5 and ongoing production at 61.8 up from November’s 59.9.

But what about the Service Sectors of the Economy?
The Non-Manufacturing ISM Report was not so upbeat but still positive with an index of 50.1 which is below the forecast of 51 that MarketWatch Economic Calendar shows but within the general range that Econoday Reports on the ISM Non-Mfg Index January 6, 2010. They state the consensus range as 48.3 to 51.0 and the consensus as 50.4. This most definitely showed the contrast with the Econoday Report: ISM Mfg Index when the final number was above the consensus range of 52.0 to 55.5 at 55.9.

Continuing on the non-manufacturing data, the sample respondents were not too positive. Business activity {production} was up and a positive sign but employment while up is still well below the 50 mark at 44 which marks its 23rd contraction for the last 24 months. The price index also rose to 58.7 which as noted in the manufacturing index that the Fed and others might need to start being concerned about inflation. Export and import index switched sides on positive and negative 50 point range. Export index decreased to 46 from 54.5 and import index rose from 46 to 52.5.

How about some more positive thinking?
I am not sure if we need some more prayers this year but the Wall Street Journal maybe hinting at such. Under the front page article entitled “World’s Factories Rebound” they have a picture with the caption:

Miracle Workers: Japanese businessmen pray for good business at Tokyo’s Kanda shrine on Monday. Tokyo stocks rose on the year’s first trading day, with Japanese exporters helped by a stronger U.S. dollar.

On to more substantial material, Larry Kudlow points out at Kudlow’s Money Politic$: {that} The Yield Curve Is Signaling Bigger Growth. And if that does not make you an optimist Alan S. Blinder presents The Case for Optimism on the Economy. Remember he also provided some econometric data to support that 25% of all jobs could be outsourced.

Another article of positive news about the US equity markets is at “5 quiet signs of a rebound”. Looking toward corporate suites might not tell us great detail about how the economy is headed but it could provide clues as to where growth might occur.

Samuel Fromartz provides us with 5 bullet points that point to a potential rebound in the economy. The first is rising cash and it clearly is the most important for sustained economic growth in that resources need to be diverted towards productive enterprises. The question is whether there are enough projects out there that will increase profits when outlook for business does not look rosy. The second is mergers increasing in frequency but as economist this would be more like transfer payments and have little direct effect on the economic growth of a country. While in the long run mergers will reallocate resources to more productive sectors and businesses, it does not have an immediate effect on the economy. The third is considered both dividends and buybacks of company common stocks, which again is merely transfer payments from one individual to another and has little economic effect on the economy. The fourth is the upswing in IPO offerings, which is a positive sign looking forward. Not only does it signify as stated that investors are more willing to take on more risky investments but also that the companies offering the IPOs also see that investors would appreciate their business opportunities as well as the company seeing broader investment potentials in their businesses moving forward.

The fifth and last sign is insider buying. Naturally this is great time to point out that:

Sabrient uses data on insider buying and analyst upgrades to create an “insider sentiment index” of the top 100 companies where these trends are strongest.

An exchange-traded fund, the Claymore/Sabrient Insider ETF (NFO), tracks the index. Since the market low in March the ETF has risen 117%.

While this is great, the 100 stocks might not be a representative sample to signify the results of the direction of the whole economy. But Scott Martindale does state in the article that:

“Buyers are outrunning sellers at the moment and that’s definitely a net positive sentiment,”

Martindale also posted on the Sabrient Blog some more information about how Sabrient created the index as well the reasoning for building it at: Net Insider Trading loses direction.

What does this all mean?
Basically the manufacturing sector seems to be taking off but non-manufacturing still has some problems especially in the aspect of increasing employment which will continue to be a drag on the economy as noted in other blog posts. We should continue to look for green shoots of recovery but be cautious to the downside risks.

Disclaimer: The writer does have a small stake in the ETF NFO and does not have any plans on selling the shares.

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Over the past several months, the claims data have flashed two somewhat contradictory messages: Fewer people are losing their jobs than were six months ago, but once a job is lost, it’s very hard to find another one.

This most definitely indicates a need for a WH Jobs Summit.  Although not much usually happens at such summits it strikes me as a bad decision to exclude from invitation both the United States Chamber of Commerce and the National Federation of Independent Business where the event featured 133 guests. A couple of names should be familiar on the invite list including world famous economists like Joseph Stiglitz, Jeffrey Sachs and lastly but not least Paul Krugman. Well sure enough Dr. Krugman provided a glimpse of what he may have been thinking of when going to the summit at The Jobs Imperative.

Krugman’s opening remarks on the op-ed:

If you’re looking for a job right now, your prospects are terrible. There are six times as many Americans seeking work as there are job openings, and the average duration of unemployment — the time the average job-seeker has spent looking for work — is more than six months, the highest level since the 1930s.

Although I do not have a specific academic paper to refer to, I am sure he is right about financial crises are marked “not just by severe recessions but by anemic recoveries”. This obviously makes sense from purely a financial standpoint in that financial crises cause not just a normal business cycle but changes the way participants handle and evaluate risks. If financial institutions are not secure then evaluating returns on investment projects becomes harder as uncertainty rises. To quote a famous person: “I’m more concerned about the return of my money than with the return on my money” {Will Rogers}. When inflation adjusted rates of return drop to near zero then that sentiment is visible in the market also.

And the damage from sustained high unemployment will last much longer. The long-term unemployed can lose their skills, and even when the economy recovers they tend to have difficulty finding a job, because they’re regarded as poor risks by potential employers. Meanwhile, students who graduate into a poor labor market start their careers at a huge disadvantage — and pay a price in lower earnings for their whole working lives. Failure to act on unemployment isn’t just cruel, it’s short-sighted.

So it’s time for an emergency jobs program.

It is most certainly true about the microeconomics effects on individuals but I fail to see how an “emergency jobs program” can overcome these negative effects on individuals. The most obvious problem to this solution is that the people losing jobs are highly diverse and across a wide variety of skill sets. I have yet to see a jobs program be other than manual labor that the skill level is at the lowest common denominator and thus it will not improve worker’s present skill sets. Plus being hired into a make works program sounds like that also would carry with it a negative stigmatization in the job market.

Krugman is correct that general tax cuts are not the right remedy right now as this would probably lead to just higher deficits without much overall change in the economy as well as and most importantly employment. His suggestion for more funding of states and local governments seems to create a massive moral hazard. Fairness has also been raised on this issue since when is it fair for a citizen of one state that manages its budget to be taxed more and provided to states that can not manage their budgets. Examples given were taxing Texans to pay for the complete fiscal meltdown in California.

Krugman’s suggestion of giving incentives that increase employment is a very good idea as long as monitoring it turns out to be easy enough to do and costs to administer such a scheme is not overly burdensome. Thus it could in fact be a good ’stimulus’ as in being “timely {enacted shortly through Democractic control of both houses and White House}, targeted {jobs}, and temporary {incentives have sunset provisions}”. These seem to contrast sharply with Krugman’s statement, “That strategy might have worked if the stimulus had been big enough — but it wasn’t.” The problem is that the Stimulus Bill was Neither Timely Nor Targeted and thus lost its ability to fully perform a stimulus on the economy.

One suggestion that I have not seen Krugman offer is to lower the work force participation. What I mean by that is to provide alternative avenues of livelihood besides traditional work in the private sector. I can think of three which are: increasing military forces in uniform{like WWII}, increasing number of students in furthering education, or just provide incentives for stay at home moms and dads that are raising families. I dislike and reject the first one. The other two are acceptable in theory, but this again creates a greater burden on those productive in society and as taxes are raised to pay for any of Krugman’s or my suggestions then incentives to work become less over time.

Even education is not the absolute solution for workers losing skill sets and becoming less attractive to potential employers. As Alan S. Blinder, Professor of Economics and Public Affairs at Princeton University, academic paper shows that many present jobs are susceptible to offshoring in the paper entitled On the measurability of offshorability. He states the following:

Fear of offshoring may force its way back onto policy agendas soon. This column uses a survey of individual workers to measure the offshorability of particular jobs and says that about 25% of US jobs are offshorable. Surprisingly, routine tasks are not more offshorable but those held by more educated workers are.

Blinder also provides some suggestions for our education system in the long term. Theoretically nearly all jobs are offshorable/replaceable especially if you think in terms of science fiction as in the movie Sleep Dealer.

What does this all mean?
Since Krugman has shown some influence on politics including being invited to the jobs summit and his ideas gather traction because of his prestige then these seeds of thoughts may one day become reality. I just hope the better ones become reality and the bad ones are cast aside.

It is expected that high rates of unemployment will continue for some time and that is a cost to society in general and to individuals as Krugman rightly points out. While unemployment compensation is a counter-cyclical economic stabilizer, it is still a cost to society and as unemployment insurance rates continue to rise across the country this is going to cut into people’s paychecks and lessen the incentives to work. One bit of advice that hardly needs mentioning is workers need to constantly improve their job skills and adapt to the changing economic structures.

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‘He’s part of the problem’
A Senate panel this week will hold a hearing on Federal Reserve Chairman Ben Bernanke’s nomination to a second term in charge of the nation’s central bank. The appointment is subject to Senate confirmation. Senator Bernie Sanders said he will vote no. “The middle class of America is collapsing; we have seen incredible greed, recklessness and illegal behavior on Wall Street. This guy…missed the boat on the most significant economic crisis since the Great Depression,” Sanders said Monday on “Morning Meeting” on MSNBC. “We need a whole new direction in the Fed and in our economic policies. A direction that stands up for a change, not for the rich, not for the top 1 percent, not for the giant financial institutions, but for the working class and the middle class of this country. Nobody thinks that Ben Bernanke is that person.”

That is, other than the President and most of the Senate. One of sanders loudest complaints that does seem to hold some water was Bernanke’s handling of the TARP process but so many others were involved in that that it hardly can be blamed solely on the Fed Chairman. Some of his other complaints were the Fed did not “stop the casino-type activities of large financial companies”, demanding bailed-out banks lower interest rates on credit cards, unemployment nearly doubled, and 120 banks failed. While it is most definitely true that a lot of stuff has happened on Ben Bernanke’s time, it is hard to place all the blame on him.

ISM Reports
But let me put aside the problems on one person’s employment or unemployment status and discuss the market as noted with the release of the ISM numbers for manufacturing released on Dec. 1st and non-manufacturing on the 3rd. {Links: ISM – Media Release: November 2009 Manufacturing ISM Report On Business®, ISM – Media Release: November 2009 Non-Manufacturing ISM Report On Business®} The manufacturing sector was still positive and growing for the 4th consecutive month but was below consensus estimate of 55 at 53.6 and below last months number of 55.7 indicating a slowing growth trend. Non-manufacturing overall index was disappointing as the market reacted slightly negatively noted by the article Stocks pull back after ISM services index falls. It was below consensus expectations of 52 which would have been above the index level for last month of 50.6. Thus economists had expected a growing at a faster rate than the net result of 48.7 indicating a contraction of that segment.

New orders were maintaining its strong growth trend in manufacturing and in non-manufacturing sectors with the trend being growth for 5 and 3 months respectively with the current index at 60.3 and 55.1 respectively. This may be one reason for the continuing optimism for the consensus numbers we looked at earlier.

Since we are talking about forward indicators of the economy, I think it might be worth looking at the Architecture Billings Index (ABI) which provides a forward indicator to construction activity/spending of about 9 to 12 months. The index is like the ISM in that over 50 indicates expansion. The ABI was 46.1 up sharply from 43.1 in September and the good news was that the project inquiries index was 58.5 indicating strong interest for new projects but follow through may be the issue until we see more “green shoots” of recovery.

Hat tip to Calculated Risk for the graphic at AIA: Architecture Billings Index Shows Contraction.

I know that the job market for architects has been dismal as it is reflected here in the West having the lowest regional averages with the South being the highest but still well below 50, meaning contraction. As I stated in earlier posts, I just do not see the construction sector providing the engine for growth going forward for some time especially to absorb the high levels of unemployment. All this just shows that even further up the supply chain of economic recovery is slow at coming to the rescue. The ABI having a lag of 9-12 months and the inquiries even being longer lags means that recovery in the construction industry could be 18 months to two years off at the earliest.

While the forward looking indicators looked positive for the ISM indexes, employment has not yet gotten traction. Although the manufacturing index was positive with an indicator of 50.8 it is down from the 53.1 in October. It must be noted that even though there are 6 industries reporting growth and 6 reporting decreases in employment the percentage of firms reporting increases is 17% while decreases is 18%. This does not bode well for continuing growth in employment but it is even worse in the non-manufacturing sector with the index of 41.6 which is above last month but is the 19 month trend of reducing employment and the 22nd time out of 23 times in negative territory.

Pass through costs and export segments.

The comments sections of both reports also show much caution looking forward including this noteworthy comment: “No one trusts that the recovery is real. Seems everything and everyone is in a holding pattern.” (Public Administration) Even the manufacturing sectors did not respond positively to the reduced value of the dollar and were most concerned about increasing costs of imports. Prices paid for both sectors were in positive territory but non-manufacturing was clearly and significantly trending up with the latest being 57.8 while manufacturing price index dropped 10 points to 55. The last point is important to indicate inflation {and inflation expectations} remains subdued.

I have been suggesting in some of my blog posts that exports are a needed factor in our economic growth and important in unwinding the “global imbalances” so let us look at the numbers for imports and exports according to the ISM reports. Net export orders are positive and trending up with the index 56 in manufacturing and 54.5 in non-manufacturing. Imports in the manufacturing sector is positive but lower index than the exports and non-manufacturing is below the 50 mark with 46. Both import indexes seem to be holding steady.

Since this post has thrown a lot of numbers around, I reproduced the graph from the ISM below {click image for larger view}:

David Brown has also noted that the markets have been sitting up and noticing the exchange rate as he noted in WTMW starting on November 16th at: Market in Strange Dance with the Dollar and Anticipating Black Friday.

Over the past several weeks, the market has seemed inversely tied to the value of the dollar. The dollar goes down, the market goes up; the dollar goes up, the market goes down. Generally speaking, the dollar has gone down, and the market has gone up.

In fact, today as I write, we have reached a new high for the year for the S&P500, the Nasdaq, the Dow, and just about anything you want to name. And sure enough, the dollar is down once again today.

Frankly, this inverse relationship between the dollar and the market is not that surprising since a weak dollar means more exports and fewer imports for the U.S. and higher material prices. That also explains the strength of large-caps over small-caps, since as general rule large-cap stocks have much more revenues from exports than small-caps. Clearly, most major natural resource companies are also large caps. At the November 7th G-20 meeting, the leaders had pledged to continue to support the recovery until it is assured, and that has led to a weaker dollar.

Looking forward.
There are some positive signs going forward but without some indicators of employment improving then not likely that the equity markets can continue to be positive in its outlook. I still hope for a gradual decline in the value of the dollar accompanied by increases in exports/decreases in imports.

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Can Krugman Understand Economics?
Steven E. Landsburg, Professor of Economics at the University of Rochester, gave one of the best backhanded complements ever to Krugman at Krugman to the Rescue.

It’s always impressive to see one person excel in two widely disparate activities: a first-rate mathematician who’s also a world class mountaineer, or a titan of industry who conducts symphony orchestras on the side. But sometimes I think Paul Krugman is out to top them all, by excelling in two activities that are not just disparate but diametrically opposed: economics (for which he was awarded a well-deserved Nobel Prize) and obliviousness to the lessons of economics (for which he’s been awarded a column at the New York Times).

But I am more inclined to believe that Krugman just gets confused between good politics and good economics. As we explore the issues Krugman brings up, there may be good political reasons for doing certain things even if economics would state the opposite. It is up to him to explain the concepts in the different fields of study.

Landsburg looks specifically at the suggestions by Krugman and quotes the top three paragraphs of his Krugman’s Op-Ed. Landsburg notes the differences in total amount produced per worker because of differences in hours worked and thus asks Krugman if it should not be the US to be emulated. A couple of excerpts of his post:

And exactly which brilliant European policies does Krugman believe the U.S. should now consider with favor? Among others, labor rules that discourage firing and incentives for “short-time work schemes”, where everybody puts in fewer hours.

* A really really really good way to get employers to stop hiring people is to tell them they can’t fire people.
* Putting people to work is not really terribly useful unless you put them to work productively. If they’re not producing, you might as well pay them to stay home. But imposed “short-time work schemes” are designed to diminish productivity. (In those cases where they can enhance productivity, employers have already adopted them).

He also gives some tongue in cheek suggestions for making each worker less productive. Donald J. Boudreaux, chairman of the department of economics at George Mason University, also notes the discrepancies between intent and results of such suggestions. In the post entitled Perhaps Demand Curves Slope Upward to the Right – or, Alternative-Universe Economics, he makes the following statement which he sends to the NYT.

But no student in my class would ever write such nonsense. My students learn from day one to distinguish intentions from results. So my students understand that the intention of such labor rules might be to decrease unemployment, but that the result will be to increase it – because my students also understand that labor rules that discourage firing raise employers’ costs of hiring workers to begin with. Firms will think twice – thrice! – before hiring employees who, once on the job, are difficult to fire.

Basically they are saying the demand for labor shifts to the left and down which will result in less employment and even lower wages. That is true for future employees as their costs of hiring (through forced retainment) is raised, but it is not necessarily the case for those already working. They would benefit from the increased costs of dismissal and for those already hired it would help maintain the employment levels for the short term. Eventually any additional costs are born out by decreased hiring and eventual letting go of the non-performing workers.

Boudreaux is at it again with another letter to NYT at Achtung! He presents a summary of OECD average rates of unemployment in Germany and the USA and closes with his contention that the Germans have been more prudent in the latest financial crisis instead of the “irresponsibly orgied” stimulus spending of the USA. His longer post on these issues are at Unemployment-Smoothing, Krugman, and Quackery where he summarizes the data as:

While it’s true that Germany’s unemployment rate today of 7.7% is lower than America’s current rate of 10.2%, it’s very difficult to look at the above numbers on unemployment rates over recent years and conclude that European-style labor-market restrictions are good policies for people seeking gainful employment. The average rate of unemployment for Germany over the 1998-2007 period was 8.9% while that for the U.S. was 4.9%.

Boudreaux concludes that while unemployment is costly to society and thus smoothing UE over time is a good thing it is not necessarily a good thing if it smooths it at a much higher rate of unemployment.

Krugman’s Social Costs.
Let me quote at least a portion of Krugman’s Op-Ed piece here:

And long-term unemployment inflicts long-term damage. Workers who have been out of a job for too long often find it hard to get back into the labor market even when conditions improve. And there are hidden costs, too — not least for children, who suffer physically and emotionally when their parents spend months or years unemployed.

There is clearly a social cost to society for long-term unemployment but he has not shown that German work rules would increase employment now or in the future. He would be better off promoting more job training or direct transfer payments or even some work jobs program and not schemes to shift the social costs off onto the labor markets. The distortions he suggests would actually make long term employment worst and not better. Instead of his constant promotion for another and even bigger “stimulus” he could actually try to use his influence on trying to correct the last stimulus package and what monies has not been allocated and making government more efficient with the massive amounts of resources it has at its disposal now.

An Intriguing Question.
Boudreaux asks another intriguing question, Would Productivity Fall or Rise?, and suggesting the following idea:

Let’s start at the New York Times. I know several economists currently without jobs (and certainly without regular newspaper columns). I propose that Times Co. chairman Arthur Sulzberger reduce Mr. Krugman’s presence on the editorial page to, say, one column per year. The remaining hundred or so columns that Mr. Krugman would otherwise have written for the NYT can be written by unemployed economists.

I’ll be very happy to supply Mr. Sulzberger with names of economists who need the work.

Great suggestion! The problem is that the people that suggest that know that their unique status prevents such solutions from being forced on themselves. Krugman for lack of a better way to explain it is a “star” and when Boudreaux talks about productivity changes when 100 unknown or little known economists fill Krugman’s shoes they will not “produce” as much. In this case the other economists would not produce as many page views and readership would slip without his presence. Some radio talk show hosts also have suggested that, such as Thom Hartmann.

Why Can’t We Have Better Economists?
As one economist laments “Why Oh Why Can’t We Have a Better Press Corp?”, I wonder if Krugman will show us what a winner of the Nobel Memorial Prize in Economics can do to inform and instruct us in sound economic policies.

This is not to say the world would end as we know it if in fact some policies that Krugman proposes passes but it again becomes an obvious distortion in the labor markets that acts like a hidden tax on the economy. It is just sensible to have a basic understanding of economics that can help identify at least some obvious conflicts between intentions and results based on basic knowledge of economics.

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