What output gap?

James Bullard

In case you haven't seen it, you may be interested in this speech given recently by Jim Bullard, president of the St. Louis Fed: Inflation Targeting in the USA.

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along it's original growth path. This part is incorrect given the model I have in mind here.) The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:

But the near-zero rate policy has its own costs.  If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy.  But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.  

Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.

At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.

Update available here: The trend is your friend (until it ends)

Update: The "terrifying" James Bullard offers a reply to Tim Duy here.

Using Beveridge curve dynamics to identify cyclical and structural shocks

I recently gave a short presentation to the Board of Directors of the Louisville branch of the St. Louis Fed. Following my presentation (which stimulated a lively discussion), I had the opportunity to listen to each member report on local economic conditions from different parts of Kentucky. Two themes stood out. The first was how "an air of uncertainty" along a variety of dimensions had "frozen" investment plans (with the apparent exception of younger entrepreneurs, who probably do not know any better-jk). The second was the unfilled demand for highly skilled, specialized workers (primarily in manufacturing).

I want to focus on the second theme here. In some sense, it is really amazing that firms are struggling to find qualified workers in an era of 8% unemployment. The Financial Times recently ran a piece on the subject: Skills Gap Hobbles US Employers, and I have to say that Mr. Greenblatt below would have fit right in at my BOD meeting:

Drew Greenblatt has been looking for more than a year for three sheet-metal set-up operators to work day, night or weekend shifts. 

The president of Marlin Steel Wire Products, a company in Baltimore with 30 employees, Mr. Greenblatt says his inability to find qualified workers is hampering his business' growth. "If I could fill those positions, I could raise our annual revenues from $5m to $7m," he says.  

He is offering a salary of more than $80,000 with overtime, including health and pension benefits. Yet in spite of extensive advertising,  he has had no qualified applicants. He is trying to train some of his unskilled staff but says none has the ability or the drive to complete the training. 

This quote identifies two problems. The first is what economists call "skills mismatch" caused by a "structural" shock. The second, that some workers are unwilling and/or unable to upgrade their skills is another matter that deserves attention, but is something that I will leave aside here. 

  
Apart from anecdotal evidence, how does one go about measuring "skills mismatch caused by structural shock?" One idea, initially proposed by Abraham and Katz (JPE, 1986), is to use the comovement to in vacancy and unemployment rates to identify "cyclical" and "structural" shocks. 

I put those terms in quotes because there are no set definitions for them. I like to think of a cyclical shock as an event that makes it more or less profitable to find the same kind of worker for the same kind of job. And I like to think of a structural shock as an event that makes it more or less profitable to find a different kind of worker for a different kind of job. 

Anyway, the Abraham and Katz idea is that one would expect cyclical shocks to trace out a stable, negatively-sloped Beveridge curve. That is, one would expect the job-vacancy rate and the unemployment rate to move in opposite directions.  A structural shock, by contrast, is expected to move vacancy and unemployment rates in the same direction. The idea here is that it is now more difficult to find the right kind of worker, so that even greater levels of recruiting intensity is likely to be associated with higher unemployment rates. 

The FT article cited above uses this idea in the diagram to the right (together with the results of a Kaufman poll of entrepreneurs) to suggest that the high U.S. unemployment rate is primarily the consequence of "structural" factors. 

Here is what the U.S. Beveridge curve looks like from May 2005 - November 2011 (The vacancy rate is computed from the Conference Board's help-wanted-online data, which is available from 2005 only).

As the HWOL measure of job vacancies is available at the city level, Constanza Liborio and I thought it might be interesting to see how job availability varies across major U.S. metropolitan areas and how job vacancy rates correlate with regional unemployment rates before and after the beginning of the most recent recession.

Specifically, the exercise we perform is as follows. Consider a major U.S. metropolitan area. Compute the average job vacancy rate and unemployment rate for this metropolitan area over the prerecession period May 2005 – November 2007. Recalculate these averages since the beginning of the last recession, December 2007 – November 2011. Next, compute the change in the vacancy rate and unemployment rate across these periods. Perform this exercise for a set of the largest metropolitan areas in the U.S. 

The results are displayed in the following figure.

Not surprisingly, we see that the unemployment rate in all these metropolitan areas went up since the recession began.  However, the same is not true of job vacancy rates (that is, not all vacancy rates went down, as one might have expected). Specifically, while we observe the typical Beveridge curve dynamic in many jurisdictions (suggesting that cyclical factors are dominant), we also observe vacancy rates remaining relatively stable, or even rising, in several others (suggesting that structural factors are dominant). 

So the tentative conclusion here is that the relative importance of cyclical vs. structural factors appears to vary across regions. To the extent that monetary policy is an effective stabilization tool, it cannot be expected to impact all regions of the country equally. In many regions, localized fiscal policies (education and training subsidies, etc.) may prove to be a more direct and effective tool.
Related story:
More Workers Moving for Out-of-State Jobs

Alien Employers or: How I Learned to Stop Worrying and let the World Run a Current Account Surplus

Meet your new boss.

Back when the Greek crisis was just breaking, I remember having my morning coffee, still half asleep, TV turned on in the background, when I heard a news reporter ask an interesting question. I put my coffee down and turned to the TV. The Parthenon was in the background, communist banners were draped about, and small smokey fires burning here and there. And the reporter, standing excitedly in the middle of all this, rather earnestly asked what I thought was a very good question: Why should Germany even consider bailing out Greece? 

Then, with hardly a pause, he breathlessly began to explain why. His answer went something like this...

"Why?! Let me tell you why, people..." [turns head to the left] "As I look over here, I see and Audi and a BMW..." [turns head to the right] "...and as I look over there, I see a Mercedes and a Volkswagen!" [turns to camera--big light bulb flashing over his head] "Greece is an extremely important export market for Germany!"

Well, as the following diagram shows, this certainly does appear to be the case (source):

So as far as I can gather, what the fellow is trying to tell us is this. The Germans should forgive Greeks their debts because, well, how else will the Greeks continue to afford importing German-made cars? After all, it is the Greek consumer that is selflessly keeping the German autoworker employed. Moreover, it has been a fine recipe for keeping German unemployment low, and growing German wealth. Yes, that's right...wealth in the form of...well, you know...grade A assets, like Greek government bonds.

Now where on earth might a fellow get an idea so bizarre as this? Well, how about here: Germans and Aliens (Paul Krugman):

But the Germans believe that their own experience shows that austerity works: they went through some tough times a decade ago, but they tightened their belts, and all was well in the end. Not that it will do any good, but it's worth emphasizing that Germany's experience can only be generalized if we find some space aliens to trade with, fast. Why? Because the key to German economic affairs this past decade has been a truly massive shift from current account deficit to surplus. 

Now, other countries within Europe could emulate Germany's past if Germany herself were willing to let its current account surplus vanish. But it isn't, of course. So the German demand is that everyone run a current account surplus, just like they do -- something that would only be possible if we can find someone or something else to buy our exports. It remains remarkable to see with how little wisdom the world is governed.

Now, I'm not sure whether any German really has made an explicit demand for all countries to run current account surpluses. But if anyone did, it would clearly be silly. The current accounts of all countries must necessarily sum to zero; at least, in the absence intergalactic trade.

But then, that sort of gave me an idea. Why not a world current account surplus?  What is an account, anyway? It's just a book-entry object. Let's give the account owner a proper name. And what's in a name? May as well call the account holder "Space Alien," with a "local" delivery address, say, the Pacific Ocean.

Next step. Contract some agency to print up Space Alien bonds, rate them AAA, then use them to acquire goods from all over the world, including ocean vessels. That should lower world unemployment. Then load the vessels with the newly purchased cargo, sail them out to their delivery point (the mid Pacific, say), and sink them all. (This last step is absolutely necessary, as sending the goods to any country on earth will mean job-killing imports for that country, jeopardizing their current account surplus).  Alas, the Space Aliens will ultimately have to default on its debt but, you know, who really cares? Just means more work is needed to replenish our lost wealth.

Now, if you think this sounds a little loopy, let me direct you to this: Fake Alien Invasion Would End Economic Slump.

Of course, this is all just a variation of the old Keynesian prescription of employing people to dig up holes and fill them up again. And, contrary to what you may be thinking, the purpose of this post is not to argue against the ability of such a program to increase net employment. What I want to question instead is why running a current account surplus is necessary for all this hocus pocus to work? 

Here's an idea. Instead of exporting vehicles to Greece, why don't German car manufacturers ship their cars to domestic German residents instead? The domestic purchasers could pay for the cars by issuing fake paper, just like their foreign counterparts. And when the time comes to default, well, at least all the BMWs, Audis, Mercedes, and Volkswagens will be residing on German soil. 

The regional dispersion in U.S. vacancy and unemployment rates

Since I happen to have handy some regional data on the help-wanted index (HWI) for the U.S., I thought it might be interesting to see whether U.S. vacancy and unemployment dynamics in a cross-section display any interesting patterns. (I would like to thank Kyle Herkenhoff for suggesting this exercise to me).

The regional HWI data is from the Conference Board. I explain here how the data was corrected for the recent substitution from print to electronic media in job advertising activities. That data was constructed for 36 U.S. cities.  I construct a "vacancy rate" measure by dividing the HWI by the labor force and normalizing to 10  in 1990:1. Here is what the aggregate data looks like:

As one would expect, there is a strong negative correlation between vacancies and unemployment; this is the so-called Beveridge Curve.

Labor economists sometimes like to gauge labor market conditions by constructing a "labor market tightness" variable--the ratio of vacancies to unemployment, or the v/u ratio. The v/u ratio plays a prominent role equilibrium unemployment theory; see Diamond, Mortensen and Pissarides. As the following diagram shows, labor-market-tightness is highly procyclical.

Regional Patterns

The following diagram plots the unemployment rates for 36 metropolitan areas in the U.S. The solid black line is a population-weighted average (it corresponds to the national unemployment rate).

The figure shows that there is significant disparity in regional unemployment rates at all points in the business cycle. As the U.S. economy emerged from the recession in the early 1990s, regional variation in unemployment rates seems to have declined for the rest of that decade. Nothing much changed until the most recent recession, where we see a dramatic increase in both the average unemployment rate and its in its dispersion across regions.

Next, let's take a look at regional "vacancy rates" (the city-based HWI divided by regional labor force).

The dispersion in regional vacancy rates appears to be very, very large (measurement error?). Using my eyeball metric, it appears that the dispersion in vacancy rates is somewhat procyclical. In particular, look at how the dispersion appears to increase throughout the 1990s expansion--at the same time, the dispersion in unemployment rates is declining. This suggests that the dispersion in labor-market-tightness is procyclical; and indeed, the following diagram shows this to be the case.

It would be interesting to know what might be behind these regional differences in labor market tightness, and why this regional dispersion varies over the business cycle.

First, what accounts for the dispersion? In a basic Mortensen-Pissarides labor market search model, extended to incorporate regions, I think that the labor-market-tightness variable is likely to equate across regions (at least, allowing for factor mobility). Regional differences in tax rates, etc., might account for some of the disparity. But the measured disparity is huge.

Second, what accounts for the cyclical properties of the dispersion? Is it simply the case that some regions are populated by industries that are more cyclically sensitive to aggregate shocks? Or is it the case that the shocks themselves are concentrated in certain regions, with the effects propagating to other regions of the country?

If anyone would like to see this data plotted in a different way, or see some statistics reported, feel free to let me know. (Thanks to Constanza Liborio for preparing these graphs.)

The China Factor

The sovereign debt crisis in Europe has garnered most of our attention as of late. But should Europe really be our main concern? For several months now, many economists (including myself) have been casting a nervous eye over to China. Paul Krugman summarizes these concerns nicely in his NYT article today: Will China Break? Mark Gongloff earlier asked the million dollar question here: China's Shadow Banking System: The Next Subprime?  Hmm...

P.S. And what's with these stories I keep hearing about China's missing bosses? (e.g., China's Vanishing Factory Bosses). Sounds ominous, if true. We truly do live in interesting times. 

Beveridge Curves for 36 U.S. Cities (updated)

On October 9, 2010, I posted some regional vacancy-unemployment data for the United States; see: Beveridge Curves for 36 U.S. Cities.

My measure of vacancies was the Conference Board's help-wanted index (HWI).  A colleague of  mine (Silvio Contessi) pointed me to a paper by Regis Barnichon (EL 2010) that identifies a major flaw in this data series. Barnichon summarizes the problem here:

The traditional measure of vacancy posting is the Conference Board Help-Wanted Index (HWI) that measures the number of help-wanted advertisements in 51 major newspapers. However, since the mid-1990s, this “print” measure of vacancy posting has become increasingly unrepresentative as advertising over the internet has become more prevalent. Instead, economists increasingly rely on the Job Openings and Labor Turnover Survey (JOLTS) measure of job openings. However, this measure is only available since December 2000 and cannot be used to contrast current labor market situations with past experiences.

In this paper, I build a vacancy posting index that captures the behavior of total—“print” and “online”—help-wanted advertising, by combining the print HWI with the online Help-Wanted Index published by the Conference Board since 2005. 

Here is how Barnichon's correction looks for the aggregate data.

That is, the secular decline (blue line) in the original HWI series is estimated to be entirely the consequence of a substitution away from print to electronic forms of job advertising.

With this in mind, I asked my tireless research assistant (Constanza Liborio) to recalculate our regional Beveridge curves using Barnichon's correction (for those interested, I can email you a file describing the exact procedure employed).

The regional vacancy data was purchased from the Conference Board (their Help Wanted Online data series), so unfortunately, I cannot make it available to you without their permission. I have permission to display the data, however. Here is what we get.

Addendum: Dec. 13, 2011

As I have stressed in an earlier post, one should be careful in using these raw correlations to identify the source of disturbance; see: Interpreting the Beveridge Curve.

A reader points out that the Monster Employment Index (available since 2004) might be of some use for measuring regional employment opportunities. 

On Bagehot's Penalty Rate

What principles should govern the way a lender-of-last-resort (LLR) operates during a financial crisis? On this question, one is frequently referred to two key principles, attributed to Walter Bagehot in his book Lombard Street. The two principles are usually summarized as "lend freely and at a penalty rate." What does this mean?

In "normal times," firms regularly borrow cash on a short-term basis (say, to meet payroll). These loans are usually collateralized with a host of assets (e.g., accounts receivable, property, securities). The dictum "lend freely" in this context means to extend cash loans freely against the collateral that is normally put up to secure short-term lending arrangements.

The rationale commonly offered for the LLR is that during a crisis, "perfectly good" collateral assets are either no longer accepted as security for short term loans, or that if they are, they are heavily discounted (e.g., a creditor will only lend 75 cents for every dollar in collateral, instead of the usual 99 cents). Whatever the ultimate cause, this type of "liquidity crisis" creates havoc in the payments system. This havoc can be avoided, or at least mitigated, by a LLR that stands ready to replace the "missing" lending activity. (Or so the story goes.)

Let's say that the normal discount rate on high grade collateral is 0 < d < 1. So if a creditor offers to lend $99 for every $100 in collateral, d = 0.01 (one percent discount). Let's suppose that during a crisis, the discount rate rises to c > d. (If c = 0.5, then there is a 50% discount or "haircut" on collateral.) One issue that the LLR must address is the discount rate it should offer on an emergency loan. Let me call this discount rate p.

Now, if the LLR sets p = c, then what is the point of having an LLR? So clearly, if the LLR is to influence lending activity in any manner, it must  set p < c. Opponents of LLR activity like to label p < c a "bailout." (This term is rarely defined precisely; it appears to be a label to attach to programs that one does not like.)

At the other extreme, the LLR could set p = d. In this case, the LLR is discounting collateral in the same way that the market does during "normal" times. If the LLR instead set p > d, it is charging a "penalty rate." (Note: I do not think that Bagehot ever used this term.) How should the LLR set this penalty rate and why? Here is Bagehot:

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who did not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible. (emphasis, my own)

Well, O.K., so he does not appear to answer the question of what discount rate to apply; only that it should be "very high." But I am less interested here in the precise penalty rate as to the rationale for why a penalty rate is necessary. A colleague of mine (who appears to have done a great deal of reading in the area) suggests that the rationale was primarily to ensure that the Bank of England did not run out of reserves (an event that would have led to its failure, and the subsequent end of civilization in the minds of many at the time).

Of course, the Federal Reserve Bank of the United States does not face the prospect of running out of cash reserves, the way that the Bank of England did back then. This is because "cash" back then took the form of specie (gold and silver coin). "Cash" today takes the form of small denomination paper notes (and electronic digits in reserve accounts) that the Fed can issue "out of thin air." In light of our modern institutional structure, I wonder whether Bagehot, living in today's world, might not have dropped his "penalty rate" dictum?

Is there any good reason left for the penalty rate? Perhaps there is. But it is clearly of second-order importance during a financial crisis. First, lend freely. It is probably not the time to worry about this penalty rate or that penalty rate in the depths of a liquidity crisis. If an institution is deemed, after the fact, to have benefited "unfairly" at the expense of society during an emergency lending episode, then a "fee for service" (i.e., tax) could be applied after the crisis has passed.

P.S. Would be interested to hear from historians on this subject.

Postcript: January 30, 2012
I would like to thank Josh Hendrickson for sending me the link to this paper:

Turning Bagehot on his Head.
Abstract: Ever since Bagehot’s (1873) pioneering work, it is a widely accepted wisdom that in order to alleviate (ex ante) bank moral hazard, a lender of last resort should lend at penalty rates only. In a model in which banks are subject to shocks but can exert effort to affect the likelihood of these shocks, we show that the validity of this argument crucially relies on banks always remaining solvent. The reason is that when banks become insolvent, Bagehot’s prescription dictates to let them fail. Penalty rates charged when banks are illiquid (but solvent) then reduce banks’ incentives to avoid insolvency ex ante and thus increase bank moral hazard. We derive a condition which shows precisely when this effect on ex ante incentives outweighs the traditional one and show that it is fulfilled under plausible scenarios.