Labor Force Participation is Secular: Unemployment is Cyclical!

Updated data at the request of Andrew Sentence on participation and unemployment in the U.S.  

Business cycles are about unemployment; not about changes in the participation rate.

(c) Roger E. A. Farmer March 2015

See my twitter posts today on this topic. 

If people choose to look for a job; that's their business. If people can't find a job; that's our collective business as a society.

Participation is a voluntary choice.  Unemployment is not. 

The idea that unemployment is voluntary is classical nonsense.

Anybody want to explain to me why they think labor force participation is a cyclical phenomenon?

Participation is not cyclical! Unemployment is!  

The secular trend in participation dwarfs the cyclical movement. That's an important fact! 

Follow me on twitter @farmerrf 

Sam and Janet go to College

My reading list on the overlapping generations model has already generated some questions. Rather than respond in the comment section to each question individually, I will answer these questions in a new post. Here goes.

In a comment on my previous blog Brian Romanchuck has a “good grounding in mathematics” and he “understands the [overlapping generations] models.” He is my ideal reader. Brian raises a number of points that may be shared by others with a similar background. If you also have a good grounding in mathematics and you think you understand the models: this post is for you.

The Great Blog Debate about Debt: A Reading List

I applaud everyone who has weighed in on the Great Blog debate about debt (Simon,  Bob,  me, and others too numerous to link. All of the issues that have been raised on Nick's blog were the topic of frontier research in economics journals in the 1950s -- 1970s.  Nick has links to earlier posts here.

The paper that started all of this (at least in the English speaking world) was by Paul Samuelson. "An exact consumption-loan model of interest with or without the social contrivance of money", Journal of Political Economy 1958, Vol 66 No. 6. The French lay claim to an earlier version by Maurice Allais, but that's another story. 

Samuelson's paper was a revelation to economists because it provided an example where markets don't work. In Samuelson's example, there is an equilibrium, (people optimize taking prices as given and all markets clear) that can be improved upon by a government institution. Samuelson's paper is a good starting point for those who would like to read more about this.

Sam and Janet Learn about Debt

In a recent post on the (non)-importance of debt buildup worldwide, Antonio Fatas makes the point that debt is not necessarily a problem. While I agree with that statement: a great deal hinges on the qualification “not necessarily”.  

Paul Krugman goes further than Antonio. According to Paul debt is “money that we owe to ourselves”. That is at best misleading and at worst;  false. Money is money we owe to ourselves. Debt is money that some of us owe to others. 

Lessons from the Great Galactic Depression

A long time ago, in a galaxy far far away, there were two planets orbiting a star, not unlike our own sun.  The inhabitants of these planets share a common ancestry but, over the years, they have developed somewhat different temperaments. 

The names of these planets are difficult to pronounce in English, but we will call them Nordus and Sudus. The name of their star is Sol.

Nordus, being further away from Sol, has a colder climate than Sudus and its inhabitants are known to be frugal and patient. The Sudusians, in contrast, live for the moment. Using the language of economics, earth people would say that the Sudusians have a higher rate of time preference. 

Why the ECB Should Take More Risks

Mrs. Merkel and Mr. Schäuble are worried. The ECB is planning to buy the sovereign debt of its member states and Mr. Schäuble doesn't trust his southern European partners. He thinks that Portuguese, Spanish and Italian debt is risky and he knows that Greek debt is.

Bankers are supposed to be boring. And central bankers are supposed to be boring in spades. What would happen if the Fed were to bet the farm, buying shares in an internet start-up that subsequently goes bust? The public purse would be on the hook for the loss. At least, that’s the theory. That theory is wrong.

The central banking business plan is a money-spinner beyond a venture capitalist’s wildest dream. Buy an asset, any asset, and pay for it by issuing little pieces of colored paper. Collect the interest payments and dividends from the assets and use them to pay for your house, your car and a holiday in Spain. If you happen to be the central bank of a sovereign state, pay the interest and dividends to the treasury to help reduce the tax bill of your citizens.

Does it matter which assets you buy? Conventional wisdom says yes. A central bank should buy safe assets, typically promises issued by its own national government that will never fall in value. The Fed buys T-bills on the private market. The Treasury pays the interest and principal to the Fed, and the Fed turns around and pays them straight back to the Treasury. The point of all of this is to keep enough of the little pieces of colored paper passing from one person to another to “oil the wheels of trade”.

Financial crises as global sunspots

I have just written a new working paper, 'Global Sunspots and Asset Prices in a Monetary Model', that is available on the NBER website here. The paper is a continuation of research on financial markets that I began in 2002, (2002a, 2002b) and it provides intellectual ammunition to support a proposition that I put before the UK parliament in April of 2012. We must develop a new institution that is designed to counter financial market volatility. 

My paper explains three asset pricing puzzles that are difficult to reconcile with the now standard representative agent approach to macroeconomics. First, asset prices are volatile and persistent and price dividend ratios are predictable. Second, long lived risky assets earn 5% more on average than short term government debt. And third, the volatility of asset prices changes through time. I argue that all of these puzzles are caused by the simple fact that we cannot buy insurance over the state of the world we are born into.

Secular stagnation: a neo-paleo-Keynesian perspective

I first posted this piece back in January but it got deleted by from my blog by mistake. Since secular stagnation is back in the blogosphere with a vengeance: its time to repost it.

In a recent piece on his blog, David Beckworth has taken another swing at the secular stagnation hypothesis. Secular stagnation is a term coined by Alvin Hansen in a 1938 article in which he claimed that public expenditure might be required to maintain full employment.

Here is Alvin, as quoted by David...

"The business cycle was par excellence the problem of the nineteenth century. But the main problem of our times, and particularly in the United States, is the problem of full employment. ... This is the essence of secular stagnation— sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment."

Hansen is writing in 1938, before Keynesian economics had been forever altered by Samuelson's bastardization of Keynes' key idea: that high involuntary unemployment is an equilibrium that can persist for decades. 

The Greek dance with debt

If you thought that the Greek debt crisis was over; think again. Tomorrow, the Greek parliament will try, for the third time, to agree on who will be the next president. If parliamentarians cannot agree (and that now seems likely) we are headed for the first potential rock in the road to recovery for 2015.  There is a real danger that the Greek debt crisis will emerge with a vengeance and, once again, throw world financial markets into turmoil.

Under the rules of the Greek constitution, if no candidate receives an absolute majority, parliament will be dissolved, and there will be a general election, most likely in early February. If that happens, all signs point to a victory by Syriza, a left of center party that proposes to renegotiate the Greek debt.

A Syriza victory would force the core Euro countries to decide either to give up on the project of European integration, or to move to the next stage of full scale fiscal union in which German taxpayers assume responsibility for Greek debt.

If the Euro breaks apart, the fallout will be global. The world economy has been hit by a falling demand for raw materials and oil is trading at less than US$60 a barrel. Some of this is caused by newly discovered proven reserves and that is a good thing. But Jim Hamilton has argued that  falling world demand is a big part of the reason for lower oil prices and that does not bode well for a truly global recovery.

The US economy has been the single flickering light in a dark sky. If the Euro collapses, the knock-on-effect will derail the US recovery and send the entire world economy back into recession.

Is a Greek default and a breakup of the Euro the most likely outcome? Probably not. But it is the first of many building storms that the global economy will need to weather in 2015. All eyes on Greece tomorrow!

Real business cycle theory and the high school Olympics

I have lost count of the number of times I have heard students and faculty repeat the idea in seminars, that “all models are wrong”. This aphorism, attributed to George Box,  is the battle cry  of the Minnesota calibrator, a breed of macroeconomist, inspired by Ed Prescott, one of the most important and influential economists of the last century.

All models are wrong... all models are wrong...

Of course all models are wrong. That is trivially true: it is the definition of a model. But the cry  has been used for three decades to poke fun at attempts to use serious econometric methods to analyze time series data. Time series methods were inconvenient to the nascent Real Business Cycle Program that Ed pioneered because the models that he favored were, and still are, overwhelmingly rejected by the facts. That is inconvenient.

Ed’s response was pure genius. If the model and the data are in conflict, the data must be wrong. Time series econometrics, according to Ed, was crushing the acorn before it had time to grow into a tree. His response was not only to reformulate the theory, but also to reformulate the way in which that theory was to be judged. In a puff of calibrator’s smoke, the history of time series econometrics was relegated to the dustbin of history to take its place alongside alchemy, the ether, and the theory of phlogiston.

John, Paul and Say's Law

I've followed, with a great deal of interest, the debate between John Cochrane and Paul Krugman. I have a lot in common with both of them.

I agree with Paul that, for the most part, the IS-LM model provides the right answer to policy questions. I agree with John, that we have learned a lot since 1955, when Paul Samuelson invented the Neo-classical synthesis.

But there were a couple of ideas in the General Theory that have been buried by MIT macro. The first, and most important, is that high unemployment is an equilibrium. Repeat after me. E-Q-U-I-L-I-B-R-I-U-M. The second is that animal spirits are an independent causal factor that determines which equilibrium the private economy will select.

Let me ask a simple question that you should feel free to answer. And do please also try to guess the PK and JC answers. (To answer this question, you will need to arm yourself with a knowledge of the textbook IS-LM model. A good introduction would be Greg Mankiw's textbook or, the book I learned from, the intermediate text by Dornbusch, Fischer and Starz.)

Figure 1

Risk and Return in the Bond Markets

This is the second post to advertise the work of a UCLA graduate student who is looking for a job this year. My first post introduced Sangyup Choi who is working on uncertainty shocks in emerging markets. This post introduces Chan Mang who is working on the implications of term structure models for the foreign exchange market.

Chan Mang

Chan Mang graduated from UCLA two years ago. In 2012 he was awarded a post doc position at the prestigious National University of Singapore and last year he worked in the private sector.  Chan's research builds on the  widely cited bond pricing model developed by John Cochrane and Monika Piazzesi. 

Repeat After Me: The Quantity of Labor Demanded is Not Always Equal to the Quantity Supplied

I've been teaching a class on intermediate macroeconomics this quarter. Increasingly, over the past twenty years or more, intermediate macro classes at UCLA (and in many other top schools), have focused almost exclusively on economic growth. That reflected a bias in the profession, initiated by Finn Kydland and Ed Prescott, who persuaded macroeconomists to use the Ramsey growth model as a paradigm for business cycle theory. According to this Real Business Cycle view of the world, we should think about consumption, investment and employment 'as if' they were the optimal choices of a single representative agent with super human perception of the probabilities of future events. 

Although there were benefits to thinking more rigorously about inter-temporal choice, the RBC program as a whole led several generations of the brightest minds in the profession to stop thinking about the problem of economic fluctuations and to focus instead on economic growth. Kydland and Prescott assumed that labor is a commodity like any other and that any worker can quickly find a job at the market wage. In my view, the introduction of the shared belief that the labor market clears in every period, was a huge misstep for the science of macroeconomics that will take a long time to correct.

In my intermediate macroeconomics class, I am teaching business cycle theory from the perspective of Keynesian macroeconomics but I am grounding old Keynesian concepts in the theory of labor market search, based on my recent books (2010a, 2010b) and articles (2011, 2012, 2013a, 2013b).  I am going to use this blog to explain some insights that undergraduates can easily absorb that are adapted from my understanding of Keynes' General Theory. Today's post is about measuring employment.  In later posts, I will take up the challenge of constructing a theory to explain unemployment.

Ever since Robert Lucas introduced the idea of continuous labor market clearing, the idea that it may be useful to talk of something called 'involuntary unemployment' has been scoffed at by the academic chattering classes. It's time to fight back. The concept of 'involuntary unemployment' does not describe a loose notion that characterizes the sloppy work of heterodox economists from the dark side. It is a useful category that describes a group of workers who have difficulty finding jobs at existing market prices. 

The Impact of Financial Market Volatility on Emerging Market Economies

Early in the New Year, economists from all over the world will congregate in Boston for the 2015 annual meetings of the American Economics Association. The main purpose of these meetings is to interview new Ph.D. candidates for potential jobs as academics and in the public and private sectors as research and/or policy economists.  

Sangyup Choi

As an academic economist at UCLA, my job includes teaching undergraduates, carrying out economic research for publication in books and journals and, (my favorite part), training new Ph.D. economists. Teaching graduate students is a rewarding experience for an academic as we get to watch our students progress from undergraduates to colleagues. What begins as a teaching experience in year 1 ends up as a learning experience in year 5. 

Today's blog features my student, Sangyup (Sam) Choi, who is working on  the impact of financial market volatility on emerging market economies.  My colleague Aaron Tornell and I are Sam's principal advisors.

Sam is studying the VIX and its impact on economic activity. This is a hot topic amongst macroeconomists ever since Nick Bloom showed, in a paper published in Econometrica,  that shocks to uncertainty are a causal factor in US. recessions. What, you ask is the VIX?


The VIX is an index of volatility that goes up when traders are less certain about the future. In his Econometrica paper, Nick showed that shocks to the VIX are an independent causal factor that helps to predict future U.S. output. Here is a graph of the VIX for the period 2000 to 2014.

Figure 1: The VIX from 2000 to 2014

In a paper published last year in Economics Letters, Sam showed that Nick’s results are sensitive to the period of study. The VIX does predict future output in data from 1950 through 1982, but that result goes away after 1983. The largest recession in post war history in which the VIX jumped by a factor of four, (see Figure 1), did not have a significant independent impact on the U.S. economy, once other explanatory variables have been accounted for. That in itself is surprising. But it gets better.

Will Americans Ever Vote for a Far-Reaching Wealth Tax?

 Here is a link to my piece on inequality that was published today on the Guardian Economics Blog

What Thomas Piketty has shown us, is that since 1980, it is only the rich and the very rich who have benefited from growth, writes Roger Farmer

But there will come a time when the average American realises that the dream that his parents aspired to is no longer within his reach. Photograph: Peter Hundert/ Peter Hundert/cultura/Corbis

Don't Panic --- Yet!

Volatility has returned to the stock market and most of the gains of 2014 were wiped out in the last week. Is it time to panic? Not yet!

There is a close relationship between changes in the value of the stock market and changes in the unemployment rate one quarter later. My research here, and here shows that a persistent 10% drop in the real value of the stock market is followed by a persistent 3% increase in the unemployment rate. The important word here is persistent. If the market drops 10% on Tuesday and recovers again a week later, (not an unusual movement in a volatile market), there will be no impact on the real economy. For a market panic to have real effects on Main Street it must be sustained for at least three months.  And there is no sign that that is happening: Yet.

Figure 1: Wall Street and Main Street (c) Roger E. A. Farmer

Figure 1 plots a simple transformation of the value of the unemployment rate, measured on the left axis, and the real value of the S&P, measured on the right axis, in log units. This graph shows a clear correlation between these series and a more careful investigation reveals that this correlation is causal in the sense in which Clive Granger defined that term: there is information in the stock market that helps to predict the future unemployment rate.

It is of course, possible, that movements in the stock market are only apparently causal. In reality, the clever people who trade in the markets are prescient in their ability to foresee the very bad fundamentals that are driving the real economy. It is also possible that sometimes, market participants panic and that panic has real consequences when the rest of us find that our houses and pension plans are suddenly worthless. My own theoretical work supports the latter hypothesis but reasonable people can disagree.

So: should you be worried that we are about to enter a double dip recession? In my view, not yet, because, as of right now, the market shows no signs of a persistent drop when measured in real terms.    When (and if) the Yellen Fed follows through with its withdrawal of QE; we may be looking at a very different situation. Hang on to your hats!

Thought for the Day

 On the eve of the Nobel Prize in Economics, here is a thought for the day:

No great improvements in the lot of mankind are possible, until a great change takes place in the fundamental constitution of their modes of thought.  John Stuart Mill (Autobiography, 1824 Chapter 7)

Quoted from "How the Economy Works: Confidence Crashes and Self-Fulfilling Prophecies". Chapter 7.

Inequality and the Fourth Estate

I have been slow to chime in on Thomas Piketty’s book, Capital in the 21st Century, but it is hard to ignore the chatter that the book has generated from those on all sides of the political spectrum. The book sheds welcome light on the topic of income and wealth inequality and it has rekindled a debate in the United States and Europe on an age-old question: Should we care if some individuals earn much more than others?

As individuals in a modern democracy we make social decisions about how much of each good to produce and consume through free trade in a market economy. The rules by which we trade with others are determined through democratic elections in which we give power to our representatives to transfer resources from one human being to another. And we interact with each other through conversations, free association and social media or through more organized forms of persuasion such as newspapers and television stations. 

As economists, we are sometimes justly accused by other social scientists of taking a narrow view of human nature. A human being, to the neoclassical economist, is a preference ordering over all possible actions that he or she may take over the course of a lifetime. That preference ordering is fixed at birth and swings into action at the age of consent, at which time each of us exercises our endowed ability to choose among competing alternatives to maximize our happiness. 

That, of course, is poppycock. The view of homo-economicus as a utility seeking machine is not to be found in Smith, who had a much richer view of human nature as evidenced by his “other book” on The Theory of Moral Sentiments. Nor is it to be found in John Stuart Mill’s eloquent defense of free speech in his essay On Liberty. Both of those eminent social scientists would, I am certain, have been open to the idea that our opinions are formed through rational argument with other human beings. Our preference orderings do determine our actions; but they are not preordained. Nature and nurture are equally important determinants of human action.

Financial Policy

John Cochrane supports the case (forcefully made by Anat Admati) for higher capital requirements, citing excellent pieces by Pat Regnier at Time and Peter Coy at Business Week who explain exactly what this does and does not,  mean. I agree: we need banks to hold more capital.  But is that enough?

The following passages are extracts from my recent paper in the Manchester School on the role of the Financial Policy Committee as a guardian of financial stability.  I make the case that financial markets are inefficient because we cannot trade in markets that open before we are born. That fact is an important source of market incompleteness that I call the "absence of prenatal financial markets".

We all agree that financial crises occur. We disagree as to their cause. Some economists argue that markets are not only informationally efficient; they are also Pareto efficient. The boom and the bust are a consequence of the natural flow of knowledge acquisition in a capitalist economy. They are the price of progress. I disagree.

How to Estimate Models with Indeterminacy

My coauthors, Vadim Khramov, Giovanni Nicolo and I, have recently completed a revision of our working paper, "Solving and Estimating Indeterminate DSGE Models".

Dynamic Stochastic General Equilibrium Models (DSGE) often have many equilibria. I have long argued that we should exploit that idea to explain real world phenomena. For example, multiple equilibrium models can help to explain why "animal spirits" drive real world markets (see my survey here).

In 2004, Thomas Lubik and Frank Schorfheide published an influential paper which applied that idea to US monetary policy.  A number of authors have taken up their method, but the technique they used is not very easy to apply in practice. Our paper shows how to solve and estimate models with indeterminate equilibria using readily available software packages such as Chris Sim's code Gensys, or the widely used Matlab based package Dynare.