U.S. food stamp use up sharply, sign of hard times (Reuters) by Charles Abbott

One of the many reasons that I find the study of economics so fascinating is that what so often appears to be a negative situation to the average citizen is actually a positive one. In other words: “down is often up” and “black is often white”. One of my favorite examples of this “180 degree moment”, and why I love to teach AP Macroeconomics, relates to the study of unemployment.

Judging by today’s headlines, things aren’t looking too hot for the US economy:

• Job losses, unemployment both worse than forecast - Apr. 4, 2008
• Dollar slips against euro, yen on jobs - Apr. 4, 2008
• BBC NEWS | Business | Oil price edges up on Opec stance
• FT.com / Asia-Pacific / China - US economy is ‘down sharply’, Paulson says
• Bernanke Nods at Possibility of a Recession - New York Times

From the last article:

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

For the first time during his three years in the job, Bernanke has admitted we could be in a recession, defined as two consecutive quarters of negative GDP growth. By June, we could very well have experienced just such a decline in output; every central banker’s nightmare!

The source of America’s economic woes? Weak housing market. In fact, house prices have fallen around 10% nationwide over the last 12 months. To understand why, we need to recall the basic microeconomic principles of supply and demand. Quite simply, too many homes were built over the last decade, as low interest rates and optimism about the continued strenght of the housing market (rooted, of course, in the irrational exuberance about the economy as a whole) led builders to expand the suburban sprawl like never before, anticipating growing demand forever into the future. Problem was, demand couldn’t keep up with supply, and now the price is starting to reflect this basic economic principle.

To make things more complicated, many home buyers over the last seven years should never have been given loans based on their credit histories and household incomes. Many of these buyers were thus given “sup-prime” loans, many with adjustable interest rates, which means that today people who were too poor to get a normal loan four years ago are seeing their monthly payments increase just as the economy is slowing down. Rising unemployment puts downward pressure on wages, and inflation (caused by rising energy and commodity prices) forces poor homeowners to allocate more of their wages towards food and electricity, making it doubly hard to make their monthly mortgage payments.

The outcome is predictable: foreclosures. Banks that made loans to uncreditworthy buyers are now taking the houses back and putting them on the market for really low prices, putting even more downward pressure on all home prices. Since their homes make up the majority of Americans’ wealth, and since wealth and disposable income are the main determinants of consumption, inflation and falling home prices both lead to huge decreases in consumption.

The cycle continues: declines in household consupmtion signals to firms that it’s a bad time to invest, so investment spending declines. As consumption and investment fall, aggregate demand shifts in, causing output and employment to fall, hence our current recession.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

For now, however, judging by today’s headlines, conditions will continue to worsen for the American worker, homeowner, consumer and firm.

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FT.com / Asia-Pacific / China - Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past when the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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Job losses worst in five years - Mar. 7, 2008

The news late last week out of Washington was not what the White House was hoping for only a couple of weeks after the passing of a fiscal stimulus package meant to achieve exactly the opposite of what has happened. The US Labor Department released its latest numbers on employment on Friday:

There was a net loss of 63,000 jobs, which is the biggest decline since March 2003 and weaker than the revised 22,000 jobs lost in January. Economists had forecast a gain of 25,000 jobs…

“Based on today’s Employment Report, if we are not in a recession, it is a darned good imitation of one,” said Kevin Giddis, managing director of fixed income at Morgan Keegan.

So with a net loss of jobs, it may seem weird to hear that unemployment has actually fallen from 4.9% to 4.8%. How is this possible? In this case lower unemployment may indicate an even worse reality for the American economy:

The unemployment rate fell because of an increase of 450,000 people whom the government no longer counts as being part of the labor force for a variety of factors, such as that they are not currently looking for work. That drop in the size of the labor force allowed for the modest decline in unemployment, even as the household survey showed 255,000 fewer Americans with jobs than in January.

Discouraged workers point to a deep pessimism underlying households and workers in America, indicating that if we’re not already in a recession, it is only a matter of time. With the apparent failure of fiscal policy at achieving any immediate turnaround in consumer confidence, all eye’s are now on the Fed, America’s central bank, to see how Ben Bernanke will respond to the latest round of bad news.

“Even the silver lining of a falling unemployment rate has a little rust,” said Rich Yamarone, director of economic research at Argus Research. He predicted that the central bank will cut rates by a half percentage point at both its March meeting and again on April 30.

But Yamarone and some other experts questioned whether additional Fed cuts would do much to improve the employment outlook.

“We’re not in a crisis because the cost of borrowing is too high, it’s because people are afraid of lending,” said Dan Alpert, managing director of Westwood Capital, referring to the ongoing credit crunch. “At the end of the day, the Fed cuts don’t really solve the problems. They’ve already cut allot; if jobs continue to decline in face of further interest rate cuts, it’s prima facie evidence cuts aren’t effective.”

But few experts were ready to suggest the Fed would stop cutting rates at this point, given the problems in the economy and financial markets.

“The Fed has to do what it can to provide remedy and not scare the market as well,” said Mike Materasso, a senior portfolio manager at Franklin Templeton.

Central bankers face difficult decisions in times like these. While unemployment and falling growth rates pose significant problems to the American economy, the third macroeconomic evil is certainly in the minds of policymakers when deciding how to deal with the first two: inflation.

In order to lower interest rates, the Fed first has to implement expansionary monetary policy. In other words, the central bank must increase America’s money supply. How does it do this, exactly? Most commonly, the Fed uses open market operations, which is a fancy way of saying the Fed buys and sells government securities (treasury notes, bonds, etc…) on the bond market. When the Fed wishes to lower interest rates, it must inject new money into the economy, which it does by buying government bonds from the holders of those securities; namely, the public.

American banks, households, and firms, as well as foreigners all hold government debt. When the Fed wants to expand the money supply, it simply starts buying these debt securities back from the public. The increase in demand for securities drives up their prices, encouraging holders of the debt to sell their securities to the Fed, for which they receive money in exchange. In effect, the public exchanges illiquid (unspendable) debt certificates for liquid money. Now consumers have more money in their pockets to spend, firms have more to invest, and banks have more to loan out to borrowers who want to spend and invest. How do banks get rid of their new liquidity? Yep, they lower their interest rates.

In a nutshell, that’s how monetary policy works. To combat a recession and rising unemployment, the Fed simply buys bonds on the open market, injecting liquidity into the economy, which should result in more borrowing and more spending, shifting aggregate demand out, leading to growth and rising employment.

But what about that third evil, inflation? Won’t more spending lead to demand pull inflation? Usually this is not a major concern in times of a slowdown, since rising unemployment indicates the economy is producing below its full employment level of output. Expanding aggregate demand should result in increased output and stable prices. Today, however, Americans are facing other inflationary pressures, including a historically weak dollar (meaning imported goods and raw materials are more expensive than ever), and skyrocketing food and energy prices due to rising global demand for such commodities.

This all makes the job of monetary policy exceptionally challenging for Mr. Bernanke and his colleagues at the Fed. Expand the money supply too much (i.e. lower interest rates too much) and you risk accellerating inflation. Keep rates too high, and we can expect even worse employment and output numbers in the next few months.

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