Unpleasant Facts and Other Musings

Garett Jones had a very interesting econtalk with Russ Roberts. He mentions that one the more interesting features of this recession is that productivity has been pro-cyclical rather than counter cyclical.  The graph below shows that during recessions productivity has generally gone down.

Source: BLS, NBER

As Garett Jones points out, this is rather intuitive to the person who thinks about companies cutting the fat in hard times and laying off the least productive workers.  In really hard times, companies might also cut workers who are focusing on projects that might create future revenue. Garett’s original tweet on the topic phrased it this way:

Workers mostly build organizational capital, not final output. This explains high productivity per 'worker' during recessions.  

In order to understand the significance of counter-cyclical productivity, I looked at a paper published in October 2000 by the Federal Reserve called Why is Productivity Procyclical? Why Do We Care? by John G. Fernald and Susanto Basu.  They analyze the four main reasons why productivity is usually procyclical.

1. Procyclical technological development, where new technologies are invented during the boom rather than the bust.
2. Imperfect competition and increasing returns means that when the economy is doing well then productivity is rising.
3. Capital and labor are utilized more than is actually reported during a boom and less than is reported during a bust, so the procyclical productivity doesn’t actually exist but is caused by cyclical measurement problems.
4. The reallocation of resources across uses, so as cyclical sectors with higher markups utilize a larger percentage of resources productivity goes up.

The study found that explanations #3 and #4 are the most important.  If the recent boom and bust cycles were not quite as procyclical as before, it could be due to many reasons.

1. Better measurement of labor and capital.
2. This boom was more financial in nature with the reallocation of resources going less to industries with naturally higher markups and more industries subsidized by cheap financing
3. More firm specific capital creation in an increasingly globalized world.

Two and three are the most convincing. However, just because productivity doesn’t drop during recessions doesn’t mean that productivity is now countercyclical.  The relationship has merely weakened somewhat from the 1990’s onward, as this rolling ten year correlation between quarter on quarter changes in real GDP and nonfarm business output per hour demonstrates.

Source: BEA, BLS

Alex Tabarrok makes a very important point about some of Obama’s plans to help the middle class. 

From today's NYTimes  

The Obama administration is planning to use the government’s enormous buying power to prod private companies to improve wages and benefits for millions of workers, according to White House officials and several interest groups briefed on the plan....

Because nearly one in four workers is employed by companies that have contracts with the federal government, administration officials see the plan as a way to shape social policy and lift more families into the middle class.

At a time of 10% unemployment when real wages need to fall this is bad business cycle policy.  I am more worried, however, about the long term consequences of creating a dual labor market in which insiders with government or government-connected jobs are highly paid and secure while outsiders face high unemployment rates, low wages and part-time work without a career path.

Long-term unemployment is at shockingly high levels which in itself creates a dynamic of persistence because the longer a worker is unemployed the less employable they become (in part due to loss of human capital and signaling problems). Thus, getting these workers back to work is going to be hard enough as it is.  Labor regulations which raise wages and make hiring and firing workers even more costly will make re-employing the long-term unemployed even more difficult.

Moreover, once an economy is in the insider-outsider equilibrium it's very difficult to get out because insiders fear that they will lose their privileges with a deregulated labor market and outsiders focus their political energy not on deregulating the labor market but on becoming insiders--see Blanchard and Summers on hysteresis in unemployment and more recently Larry Ball here.  Many European economies found themselves stuck in the insider-outsider equilibrium and as a result unemployment levels in places like France and Italy hovered at 9% or more for decades.  

This is a neat explanation of the type of second order effects that people who are only trying to help usually tend to ignore.  Surprisingly, even Brad Delong agrees that creating an insider-outsider dynamic is bad.  The insider-outsider dynamic is even worse when it is the outsiders who are doing jobs that are the most productive.  Garett Jones points out that the effect of workers queuing for the higher paying insider jobs also exacerbates unemployment.

First, here is the OECD data and projections on the PIIGS with revised Greece levels:

Here is the same things with some other potentially troubled countries:

It is obvious that the problem children are Japan, Italy and Greece. Greece went from being the third highest debt/GDP country to the worst of the OECD. This move occurred not as a natural progression, but with the unveiling of their past lies/bad statistics/fraud. To look at their situation going forward, the government’s underlying primary balance, the amount of money it is spending or saving before interest payments, is quite informative.

Italy is fine; it is Greece and Japan who are in trouble.  This is before including the effect of higher interest rates on the Greek budget. Every time Greece has to issue or roll over their debt at higher interest rates their actual budget deficit gets worse. Greece is planning on increasing their underlying government balance as a percent of GDP at a rate faster than any OECD country has since Denmark in 1982. Of course, when Denmark increased their underlying primary balance they had a much higher inflation rate which meant they didn’t need to make the nominal cuts that Greece is now making. Japan’s situation looks in many ways similar to Greece, but since they have control of their own monetary policy they are in a much better position.

John Taylor’s blog Economics One points to an interesting OECD paper, The High Cost of Low Educational Performance, by Prof. Rick Hanushek and Prof. Ludger Woessmann.  They make projections based on the relationship between performance on international math and science PISA tests and economic growth.

The estimated coefficient on cognitive skills implies that an increase of one standard deviation in performance (i.e., 100 on the PISA scale) would yield an annual growth rate that is 1.74 percentage points higher.              

Their analysis leads to the following politically correct chart:

Except in the case of the lowest performing countries, this approach is very misguided.  While allowing a sizable fraction to achieve basic literacy is necessary, the marginal worker in an advanced economy isn’t going to help much once the network effect of a literate society is established.  By aiming to put a minimum under the PISA scores, they are changing the distribution of the variable that was found to be significant in the past. Scientific and technological progress will more often come from the inventions created by the high achievers on the far right of the distribution than the more sizable group on the left side, so just cutting off the leftward distribution changes the nature of what the PISA test scores were measuring in the first place.  Even if the share of literate population was more significant in their regression than the share of high achieving students*, the relationship between literate students and high achievers can be assumed to be relatively constant up until programs such as No Child Left Behind in the US encourage schools to favor creating the former over the latter.

The following charts from a BOE speech on Inflation and the Service Sector by Timothy Besley highlights what is wrong with trying to increase only the minimum PISA performance to raise economic growth. 

This is a chart of components of the UK service sector.  While the UK’s economy is geared more towards high end services than high end manufacturing, the principle remains the same. The low end services remain a sizable part of the economy. 

The employees at the bottom rung of the service sector are low productivity due to the nature of their industry. More investment in education the left side of the distribution might cut off some of the really bad results, but it will not result in a vastly more productive economy.  Focusing on manipulating the education scores upwards by targeting what looks like the lowest hanging fruit changes the nature of the underlying relationship.  Considering that in the US there is already an order of magnitude more money spent on special needs programs than on gifted programs, the low hanging fruit in education might just be on helping skew the educational score distribution further to the right.

* These regressions can be skewed by some cultures that excel at test scores at the expense of creativity or by looking at too broad a measure of high achieving students to accurately identify the countries with the highest proportion of superstar students. The really high achieving may also be more likely to change their country of residence, benefiting the countries that attract their human capital instead of the countries that produce them in the first place.

The housing crisis, crash and subsequent pressure to forestall foreclosures keeps people in their homes even though they aren’t making payments.  The average time to foreclosure has drastically increased during the recent recession, rising from three to six months to over a year in some cases.  This has had an interesting side effect: A lot of the marginal consumers are saving quite a bit of money on rent.  There are about 7.8 million mortgages that are delinquent or foreclosed. If average monthly payments are around $700 then these people are in aggregate potentially saving 65 billion dollars a year. This works out to 0.65% of 2009 personal consumption expenditures.  This helps explain how consumption has held up even in the face of declining credit, as the most marginal consumers who are cut off from credit are the same ones that are potentially living rent free.