Initial Claims for Unemployment Insurance Are at Record Lows

Weekly Initial Claims for Unemployment Insurance, January 7, 2006, to November 21, 2015

Weekly Initial Claims for Unemployment Insurance as a Ratio to Employment, January 1967 to October 2015

 

Initial claims for unemployment insurance are now at their lowest level, in terms of absolute numbers, in forty years, and the lowest ever when measured relative to employment (although the series goes back only to 1967).  There has been a steady improvement in the job market since soon after Barack Obama took office in January 2009, with (as discussed in a recent post on this blog) a steady increase in private sector jobs and an unemployment rate now at just 5.0%.  Yet the general discussion still fails to recognize this.  I will discuss some of the possible reasons for this perception later in this post.

Initial claims for unemployment insurance provides a good measure of the strength of the labor market, as it shows how many workers have been involuntarily laid off from a job and who are then thus eligible for unemployment insurance.  The US Department of Labor reports the figure weekly, where the numbers in the chart above are those updated through the release of November 25, 2015 (with data through November 21).  While there is a good deal of noise in the weekly figures due to various special factors (and hence most of the focus is on the four week moving average), it does provide a high frequency “yardstick” of the state of the labor market.  The charts above are for the four week moving averages.

The measure has been falling steadily (abstracting from the noise) since soon after President Obama took office.  News reports have noted that the weekly figures have been below 300,000 for some time now (close to a year).  This is a good number.  Even in the best year of the Bush administration (2006, at the height of the housing bubble), weekly initial claims for unemployment insurance averaged 312,000.  So far in 2015 (through November 21) it has averaged 279,000, and the lowest figure was just 259,250 for the week of October 24.  Initial claims for unemployment have not been so low in absolute numbers since December 1973.

But the population and labor force have grown over time.  When measured as a ratio to the number of those employed, initial claims for unemployment insurance have never been so low, although the series only begins in January 1967.  It is now well below the lowest points ever reached in the George W. Bush administration, in the Reagan administration, and even in the Clinton administration, under which the economy enjoyed the longest period of economic expansion ever recorded in the US (back to at least 1854, when the recession dating of the NBER begins).

Why then has the job market been seen by many as being especially weak under Obama? It should not be because of the unemployment rate, which has fallen steadily to 5.0% and is now well below where it was at a similar point during the Reagan administration.  Private job creation has also been steady and strong (although government jobs have been cut, for the first time in an economic downturn in at least a half century).  There has also been no increase in the share of part time employment, despite assertions from Republican politicians that Obamacare would have led to this.  And growth in GDP, while it would have been faster without the fiscal drag of government spending cuts seen 2010, has at least been steady.

What has hurt?  While no one can say for sure as the issue is some sense of the general perception of the economy, the steady criticism by Republican officials and pundits has probably been a factor.  The Obama administration has not been good at answering this.

But also important, and substantive, is that wages have remained stagnant.  While this stagnation in wages has been underway since about 1980, increased attention is being paid to it now (which is certainly a good thing).  In part due to this stagnation, the recovery that we have seen in the economy since the trough in mid-2009 has mostly been for the benefit of the very rich.  Professor Emmanuel Saez of UC Berkeley has calculated, based on US tax return data, that the top 1% have captured 58% of US income growth over the period 2009 to 2014.  The top 1% have seen their real incomes rise over this period by a total of 27% in real terms, while the bottom 99% have seen income growth over the period of only 4.3%.  Furthermore, most of this income growth for the bottom 99% only started in 2013.  For the period from 2009 through 2012, the top 1% captured 91% of the growth in national income.  The bottom 99% saw their real incomes rise by only 0.8% total over that period.

The issue then is not really one of jobs or overall growth.  Rather it is primarily a distribution problem.  The recovery has not felt like a recovery not because jobs or growth have been poor (although they would have been better without the fiscal drag), but rather because most of the gains of the growth have accrued to the top 1%.  It has not felt like a recovery for the other 99%, and for an understandable reason.

The Failure of the Austerity Strategy Imposed on Greece, With Some Suggestions on What To Do (and What Not To Do) Now

Greece - GDP 2008-2014 Projection vs Actual

A.  Introduction

It appears likely now that Greece will continue, at least for a few more months, with the austerity program that European governments (led by Germany) are insisting on.  In return, Greece will receive sufficient “new” funding that will allow it to pay the debt service coming due on its government debt (including debt service that was supposed to have been paid in June, but was not), as well as continued access to the liquidity lines with the European Central Bank that allow it to remain in the Eurozone.  But it is not clear how long Greece can continue on this path.

The measures being imposed by the Eurozone members are along the same lines as have been followed since the program began in 2010:  Primarily tax increases and cuts in government spending.  The most important measures (in terms of the predicted impact on euros spent or saved) in the new program are increases in value-added taxes and cuts in government pensions.  This has been a classic austerity strategy.  The theory is that in order to pay down debts coming due, a government needs to increase taxes and cut how much it has been spending.  In this way, the theory goes, the government will reduce its deficit and soon generate a surplus that will allow it first to reduce how much it needs to borrow and then start to reduce the debt it has outstanding.

The proponents of this austerity strategy, with Germany in the lead, argue that in this way and only in this way will the economy start to grow.  Others argue that austerity in conditions such as where Greece finds itself now will instead cut rather than enhance growth, and in fact lead to an economic decline.  The priority should instead be on actions that will lead to growth by raising rather than reducing demand.  Once the economy returns to full employment, one will be able to generate the public sector savings which will allow debt to be paid.  Without growth, the situation will only get worse.

One does not need to argue these points in the abstract.  Greece is now in its sixth year of the austerity program that Germany and others have insisted upon.  One can compare what has in fact happened to the economy to what was expected when the austerity program started.  The Greek program is the work of a combined group (nicknamed the “Troika”) made up of the EU, the ECB (European Central Bank), and the IMF.  The IMF support was via a Stand-By Arrangement, and for this the IMF prepares and makes available a Staff Report on the program and what it expects will follow for the economy. The EU and the ECB co-developed these forecasts with the IMF, or at least agreed with them.  This can therefore provide a baseline of what the Troika believed would follow from the austerity program in Greece.  And this can be compared to what actually happened.

The “projected” figures are therefore calculated from figures provided in the May 2010 IMF Staff Report for the Stand-By Arrangement for Greece.  What actually happened can be calculated from figures provided in the IMF WEO Database (most recently updated in April 2015).  I used the IMF WEO Database for the data on what happened as the IMF will define similarly in both IMF sources the various categories (such as what is included in “government” or in “public debt”).  Hence they can be directly compared.

This blog post will focus on a series of simple graphs that compare what was projected to what actually happened.  Note that the figures for 2014 should all be taken as preliminary. The concluding section of the post will review what might be done now (and what should not be done now).

As will be seen, the program failed terribly.  I should of course add that Germany and the Troika members do not believe that this failure was due to a failure in the design of the program, but rather was a result of the governments of Greece (several now) failing to apply the program with sufficient vigor.  But we will see that Greece actually went further than the original program anticipated in cutting government expenditures and in increasing taxes.  To be honest, I was myself surprised at how far they went, until I looked at the numbers.

Austerity was applied.  But it failed to lead to growth.

B.  The Path of Real GDP

To start with the most basic, did the austerity strategy lead to a resumption of growth or not?  The graph at the top of this post shows what was forecast to happen to real GDP in the Troika’s program, and what actually happened.  The base year is taken as 2008. Output had peaked early in that year before starting to turn down later in the year following the economic and financial collapse in the US.  (Note:  For 2008 as a whole, real GDP in Greece was only slightly below, by 0.4%, what it was in 2007 as a whole.)

The IMF Stand-by Arrangement for Greece was approved in mid-2010, with output falling sharply at the time.  The IMF then predicted that Greek GDP would fall further in 2011 (a decline of 2.6%), but that with adoption of the program, would then start to grow from 2012 onwards.

That did not happen.  The situation in 2010 was in fact already worse than what the IMF thought at the time, with a sharper contraction already underway in 2009 than the estimates then indicated and with this then continuing into 2010 despite the agreement with the Troika.  National estimates for aggregates like GDP are always estimates, and it is not unusual (including for the US) that later, more complete, estimates can differ significantly from what was initially estimated and announced.

Going forward, GDP growth was then far worse than what the IMF thought would follow with the new program.  GDP fell by 8.9% in 2011, rather than the 2.6% fall the IMF predicted.  GDP then fell by a further 6.6% in 2012 and a further 3.9% in 2013.  The widening gap between the forecast and the reality is especially clear if one shifts the base for comparison to 2010, the start of the IMF supported program:

Greece - GDP 2010-2014 Projection vs Actual

Growth appears to have returned in 2014, but by just 0.8% according to preliminary estimates (and subject to change).  But with the turmoil so far in 2015, everyone expects that GDP is once again falling.  The austerity strategy has certainly not delivered on growth.

C.  Real Government Expenditures, Taxes, the Primary Balance, and Public Debt

Advocates of the austerity strategy have argued not that the austerity strategy failed, but rather that Greece did not apply it with sufficient seriousness.  However, Greece has in fact cut government expenditures by substantially more than was called for in the IMF (and Troika) program:

Greece - Govt Expendite 2008-2014 Projection vs Actual

By 2014, real government expenditures were 17% below what the IMF had projected would be spent in that year, were 27% below where they had been in 2010 at the start of the program, and were 32% below where they had been in 2008.  Real government expenditures were in each year far less, by substantial margins, than had been called for under the initial IMF program.

It is hard to see how one can argue that Greece failed to cut its government spending with sufficient seriousness when government spending fell by so much, and by so much more than was called for in the original program.

Taxes were also raised by substantially more than called for in the initial IMF program:

Greece - Govt Revenue 2008-2014 Projection vs Actual

 

Tax effort and effect is best measured as a share of GDP.  The IMF program called for government revenues to rise as a share of GDP from 37% in 2009 and an anticipated 40.5% in 2010, to a peak of 43% in 2013 (a rise of 2 1/2% over 2010) after which they would fall.  What happened is that taxes were already substantially higher in 2009 (at almost 39% of GDP) than what the earlier statistics had indicated, and then rose from 41% of GDP in 2010 to a peak of 45% in 2013 (a rise of 4% over 2010).

Taxes as a share of GDP have therefore been substantially higher throughout the program than what had been anticipated, and the increase from 2010 to the peak in 2013 was far more than originally anticipated as well.  It is hard to see how one can argue that Greece has not made a major effort to secure the tax revenues that the austerity program called for.

With government spending being cut and government revenues rising, the fiscal deficit fell. For purposes of understanding the resulting government debt dynamics, economists focus on a fiscal deficit concept called the “primary balance” (or “primary deficit”, when in deficit).  The primary balance is defined as government revenues minus government expenditures on all items other than interest (and principal) on its debt.  It will therefore measure the resources available to cover interest (and principal, if all of interest can be covered).  If insufficient to cover interest coming due, then additional net borrowing will be necessary (thus adding to the stock of debt outstanding) to cover that interest.

With expenditures falling and revenues rising, the government’s primary balance improved sharply over the program period:

Greece - Primary Balance 2008-2014 Projection vs Actual

The primary balance improved from a deficit of 10.2% of GDP in 2009 to 5.2% of GDP in 2010, and then rose steadily to a primary surplus of 1.2% of GDP in 2013 and an estimated 1.5% of GDP in 2014 (where the 2014 estimate should be taken as preliminary). A rise in the primary balance of close to 12% of GDP in just five years is huge.

However, the primary balance tracked below what the IMF program had called for.  How could this be if government spending was less and government revenues higher?  There were two main reasons:  First, the estimates the IMF had to work with in 2010 for the primary deficit in that year and in the preceding years were seriously wrong.  The primary deficit in 2010 turned out to be (based on later estimates) 2.8% points of GDP higher than had originally been expected for that year.  That gap then carried forward into the future years, although narrowing somewhat (until 2014) due to the over-performance on raising taxes and reducing government expenditures.

Second, while the path of government expenditures in real terms was well below that projected for the IMF program (see the chart above), the decline in government expenditures as a share of GDP was less because GDP was so much less than forecast. If, for example, government expenditures are cut by 20% but GDP also falls by 20%, then government expenditures as a share of GDP will not change.  They still did fall as a share of GDP between 2009 and 2014 (by 7.7% points of GDP), but not by as much as they would have had GDP not collapsed.

Finally, from the primary balance and the interest due one can work out the path of government debt to GDP:

Greece - Govt Debt to GDP 2008-2014 Projection vs Actual

The chart shows the path projected for public debt to GDP in the IMF program (in blue) and the path it actually followed (in black).  Despite lower government expenditures than called for in the program and higher government revenues as a share of GDP, as well as a significant write-down of 50% on privately held government debt in 2012 (not anticipated in the original IMF program), the public debt to GDP ratio Greece now faces (177% as of the end of 2014, and rising) is well above what had been projected in the program (153% as of the end of 2014, and falling).

Why?  Again, the primary reason is that GDP contracted sharply and is now far below what the IMF had forecast.  If debt followed the path it actually did take but GDP had been as the IMF forecast, the debt to GDP ratio as of the end of 2014 would have been 131% and falling (the path shown in green on the chart).  This would have been well less than the 153% ratio the IMF forecast for 2014, due both to private debt write-off and to the fiscal over-performance.  Or if debt had followed the path projected in the IMF program while GDP took the path it in fact did take, the debt to GDP ratio would have been 207% in 2014 (the path in red on the chart) due to the lower GDP, or well above the actual ratio of 177% in that year.

One cannot argue that Greece failed to abide by its government expenditure and revenue commitments sought in the IMF program.  Indeed, it over-performed.  But the program failed, and failed dramatically, because it did not recognize that by implementing such austerity measures, GDP would collapse.  The program was fundamentally flawed in its design.

D.  Other Measures

While the fiscal accounts are central to understanding the Greek tragedy, it is of interest to examine two other variables as well.  First, the path taken by the external current account balance:

Greece - Current Acct 2008-2014 Projection vs Actual

For countries who have their own currency, but who borrow in a foreign currency, crises will normally manifest themselves through a balance of payments crisis.  This is not central in Greece as it does not have its own currency (it is in the Eurozone) and almost all of its public borrowing has been in euros.  Still, it is of interest that the current account balance of Greece (exports of all goods and services less imports of all goods and services) moved from a massive deficit of over 14% of GDP in 2008 to a surplus in 2013 and 2014. Relative to 2010, Greek exports of goods and services (in volume terms) were 12% higher in 2014, while Greek imports were 19% lower.

The IMF had projected that the external current account would still be in deficit in those years.  This shift was achieved despite Greece not being able, as part of the Eurozone, to control its own exchange rate.  The rate relative to its Eurozone partners is of course fixed, and the rate relative to countries outside of the Eurozone is controlled not by events in Greece but by policy for the Eurozone as a whole.  Rather, Greek exports rose and imports fell because the economy was so depressed that domestic producers who could export did, while imports fell in line with lower GDP (real GDP was 17.5% lower in 2014 than in 2010).  Lower wages were central to this, and will be discussed further below.

Finally, with the economy so depressed, unemployment rose, to a peak of 27.5% in 2013:

Greece - Unemployment Rate 2008-2014 Projection vs Actual

While the preliminary estimate is that unemployment then fell in 2014, most observers expect that it will go up again in 2015 due to the economic turmoil this year.  And youth unemployment is at 50%.

E.  What Can Be Done

I do not know Greece well, and certainly not enough to suggest anything that would be close to a complete program.  But perhaps a few points may be of interest, starting first with some things not to do (or at least are not a priority to do), and then some things that should be done (even if unlikely to happen):

1)  What not to do, or at least not worry about now:

a)  Do not continue doing what has failed so far:  While it should be obvious, if a particular strategy has failed, one should stop pursuing it.  Keeping the basic austerity strategy, with just a few tweeks, will not solve the problem.

b)  Do not make the austerity program even more severe:  Most clearly, the austerity program has savaged the economy, and one should not make things worse by tightening it even further.  Yet that is the direction that things appear to be heading in.

Negotiations are now underway as I write this between the Government of Greece and the Troika on the extension of the austerity program.  A focus is the government’s primary balance.  The original IMF program called for a primary surplus of 3% of GDP in 2015, and that has been still the official program goal despite all the turmoil between 2010 and now. The IMF program (as updated in June 2014) then envisioned the primary surplus rising to 4.5% of GDP in 2016 and and again in 2017.  Germany wanted at least this much, if not more.

Even the official Greek proposal to the Troika of July 10 had the primary surplus rising over time, from 1% of GDP in 2015, to 2%, 3%, and 3 1/2% in 2016, 2017, and 2018, respectively.  With the chaos this year, few expect Greece to be able to achieve a primary surplus target of even 1% of GDP (if one does not ignore payment arrears).  And while the IMF estimate from this past spring was that the primary surplus in 2014 reached 1.5% of GDP (reflected in the chart above), this was a preliminary estimate, and many observers believe that updated estimates will show it was in fact lower.

With even the Greek Government proposal conceding that an effort would be made to reach higher and higher primary balance surpluses, the final program as negotiated will almost certainly reflect some such increase.  This would be a mistake.  It will push the economy down further, or at least reduce it to below where it would otherwise be had the primary surplus target been kept flat.

c)  Do not negotiate over the stock of debt now:  There has been much more discussion over the last month on a need to negotiate now, and not later (some assert), a sharp cut to the stock of Greece’s public debt outstanding.  This was sparked in part by the public release on July 14 by the IMF of an updated debt sustainability analysis, which stated bluntly that the level of Greek public debt was unsustainable, that it could never be repaid in full, and that therefore a reduction in that debt will at some point be inevitable through some system of write-offs.

There is no doubt that Greek public debt is at an unsustainable level.  Some portion will need to be written down.  But I see no need to focus on that issue now, with the economy still deeply depressed and in crisis.  Rather, a moratorium on debt service payments (both principal and interest) should be declared.  The notional debt outstanding would then grow over time at the rate of interest (interest due in effect being capitalized).  At some future point, when the economy has recovered and with unemployment at more normal levels, there can be a negotiation on what to do about the debt then outstanding.  One will know only at that point what the economy can afford to pay.

Note that such a moratorium on debt service is fully and exactly equivalent to debt service payments being paid, but out of “new” loans that cover the debt service due.  This has been the approach used so far, and the current negotiations appear to be calling for a continuation of this approach.  Such “new” lending conveys the impression that debt service continues to be paid, when in reality it is being capitalized through the new loans. Little is achieved by this, and it wastes scarce and valuable time, as well as political capital, to negotiate over such issues now.

d)  Structural reforms can wait:  There is also no doubt that the Greek economy faces major structural issues, that hinder performance and productivity.  There are undoubtedly too many rules and regulations, inefficient state enterprises in key sectors, and codes that limit competition.  They do need to be reformed.

But there is a question of whether this should be a focus now.  The economy is severely depressed, with record high unemployment (similar to the peak rates seen in the US during the Great Depression).  Measures to improve productivity and efficiency will be important to allow the full capacity level of Greek GDP eventually to grow, but the economy is currently operating at far below full capacity.  The priority right now should be to return employment to close to full employment levels.

One needs also to recognize that many of the measures that would improve efficiency will also have the immediate impact of reducing rather than raising employment.  Changing rules and regulations that will make it easier to fire workers will have the immediate impact of reducing employment, not raising it.  Certain state enterprises undoubtedly should be privatized, and such actions can improve efficiency.  But the immediate impact will almost certainly be cuts in staffing, not increases.

Structural reforms will be important.  But they are not the critical priority now.  And far more knowledgeable commentators than myself have made the same point.  Former Federal Reserve Board Chairman Ben Bernanke made a similar point in a recent post on his blog, although more diplomatically and speaking on Europe as a whole.

2)  What should be done:

Finally, a few things to do, although it is likely they will not be politically feasible.

a)  Allow the primary balance to fall to zero, and then keep it there until the economy recovers:  As discussed above, the program being negotiated appears to be heading towards a goal of raising the primary surplus to 3 1/2% of GDP or more over the next few years.  The primary balance appears to have been in surplus in 2014 (the preliminary IMF estimate was 1.5% of GDP, but this may well be revised downwards), with a surplus also expected in 2015 (although the likelihood of this is now not clear, due to the chaotic conditions).  To raise it further from current levels, the program will call for further tax increases and government expenditure cuts.  This will, however, drive the economy down even further.

Keeping the primary balance at zero rather than something higher will at least reduce the fiscal drag that would otherwise hold back the economy.  Note also that a primary balance of zero is equivalent to a moratorium on debt service payments on public debt, which was discussed above.  Interest would then be fully capitalized, while no net amount will be paid on principal.

b)  Germany needs to take actions to allow Greece (and the Eurozone) to recover:  While I am under no illusion that Germany will change its domestic economic policies in order to assist Greece, the most important assistance Germany could provide to Greece is exactly that.

The fundamental problem in the design of the single currency system for the Eurozone system was the failure to recognize as critically important that Europe does not have a strong central government authority, with direct taxing powers, that can take action when the economy falls into a recession.  When a housing bubble bursts in Florida or Arizona, incomes in those states will be supported by US federal authorities, who will keep paying unemployment compensation; pensioners will keep receiving their Social Security and Medicare; federal transfers for education, highway programs, and other such government expenditures will continue; and if there is a national economic downturn (and assuming Congress is not controlled by ideologues opposed to any such actions) then stimulus measures can be enacted such as increased infrastructure spending.  And the Federal Reserve Board can lower interest rates to spur investment.  All of this supports demand, and keeps demand (and hence production and employment) from falling as much as it otherwise would.  This can then lead to a recovery.

The European Union in current form is not set up that way.  Central authority is weak, with no direct taxing powers and only limited expenditures.  Members of the Eurozone do not individually control their own currency.  If a member country suffers an economic downturn and faces limits on either what it can borrow in the market or in how much it is allowed to borrow in the market (by the limits set in the Fiscal Compact that Germany pushed through), it will not be able to take the measures needed to stabilize demand. Government revenues will decline in the downturn.  Any such borrowing limits will then force government expenditures to be cut.  This will lead to a further downward spiral, with tax revenues falling again and expenditures then having to be cut again if borrowing is not allowed to rise.  Greece has been caught in exactly such a spiral.

As was discussed some time ago on this blog, even Professor Martin Feldstein (a conservative economist who had been Chairman of the Council of Economic Advisers under Reagan) said such fiscal rules for the Eurozone could “produce very high unemployment rates and no route to recovery – in short, a depression”.  That is exactly what has happened in Greece.

The EU in its present form cannot, by itself as a central entity, do much to resolve this. However, member countries such as Germany are in a position to help support demand in the Eurozone, if they so wished.  But they don’t.  Germany had a current account surplus of 7.5% of GDP in 2014, and the IMF expects it will rise to 8.4% of GDP in 2015. Germany’s current account surplus hit $288 billion in 2014, the highest in the world (China was second, at $210 billion).  German unemployment is currently about 5%, but inflation is excessively low at 0.8% in 2014 and an expected 0.2% in 2015.  It could easily slip into the deflationary trap that Japan fell into in the 1990s that has continued to today.

To assist Greece and others in the Eurozone, Germany could do two things.  First, it could accede to the wage demands of its principal trade unions.  Germany’s largest trade union, IG Metall, had earlier this year asked for a general wage increase of 5.5% for 2015.  In the end, it agreed to a 3.4% increase.  A higher wage increase for German workers would speed the day to when they were in better alignment with those in Greece (which have been dropping, as we will discuss below) and others in the Eurozone.  Inflation in Germany would likely then rise from the 0.2% the IMF forecasts for 2015, but this would be a good thing.  As noted above, inflation of 0.2% is far too low, and risks dipping into deflation (prices falling), from which it can be difficult to emerge.  Thus the target set in the Eurozone is 2%, and it would be good for all if German inflation would rise to at least that.

Direct fiscal spending by Germany would also help.  It has the fiscal space.  This would spur demand in Germany, which would be beneficial for countries such as Greece and others in the Eurozone for whom Germany is their largest or one of their largest export markets.  Inflation would likely rise from its current low levels, but as noted, that would be good for all.

Of even greater direct help to Greece would be German support for EU programs that would provide direct demand support in Greece.  An example might be an acceleration of planned infrastructure investment programs in Greece, bringing them forward from future years to now.  Workers are unemployed now.  Bringing such programs forward would also be rational even if the intention was simply to minimize costs.  Unemployed workers and other resources are now available at cheap rates.  They will be more expensive if they wait until the economy is close to full employment, so that workers have an alternative. Economically, the opportunity cost of hiring workers now is extremely low.

A more balanced approach, where adjustment is not forced solely on depressed countries such as Greece but in a more balanced away between countries in surplus and those in deficit, would speed the recovery.  Far more authoritative figures than myself (such as Ben Bernanke in his blog post on Greece) have made similar arguments.  But Germany shows little sign of accepting the need for greater balance.

3)  What will likely happen:

With Germany not changing its stance, and with the Troika now negotiating an extension and indeed deepening of the austerity program Greece has been forced to follow since 2010 (in order to be allowed to remain in the Eurozone), the most likely scenario is that conditions will continue along the lines of what they have been so far under this program. The economy will remain depressed, unemployment will remain high, government revenues will fall in euro terms, and this will then lead to calls for even further government expenditure cuts.

One should not rule out that at some point some event occurs which leads to a more immediate collapse.  The banking system could collapse, for example.  Indeed, many observers have been surprised that the banking system has held up as well as it has. Liquidity support from the European Central Bank has been critical, but there are limits on how much it can or will be willing to provide.  Or a terrorist bomb at some resort could undermine the key tourism industry, for example.

Absent such uncontrollable shock events, there is also the possibility that at some point the Government of Greece might decide to exit the Eurozone.  This would also create a shock (and any such move to exit the Eurozone could not be pre-announced publicly, as it would create an immediate run on the currency), but at least some argue that following the initial chaos, this would then make it possible for Greece to recover.

The way this would work is that the new currency would be devalued relative to the euro, and by law all domestic transactions and contracts (including contracts setting wages of workers) would be re-denominated into the new currency (perhaps named the “new drachma” or something similar).  With a devaluation relative to the euro, this would then lead to wages (in euro terms) that have been reduced sharply and immediately relative to what they were before.  The lower wages would then lead to Greek products and services that are more competitive in markets such as Germany, leading to greater exports (and lower imports).  This is indeed how countries with their own currencies normally adjust.

It would, however, be achieved only by sharply lower wages.  It would also likely be accompanied by chaotic conditions in the banking system and in the economy generally in reaction to the shock of Eurozone exit.  Greece would also likely cease making payments of interest and principal on its government debt (payments that are due in euros).  This plus the exit from the Eurozone would likely sour relations with Germany and others in the Eurozone, at a time when the country needs help.

So far Greece has resisted leaving the Eurozone.  Given what it has accepted to do in the Troika program in order to stay in the Eurozone (with the resulting severely depressed economy), there can be no doubt that this intention is sincere.  Assuming then that Greece does stay in the Eurozone, what will likely happen?

Assuming no shocks (such as a collapse of the banking system), it would then be likely that the economy would muddle along for an extended period.  It would eventually recover, but only slowly.  The process would be that the high unemployment will lead to lower and lower wages over time, and these lower wages would then lead to Greek products becoming more competitive in markets such as Germany.  This is similar to the process following from a devaluation (as discussed above), but instead of this happening all at one point in time, it would develop only gradually.

The process has indeed been underway.  The key is what has happened to wages in Greece relative to where wages have gone in its trading partners.  One needs also to adjust for changes in labor productivity.  The resulting measure, which economists call nominal unit labor costs, measures the change in nominal wages (in euro terms here), per unit of effective labor (where effective labor is hours of labor adjusted for productivity growth).  While one cannot easily compare unit labor costs directly between countries at the macro level (it would vary based on employment composition, which differs by country), one can work out how much it has changed in one country versus how much it has changed in another country, and thus how much it has changed for one country relative to another.

Scaling the base to 100 for the year 2010 (the year the austerity program started in Greece), relative unit labor costs have fallen sharply in Greece relative to the rest of the Eurozone, and even more so relative to Germany (with the data computed from figures provided by Eurostat):

Greece and Eurozone Unit Labor Cost, 2010 = 100

Relative to 2010, nominal unit labor costs fell by 13% in Greece (up to 2013, the most recent date available).  Over that same period, they rose by 4% in the Eurozone as a whole and by 6% in Germany.  Thus relative to Germany, unit labor costs in Greece were 18% lower in 2013 than where they were in 2010.  This trend certainly continued in 2014.

The lower unit labor costs in Greece have led to increased competitiveness for the goods and services Greece provides.  Using the IMF WEO database figures, the volume of Greek exports of goods and services grew by a total of 12% between 2010 and 2015, while the volume of imports fell by 19%.  As noted in a chart above, the Greek current account deficit went from a large deficit in 2010 to a surplus in 2013 and again in 2014.  Greater exports and lower imports have helped Greek jobs.  And as seen in another chart above, Greek unemployment fell a bit in 2014 (although with the recent chaos, is probably rising again now).

This process should eventually lead to a recovery.  But it can be a slow and certainly painful process, and is only achieved by keeping unemployment high and wages falling.

Are Greek wages now low enough?  Changes in unit labor costs cannot really provide an answer to that.  As noted above, the figures can only be provided in terms of changes relative to some base period.  The base period chosen may largely be arbitrary.  The chart above was drawn relative to a base period of 2010, as that was the first year of the austerity program, but cannot tell us how much (and indeed even whether) wages were out of line with some desirable relative value in 2010.  And one can see in the chart above that Greek unit labor costs were rising more rapidly than unit labor costs in the Eurozone as a whole in the period prior to 2010, and especially relative to Germany.

Rebasing the figures to equal 100 in the year 2000 yields:

Greece and Eurozone Unit Labor Cost, 2000 = 100

The data is the same as before, and simply has been adjusted to reflect a different base year.  Relative to where they were in the year 2000, Greek unit labor costs in 2013 were below what they were for the Eurozone, but only starting in 2013:  They were higher for each year from 2002 to 2012.  And they were still above the change in Germany over the period:  German unit labor costs were 11% higher in 2013 than where they were in 2000, while Greek unit labor costs were 17% higher (but heading downwards fast).

Wages are therefore adjusting in Greece, and indeed adjusting quite fast.  This is leading to greater exports and lower imports.  Over time, this will lead to an economic recovery. But it will be a long and painful process, and it is difficult to predict at this point how long this process will need to continue until a full recovery is achieved.

Unless the depressed conditions in the country lead to something more radical being attempted, this is probably the most likely scenario to expect.

The recovery could be accelerated if Greece were allowed to keep the primary balance flat at say a zero balance (implying all interest on its public debt would be capitalized, and no net principal paid) rather than increased.  But this will depend on the acquiescence of the Troika, and in particular the agreement of Germany.  It is difficult to see this happening.

The Strong Recovery in Employment Under Obama

Unemployment Rates - Obama vs Reagan

A.  The December Jobs Report

The Bureau of Labor Statistics released on Friday its regular monthly report on employment.  Job growth was once again strong.  Total jobs (nonfarm payroll employment, to be precise) rose by a solid 252,000 in December, and the unemployment rate came down to 5.6%.  Total jobs rose by an even higher (and upwardly revised) 353,000 in November and by an also upwardly revised 243,000 in October (the two most recent monthly figures are always preliminary and subject to revision).  These are all good numbers.  The 353,000 figure for job gains in November was the highest monthly figure in over nine years.

The overall job gain in 2014 came to 2.95 million.  This was the highest annual total since 1999.  Private sector jobs rose by 2.86 million in 2014.  This was the highest annual gain in private jobs since 1997.  Government jobs (federal, state, and local) also grew, although only by 91,000 and equal to just 3% of the overall growth in jobs of 2.95 million.  But at least it was positive and stopped being the drag on growth it had been before through repeated cuts.  Government jobs had been cut each and every year since 2009, reducing American jobs by 702,000 between 2009 and 2013.

B.  Obama’s Performance on Unemployment, Compared to Reagan’s

While the pace of improvement has accelerated in the past year, the Obama record on jobs has in fact been a good deal better for some time than he has been given credit for.  Critics said that Obama’s policies, both as a consequence of the passage of the Obamacare health reforms and from his use of government regulatory powers, would (they asserted) constrain job growth and keep unemployment high.  These critics look to the Reagan presidency as a model, with the belief that there was a rapid fall in unemployment following his tax cuts, attacks on unions, and aggressive deregulatory actions.  This adulation continues.  A recent example was a column by Stephen Moore (Chief Economist of the Heritage Foundation) published in the Washington Post just two weeks ago (and which a number of commentators, including Paul Krugman, noted was full of errors).

But how do the Obama and Reagan records in fact compare?  The graph at the top of this post shows the path the rate of unemployment has taken during Obama’s presidency, and for the same period during Reagan’s presidency.  Both curves start from their respective inaugurations.

Unemployment under Reagan was high when he took office (at 7.5%), although on a downward trend.  But it then rose quickly (peaking at 10.8%) followed by a fall at a similar pace, before leveling off at a still high 7 to 7 1/2%.  It then fell only slowly for the next two and a half years, by a total of just 0.6% points.  The recovery in terms of the unemployment rate lacked strong staying power.

The pattern was different under Obama.  While unemployment was also high when he took office (7.8%), it was rising rapidly as the economy was losing 800,000 jobs a month.  It rose to a peak of 10.0% nine months later, before starting a fall that has continued to today.  The pace of the reduction was relatively steady over the years, but accelerated in 2014.  Over the last two and a half years, the unemployment rate has been reduced by 2.6% points, far better than the 0.6% reduction for the comparable period under Reagan.

As a result, the unemployment rate is now 5.6% under Obama, versus 6.6% at the same point in Reagan’s tenure.  By this measure, performance has been better under Obama than it was under Reagan.  The 5.6% rate under Obama can also be compared to Mitt Romney’s statement in 2012, during his presidential campaign, that adoption of his policies would bring the unemployment rate down to 6% by January 2017.  Romney viewed this as an ambitious goal, but achievable if one would follow the policies he advocated.  It was achieved under Obama already by September 2014.  One did not hear, however, any words of congratulations from Romney or others in the Republican Party to mark that success.

Of possibly more interest in the debate about the response to the respective policy regimes of Obama vs. Reagan, was the flattening out of unemployment under Reagan at the still high level of 7.5% or close to it in mid-1984.  If his “supply-side” policies were going to be effective in bringing down unemployment, this was the period when they should have been working.  The tax cuts had been passed, and the regulatory and other policies of the Reagan administration were being implemented and enforced.  But unemployment was trending down only slowly.  In contrast, unemployment was falling rapidly for the same period in the Obama presidency, with the pace of reduction indeed accelerating in 2014.  There is absolutely no evidence that Obamacare, actions to protect the consumer or the environment, the application of government regulations under Obama, or even “policy uncertainty” (a new criticism of Obama that was given prominence during the 2012 campaign), have acted to slow job growth.

C.  A Few More Points

1)  Why did unemployment rise rapidly from mid-1981 to late-1982 (to 10.8%), and then fall at almost the same rapid rate from that peak to mid-1984?  This had less to do with the policies of Reagan than of those of Paul Volcker, then Chairman of the Federal Reserve Board (and a Jimmy Carter appointee).  Volcker and the Fed raised interest rates sharply to bring down inflation, with the federal funds rate (the interest rate at which banks lend funds on deposit at the Fed to each other; it is the main policy target of the Fed) reaching over 19% at its peak.  Inflation came down, the Fed then reduced interest rates, and the economic downturn that the Fed policy had induced was then reversed.  Unemployment thus rose fast, and then fell fast.

2)  Has the fall in the unemployment rate under Obama been more a reflection of people dropping out of the labor force than a recovery in jobs?  No.  A previous post on this blog looked at this issue, and found that labor force participation rates have been following their long term trends.  There is no evidence that labor force participation rates have made a sudden shift in recent years.

3)  Why has the pace of improvement in the unemployment rate accelerated in 2014?  As earlier posts on this blog have noted,  Obama is the only president in recent history where government spending has been cut in a downturn.  The resulting fiscal drag pulled back the economy from the growth it would have achieved had government spending, and its resulting demand for goods and services and hence jobs to produce those goods and services, not been cut.

But this finally turned around in 2014.  Congress finally agreed to a budget deal with Obama, and state and local governments saw spending stabilize and then start to rise as the recovery got underway and boosted tax revenues.  The result is shown in this chart, copied from an earlier post whose focus was on austerity policies in Europe:

Govt Expenditures, Real Terms - Eurozone and US, 2006Q1 to 2014 Q2 or Q3

Total US government expenditures (federal, state, and local; in real terms; and for all purposes, including both direct purchases of goods and services and for transfers to households such as for Social Security and Medicare), turned around in the first quarter of 2014 and began to rise.  Government spending had previously been falling from mid-2010.  With that turnaround in government spending, GDP rose by 4.6% (at an annualized rate) in the second quarter of 2014 and by 5.0% in the third quarter.  Much more was going on, of course, and one cannot attribute all moves in GDP growth to what has happened to government spending.  But the turnaround in government spending meant that this component of GDP stopped acting as the drag on growth that it had been before.

Jobs then grew in 2014 at the most rapid rate since 1999, and unemployment fell.  The unemployment rate of 5.6% is the lowest since 2008, the year the economy entered into the economic collapse that marked the end of the Bush administration.

D.  How Much Further Does Unemployment Need to Fall to Reach Full Employment?

The 5.6% rate is not yet full employment.  While it might appear to some to be a contradiction in terms, there will always be some unemployment in an economy, even at “full employment”.  There will be frictions as workers enter and leave jobs, mismatches in skills and in geographic location, and so on.  But the 5.6% rate is still well above this.

Historically, the US economy was often able to achieve far lower rates of unemployment and not see excessive upward pressure on wages and prices.  The unemployment rate was at 4.4% in 2006/07, at 3.9% in 2000, and at 4.0% or below continuously from late 1965 through to early 1970 (and reached 3.5% or below for a full year from mid-1968 to mid-1969).  It even dipped to a post-war low of 2.5% in 1953, although few would say that the conditions then would apply to now.

Based on such historical measures, the unemployment rate could still be reduced substantially from where it is now before the labor market would be so tight as to cause problems.  Economists debate what that rate might be at any given time, but personally I would say that a reasonable target would be no higher than 4 1/2%, and perhaps as low as 4%.

But rather than try to predict what the full employment rate of unemployment might be, one can follow a more operational approach of continuing to push down the rate of unemployment until one sees whether upward wage and price pressures have developed and become excessive.  That is how the Fed operates and determines what policy stance to take on interest rates.  And there is absolutely no sign whatsoever that there is such upward wage or price pressure currently, with the unemployment rate of 5.6%.

As a number of the news reports on the December BLS employment report noted, while unemployment has come down, estimated hourly earnings in December also fell by 5 cents from the previous month (to $24.57 for all private non-farm jobs, from $24.62 the previous month).  Such a one-month change is not really significant, and could be due to statistical fluctuations (as the data comes from a survey of business establishments).  But what is significant is that average hourly earnings in recent years have only kept pace with low inflation of less than 2% a year.  In real terms, wages today are almost exactly the same as they were in late 2008.  This has been the case even though labor productivity is about 10% higher now than in late 2008 (this figure is an estimate, as the GDP figures for the fourth quarter of 2014 have not yet been reported).  In a properly functioning labor market, real wage growth will be similar to labor productivity growth.  But high unemployment since the 2008 downturn has weakened labor’s bargaining position, leaving real wages flat.

Government policy, including actions by the Fed, should be to keep the expansion going at as fast a pace as possible until unemployment has fallen so low that one sees upward pressures on wages and hence prices.  As I noted above, I would not expect to see that until the unemployment rate falls below 4 1/2%, and quite possibly below 4%.

How Much Was Bank Regulation Weakened in the New Budget Bill? And What Can Be Done Now?

A.  Introduction

In a rare, late-night and weekend, session, the US Senate on Saturday night passed a $1.1 trillion government funding bill to keep the government running through to the end of fiscal year 2015 (i.e. until September 30, 2015).  The House had passed the bill on Thursday, and it has now gone to Obama for his expected signature.  Had it not been passed, the government would once have been forced to shut down due to lack of budget authority.  It was a “must-pass” bill, and as such, was a convenient vehicle for a number of provisions which stood little chance to pass on their own, but which could only be blocked by opponents now at the cost of forcing a government shutdown.  The specific provisions included were worked out in a series of deals and compromises between the leadership of the Republican-controlled House and the now Democrat-controlled (but soon to be Republican-controlled) Senate.

One such provision was an amendment to the Dodd-Frank Wall Street reform bill, originally passed in July 2010, which enacted a series of measures to strengthen the regulatory framework for our financial sector.  The failure of this framework had led to the 2008 economic and financial collapse in the last year of the Bush administration.  The amendment in the new budget bill addressed just one, and some would say relatively minor, provision in Dodd-Frank.  But its inclusion drew heavy criticism from liberal Democrats, led by Senator Elizabeth Warren of Massachusetts.  Senator Warren argued that the amendments to Section 716 of Dodd-Frank would “would let derivatives traders on Wall Street gamble with taxpayer money and get bailed out by the government when their risky bets threaten to blow up our financial system.”  The amendments were reportedly first drafted by lobbyists for Citibank, and would benefit primarily a very small group of large Wall Street banks.

The amendments do reflect a backwards step from the tighter controls on risk that Dodd-Frank had provided for.  In my view, it would have been better to have kept the original provisions on the issue in Dodd-Frank.  But with a positive response now by the regulators to the reality of this new provision, the impact could be negated.  This blog post will discuss what was passed, what could be done now by bank regulators to address the change, and the politics of it all.

B.  The Amendment to Dodd-Frank, and the Economics of Derivatives

The amendment to Dodd-Frank addresses one specific provision in a very large and comprehensive bill.  An important link in the 2008 financial collapse was the risk major banks had carried on their books from certain financial derivative instruments.  “Derivatives” are financial instruments that derive their price or value from the price or value of some other product.  For example, oil derivatives derive their value from the price of oil (perhaps the price of oil at some future date), foreign exchange derivatives are linked to foreign exchange rates, credit default swaps are linked to whether there is a default on some bond or mortgage or other financial instrument, and so on.

Derivatives can be quite complicated and their pricing can be volatile.  And they can lead to greater, or to reduced, financial risk to those who hold them, depending on their particular situation.  For example, airlines must buy fuel to fly their planes, and hence they will face oil price risk.  They can hedge this risk (i.e. face reduced risk) by buying an oil derivative that locks in some fixed price for oil for some point in the future.  An oil producer similarly faces an oil price risk, but a bad risk for it is the opposite of what the airline faces:  The oil producer gains when the price of oil goes up and loses when it goes down.  Hence both the airline and the oil producer can reduce the adverse risk each faces by entering into a contract that locks in some future price of oil, and derivative instruments are one way to do this.  Banks will often stand in the middle of such trades, as the buyer and the seller of such derivative instruments to the airlines and the oil producers (in this example), and of course to many others.

Derivatives played an important role in the 2008 collapse.  As the housing bubble burst and home prices came down, it became clear that the assumptions used for the pricing of credit default swaps on home mortgages (derivatives which would pay to the holder some amount if the underlying mortgages went into default) had been badly wrong.  Credit default swaps had been priced on the assumption that some mortgages here and there around the US might go into default, but in a basically random and uncorrelated manner.  That had been the case historically in the US, for at least most of the time in the last few decades (it had not always been true).  But this ignored that a bubble could develop and then pop, with many mortgages then going into default together.  And that is what happened.

Dodd-Frank in no way prohibits such derivative instruments.  They can serve a useful and indeed important purpose.  Nor did Dodd-Frank say that bank holding companies could no longer operate in such markets.  But what Section 716 of Dodd-Frank did say was that banks that took FDIC-insured deposits and which had access to certain credit windows at the Federal Reserve Board, would not be allowed, in those specific corporate entities, also to trade in a specifically defined set of derivatives.  That list included, most notably, credit default swaps that were not traded through an open market exchange, as well as equity derivatives (such as on IBM and other publicly traded companies) and commodity derivatives (such as for oil, or copper, or wheat).  The bank holding companies could still set up separate corporate entities to trade in such derivatives.  Thus while Citigroup, for example, could set up a corporate entity owned by it to trade in such derivatives, Citibank (also owned by Citigroup), with its FDIC-insured deposits and with its access to the Fed, would not be allowed to trade in such derivatives.  That will now change.

It is also worth highlighting that under Dodd-Frank, banks with FDIC-insured deposits could still directly trade in such derivatives as interest rate swaps, foreign exchange derivatives, and credit default swaps that were cleared through an organized public exchange.  That had always been so, and will remain so.  The banks could also always hedge their own financial positions.  But they will now be allowed to trade directly (and not simply via an associated company under the same holding company) also in the narrow list of derivative instruments described above.

It is arguable that this is not a big change.  All it does is allow bank holding companies to keep their trading in such derivative instruments in the banks (with FDIC-insured deposits) that they own, rather than in separately capitalized entities that they also own.  The then Chairman of the Federal Reserve Ben Bernanke noted in testimony in front of a House panel in 2013 that “It’s not evident why that makes the company as a whole safer.”

So why do banks (or at least certain banks) want this?  Banks with FDIC-insured deposits and who also have access to certain credit windows at the Fed, are seen in the market as enjoying a degree of support from the government, that other financial entities do not enjoy.  The very largest of these banks may be viewed as “too-big-to-fail”, since the collapse of one or more of them in a financial crisis would in turn lead to a financial cataclysm for the country.  Thus depositors and other lenders are willing to place their money with such institutions at a lower rate of interest than they would demand in other financial institutions.

Thus Senator Warren and others charge that the amendments to Dodd-Frank “would let derivatives traders on Wall Street gamble with taxpayer money and get bailed out by the government when their risky bets threaten to blow up our financial system”, as quoted above.  To be more precise (and less eloquent), any bank with FDIC-insured deposits will make investments with those deposits, those investments will have varying degrees of risk, and if there is a threat that they will fail, the government may decide that it is better for the country to extend a financial lifeline to such banks (as they did in 2008) rather than let them fail.  The amendments to Dodd-Frank will allow these banks to invest in a broader set of derivative contracts directly (rather than only at the holding company level) than they could have before.  Thus they could end up investing directly in a riskier set of assets than they could have before without this amendment, and all else being equal, there could then be a higher risk that they will fail.

Finally, it should be noted that the amendments to Dodd-Frank will benefit largely only four very large banks.  The most recent quarterly report from the Office of the Comptroller of the Currency indicates that just four big banks (Citibank, JP Morgan Chase, Goldman Sachs, and Bank of America) account for 93% of derivative contract exposure among banks (as of June 30, 2014).  While this figure includes all types of derivatives, and not just those on the list that is at issue here, it is clear that trading in such instruments is highly concentrated.

C.  What Can Be Done Now? 

Over the objections of Senator Warren and others, the amendments to Section 716 of Dodd-Frank have been passed as part of the budget bill.  Banks, and in practice a limited number of very large banks, will now be able to take on a riskier set of assets on their balance sheets.  But Dodd-Frank, and indeed previous bank regulation, has established a bank regulatory and supervision regime that requires that banks hold capital sufficient, under reasonable estimates of the risks they face, to keep them out of insolvency and an inability then to repay their depositors.  The bank regulatory and supervision framework was clearly inadequate before, as the 2008 collapse showed.  Dodd-Frank has strengthened it considerably.  The specific rules are now being worked out, and like all such rules will evolve over time as experience dictates.

The amendments to Section 716 of Dodd-Frank will now change the set of risks the banks will possibly face.  I would suggest that now would be a good time for current Fed Chair Janet Yellen, or one of the other senior bank regulators heading up the process or even President Obama himself, to make a statement that they will of course follow the dictate of the law (as spelled out in Dodd-Frank, as it still stands) to take into account these possible new risks as they work out the capital adequacy ratios for the banks that will be required.

Specifically, the statement should make clear that the capital ratios required of banks that trade in these newly allowed instruments will now have to be set at some higher level than would previously have been required, due to the higher risks of such assets now in their portfolio.  It could and should be made clear that the law requires this:  The regulators are required to determine what the capital ratios must be on the basis of the risks being held by the banks in their portfolios.  How much higher the capital ratios will need to be will depend on the riskiness of these new assets compared to what the banks previously invested in, and how significant such new assets will be in their portfolios.  It is quite possible that faced with such higher capital requirements, the banks that had pushed for this new latitude will decide that it would be wiser not to enter into those new markets after all.  They may well come to regret that they pushed so strongly for these amendments to Dodd-Frank.

This is perhaps not the best solution.  The prohibition on direct trading in the proscribed list of certain financial derivative instruments is cleaner and clearer.  Most importantly, while current bank regulators may use their authority to ensure banks hold sufficient capital to reflect the greater risk in their portfolio, there is the danger that regulators appointed by some future president may not exercise that authority as wisely or as carefully.  This was indeed the fundamental underlying problem leading up to the 2008 collapse.  The Bush administration was famously anti-regulation, and Bush appointed officials who were often opposed to the regulations they were in office to enforce.  In at least some cases, the officials appointed who were not even competent to carry out their enforcement obligations.  For example, Bush famously appointed former Congressman Christopher Cox as head of the SEC.  The SEC at the time had the obligation to regulate investment banks such as Lehman Brothers, Goldman Sachs, and Morgan Stanley.  As Lehman Brothers collapsed, with worries that Goldman Sachs, Morgan Stanley, and others would soon be next, Christopher Cox was at a loss on what to do, and was largely by-passed.  Dodd-Frank changed regulatory responsibility (the Fed and other financial regulators are now clearly responsible, where Goldman Sachs and Morgan Stanley had already been “encouraged” to become formal banks and as such subject to Fed oversight), but there is the risk that some future president will choose, like Bush, to put in place figures who either do not believe in, or are not capable of, serious financial supervision and oversight.

In addition, financial crises are always a surprise.  They occur for some unexpected reason.  If they were expected, actions could be taken to address the causes, and they would not happen and hence not be observed.  But surprises happen.  Hence Dodd-Frank, and indeed all financial regulation, includes an overlapping and mutually reinforcing set of measures to try to ensure crises will not occur and that banks will not become insolvent should they occur.  One does not know beforehand which of the regulatory measures might be the critical one for some future and unforeseen set of circumstances leading to a crisis.  it is therefore wise to include what others might call redundancies.  The amendment to Dodd-Frank will remove one of the possibly redundant measures to ensure bank safety.  The remaining measures (e.g. the capital adequacy requirements) may well suffice to address the safety issue, but in cases like this, redundancy is better.

D.  The Politics of It All

While the economics may suggest that the change resulting from the amendment to Dodd-Frank need not be catastrophic if regulators respond wisely, and hence that the amendment is not such a big deal, the politics might be different.

The biggest concern is that many see this as possibly the opening round of a series of amendments to Dodd-Frank and other laws identified with the Obama administration, that a Republican Congress and now Senate will push through on “must-pass” legislation such as budget bills.  Particularly if this had slipped through quietly, with little public attention until after the bill had been passed, the bankers and their Republican representatives could have seen this as a model of how to pass changes to legislation that would not otherwise have gone through.  While the model is certainly not a new one, its affirmation in this instance would have strengthened their case.

The loud objections by Senator Warren and others has served to bring daylight to the changes in financial regulation being proposed.  This will hopefully make it more difficult to push through further, possibly much more damaging, changes to Dodd-Frank at the behest of the banks.

Ensuring attention was paid to the issue also served to make clear who in the House and the Senate are in fact in favor of bank bailouts.  Weakening Dodd-Frank will increase the likelihood (even if only marginally so) that bank bailouts will be necessary in some future crisis to protect FDIC insured deposits and to protect the economy from a full financial collapse.  Republicans, including in particular Tea Party supported Republicans, have asserted they are against bank bailouts.  But their actions here, with the Dodd-Frank amendments inserted into the budget bill at the insistence of the House Republican leadership, belies that.

The actual economic substance of the Dodd-Frank amendments might therefore be limited, especially if there is now the regulatory response that should be required in the environment of certain banks holding more risky assets.  But the politics may be quite different, and could explain why there was such a vociferous response by Senator Warren and others to this ultimately successful effort to weaken a provision in Dodd-Frank.

The Impact of Austerity Policies on Unemployment: The Contrast Between the Eurozone and the US

Unemployment Rates - Eurozone and US, Jan 2006 to Oct 2014

A recent post on this blog looked at the disappointing growth in the Eurozone since early 2011, when Europe shifted to austerity policies from its previous focus on recovery from the 2008 economic and financial collapse.  There has indeed been no growth at all in the Eurozone in the three and a half years since that policy shift, with GDP at first falling by about 1 1/2% (leading to a double-dip recession) and then recovering by only that same amount thus far.  The recovery has been exceedingly slow, and prospects remain poor.

The consequences of the shift to austerity can be seen even more clearly in the unemployment figures.  See the chart above (the data comes from Eurostat).  Unemployment in Europe rose sharply starting in early 2008 and into early 2009.  But it then started to level off in late 2009 and early 2010 following the stimulus programs and aggressive central bank programs launched in late 2008.  Unemployment in the US followed a similar path during this period, and for similar reasons.

But the paths then diverged.  After peaking in early 2010 at about 10% and then starting to come down, the unemployment rate in the Eurozone switched directions and started to rise again in mid-2011.  It reached 12.0% in early 2013 and has since come down slowly and only modestly to a still high 11.5% currently.  In the US, in contrast, the unemployment rate reached a peak of 10.0% in October 2009, and has since fallen more or less steadily (with bumps along the way) to the current 5.8% (as of October 2014).  It has been a slow recovery, but at least it has been a recovery.

This divergence began in 2010, as Europe shifted from its previous expansionary stance to austerity.  Influential Europeans, in particular German officials and Jean-Claude Trichet (then the head of the European Central Bank) argued that not only was austerity needed, but that austerity would be expansionary rather than contractionary.  We now see that that was certainly not the case:  GDP fell and unemployment rose.

The most clear mark of that shift in policy can be found in the actions of the European Central Bank.  ECB interest rates had been kept at a low 0.25% for its Deposit Facility rate (one of its main policy rates) for two years until April 2011.  The ECB then raised the rate to 0.50% on April 13, and to 0.75% on July 13, 2011.  But European growth was already faltering (for a variety of reasons), and it was soon recognized by most that the hike in ECB interest rates had been a major mistake.  Trichet left office at the end on his term on November 1, replaced by Mario Draghi.  On November 9 the ECB Board approved a reversal.  The Deposit Facility rate was cut to 0.50% that day, to 0.25% a month later on December 11, and to 0.00% on July 11, 2012.

Fiscal policy had also been modestly expansionary up to 2010, as monetary policy had been up to that point, but then went into reverse.  Unfortunately, and unlike the quick recognition that raising central bank interest rates had been a mistake, fiscal expenditures have continued to be cut since mid-2010.

Germany in particular called for cuts in fiscal spending for the members of the Eurozone, and forced through a significantly stricter set of rules for fiscal deficits and public debt to GDP ratios for Eurozone members.  Discussions began in 2010, amendments to the existing “Stability and Growth Pact” were approved on March 11, 2011, and a formal new treaty among Eurozone members was signed on March 2, 2012.  The new treaty (commonly referred to as the Fiscal Compact) mandated a balanced budget in structural terms (defined as not exceeding 0.5% of GDP when the economy was close to full employment, with a separate requirement of the deficit never exceeding 3% of GDP no matter how depressed the economy might be).  Financial penalties would be imposed on countries not meeting the requirements.

The result was cuts to fiscal expenditures:

Govt Expenditures, Real Terms - Eurozone and US, 2006Q1 to 2014 Q2 or Q3

Government fiscal expenditures in the Eurozone had been growing in real terms in line with real GDP up to 2008, at around 2 to 3% a year.  With the onset of the crisis, fiscal expenditures at first grew to counter the fall GDP.  But instead of then allowing fiscal expenditures to continue to grow even at historical rates, much less the higher rates that would have been warranted to offset the fall in private demand during the crisis, fiscal expenditures peaked in mid-2010 and were then cut back.  By 2014 they were on the order of 14 to 15% below where they would have been had they been allowed to keep to their historical path.  This has suppressed demand and therefore output.

The path of US real government expenditures is also shown on the graph.  Note that government expenditures here include all levels of government (federal, state, and local), and include all government expenditures including transfers (such as for Social Security).  Government expenditures for the Eurozone are defined similarly.  The US data comes from the BEA, while the Eurozone data comes from Eurostat.

Government expenditures in the US also peaked in 2010, as they had in the Eurozone, and then fell.  This has been discussed in previous posts on this blog.  But while US government expenditures fell after 2010, they had grown by relatively more in the period leading up to 2010 than they had in the Eurozone, and then fell by relatively less.  They have now in 2014 started to pick up, mostly as a consequence of the budget deal reached last year between Congress and President Obama.  State and local government expenditures, which had been severely cut back before, have also now stabilized and started to grow as tax revenues have begun to recover from the downturn.  And in part as a result, recent GDP growth in the US has been good, with real GDP growing by 4.6% in the second quarter of 2014 and by 3.9% in the third quarter.

The fiscal path followed in the US could have been better.  An earlier post on this blog calculated that GDP would have returned to its full employment level by 2013 if government spending had been allowed to grow merely at its historical rate.  And the US could have returned to full employment by late 2011 or early 2012 if government spending had been allowed to grow at the more rapid rate that it had under Reagan.

But with the fiscal cuts, unemployment has come down only slowly in the US.  The recovery has been the slowest of any in the US for at least 40 years, and fiscal drag by itself can account for it.  But at least unemployment has come down in the US, in contrast to the path seen in Europe.