Economic Modeling in the Post Great Recession Era E-Book

John E. Silvia

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: SAS Institute Inc
• Sprache: Englisch

Seitenzahl: 465

Veröffentlichungsjahr: 2016

Beschreibung

Reality-based modeling for today's unique economic recovery Economic Modeling in the Post Great Recession Era presents a more realistic approach to modeling, using direct statistical applications to address the characteristics and trends central to current market behaviors. This book's unique focus on the reality of today's markets makes it an invaluable resource for students and practitioners seeking a comprehensive guide to more accurate forecasting. While most books treat the economy as if it were in a vacuum, building models around idealized or perception-biased behaviors, this book deals with the economy as it currently stands--in a state of recovery, limited by financial constraints, imperfect information, and lags and disparities in price movements. The authors identify how these characteristics impact various markets' behaviors, and quantify those behaviors using SAS as the primary statistical tool. Today's economy bears a number of unique attributes that usual modeling methods fail to consider. This book describes how to approach modeling based on real-world, observable data in order to make better-informed decisions in today's markets. * Discover the three economic characteristics with the greatest impact on various markets * Create economic models that mirror the current post-recession reality * Adopt statistical methods that identify and adapt to structural breaks and lags * Factor real-world imperfections into modeling for more accurate forecasting The past few years have shown a clear demarcation between policymakers' forecasts and actual outcomes. As the dust settles on the Great Recession, after-effects linger--and impact our current recovery in ways that diverge from past experience and theoretical expectations. Economic Modeling in the Post Great Recession Era provides comprehensive guidance grounded in reality for today's economic decision-makers.

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Economic Modeling in the Post Great Recession Era

Incomplete Data, Imperfect Markets

John Silvia

Azhar Iqbal

Sarah Watt House

Cover image: © styleTTT/iStockphoto Cover design: Wiley

Copyright © 2017 by John Silvia, Azhar Iqbal, and Sarah Watt House. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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ISBN 978-1-119-34983-9 (Hardcover) ISBN 978-1-119-35082-8 (ePub) ISBN 978-1-119-35086-6 (ePDF)

To Jack, Ellery, William, Francis, Isaac, and Michael

Brutus, Caesar, and Diesel

Shahkora and Mohammad Iqbal, Nargis, Saeeda, Shahid, and Noreen

Ken & Gingie and Mark & Millie

And to the family and friends who remain our wellsprings of inspiration

In memoriam

To Lorrie DeGraffenreid Tubbs, teacher and principal, who was one of the initial white teachers to go into Memphis's historically black schools at the initiation of desegregation

CONTENTS

Preface/Justification

FOUR CHARACTERISTICS OF A LESS-THAN- PERFECT ECONOMY

WHY THIS BOOK?

Acknowledgments

CHAPTER 1 Setting the Context

THE PROBLEM WITH UNCRITICAL ASSUMPTIONS IN A LESS-THAN-PERFECT ECONOMY

THE PROBLEM WITH MODELS IN AN IMPERFECT ECONOMY

FOUR CHARACTERISTICS OF A LESS-THAN-PERFECT ECONOMY

ECONOMIC POLICY INCONSISTENCIES—THE PARABLE OF STRANGE BEDFELLOWS

NOTES

CHAPTER 2 Dynamic Adjustment in an Economy:

Frictions Matter

INTRODUCTION

QUANTIFYING FRICTIONS: IS THE LONG-RUN AVERAGE A USEFUL GUIDE FOR THE FUTURE?

MODELING DYNAMIC ADJUSTMENT DUE TO ECONOMIC FRICTIONS: DECISION MAKING IN AN EVOLVING WORLD

DYNAMIC ECONOMIC ADJUSTMENT: AN EVOLUTION UNTO ITSELF

Appendix

A CASE FOR THE MULTIPLE MARKETS: 1983–2008

THE LABOR MARKET: 1983–2008

NOTES

CHAPTER 3 Information:

Past Imperfect, Present Incomplete, Future Uncertain

STORY BEHIND THE NUMBERS

CONCLUSION

NOTES

CHAPTER 4 Price Adjustment and Search for Equilibrium

WHAT BARRIERS ARE THERE TO PERFECTLY FLEXIBLE PRICES?

IMPLICATIONS

FINDING DYNAMIC ADJUSTMENT IN THE DATA

CONCLUSION

NOTES

CHAPTER 5 Business Investment:

This Time is Different

DRIVERS OF BUSINESS SPENDING

PUTTING IT ALL TOGETHER: EXPLAINING SLOW RECOVERY IN CAPITAL INVESTMENT

NOTES

CHAPTER 6 Corporate Profits:

Reward, Incentive, and That Standard of Living

INTRODUCTION: PROFITS AS ESSENTIAL PARTNER

THE ROLE OF PROFITS IN THE ECONOMIC CYCLE: FIVE DRIVERS

THE ROLE OF PROFITS: INCENTIVES AND REWARDS

CONCLUDING REMARKS: MODELING PROFITS

NOTES

CHAPTER 7 Labor Market Evolution:

Implications for Private-Sector and Public-Policy Decision Makers

PART I: LABOR MARKET IMPERFECTIONS

PART II: HETEROGENEITY IN THE LABOR MARKET

PART III: HOW DO SECULAR LABOR MARKET TRENDS IMPACT ECONOMIC POLICY?

NOTES

CHAPTER 8 Inflation:

When What You Get Isn’t What You Expect

INTRODUCTION

WHAT IS INFLATION?

WHY DOES INFLATION MATTER?

WHAT DETERMINES INFLATION?

INFLATION AFTER THE GREAT RECESSION

APPLICATION: PREDICTING IF CENTRAL BANKS CAN ACHIEVE PRICE STABILITY

NOTES

CHAPTER 9 Interest Rates and Credit:

Capital Markets in the Post–Great Recession World

IMPERFECT GUIDANCE IN AN UNCERTAIN WORLD

A LOOK AT ACTUAL HISTORY OVER THE LONG RUN

CREDIT AND ADMINISTERED RATES

IMPERFECT INFORMATION AND CREDIT

CONCLUSION: SHIFT FROM HISTORICAL BENCHMARKS

NOTES

CHAPTER 10 Three-Dimensional Checkers:

Open Economy, Capital Flows, and Exchange Rates

NEWTON’S THIRD LAW

INTRODUCING A NEW PRICE TO THE ANALYSIS: THE ROLE OF EXCHANGE RATES

THREE-DIMENSIONAL CHECKERS ON AN INTERNATIONAL PLAYING FIELD

A PERFECT MODEL IN AN IMPERFECT WORLD

CONCLUDING REMARKS: FUTURE LOOKS DIFFERENT

NOTES

CHAPTER 11 Assessing Economic Policy in an Imperfect Economy

GENERALIZED POLICY MODEL

RULES AND REPUTATION: BEYOND ECONOMIC BENCHMARKS

CONFRONTING OUR THREE MARKET IMPERFECTIONS

ECONOMIC POLICY IN THE CONTEXT OF AN IMPERFECT ECONOMY

NOTES

About the Authors

JOHN E. SILVIA

AZHAR IQBAL

SARAH WATT HOUSE

Index

EULA

List of Tables

Chapter 2

Table 2.1

Table 2.2

Table 2.3

Table 2.4

Table 2.5

Table 2.6

Table 2.7

Table 2.8

Chapter 4

Table 4.1

Chapter 6

Table 6.1

Table 6.2

Table 6.3

Table 6.4

Chapter 7

Table 7.1

Table 7.2

Table 7.3

Chapter 9

Table 9.1

Table 9.2

Table 9.3

Table 9.4

Table 9.5

Table 9.6

Table 9.7

Table 9.8

Table 9.9

Table 9.10

Table 9.11

Chapter 10

Table 10.1

Table 10.2

Table 10.3

Table 10.4

Table 10.5

Table 10.6

Table 10.7

Table 10.8

Table 10.9

Table 10.10

List of Illustrations

Chapter 1

Figure 1.1

Deviation from the Long-Run Trend

Figure 1.2

10-Year Treasury Yields

Figure 1.3

ERM Breakup

Figure 1.4

Swiss Exchange Rate

Figure 1.5

The Beveridge Curve

Figure 1.6

U-6 Unemployment

Figure 1.7

Real GDP Changes—CAGR

Figure 1.8

Gross Domestic Product vs. Income

Figure 1.9

Index of Economic Policy Uncertainty

Chapter 2

Figure 2.1

Fed Funds Rate

Figure 2.2

Unemployment Rate

Figure 2.3

Part-Time Workers for Economic Reasons

Figure 2.4

The Beveridge Curve

Figure 2.5

Labor Market Example

Figure 2.6

S&P 500 Index

Figure 2.7

Consumer Confidence Index

Figure 2.8

Productivity—Total Nonfarm

Figure 2.9

The Labor Market Index

Figure 2.10

M2 Money Supply Growth vs. PCE Inflation

Figure 2.11

Nonfarm Employment Growth

Figure 2.12

Industrial Production

Figure 2.13

Long-Term Unemployment

Figure 2.14

H-P Filter–Based Long-Run Trend of Employment

Figure 2.15

H-P Filter–Based Long-Run Trend of Unemployment Rate

Figure 2.16

H-P Filter–Based Long-Run Trend of Fed Funds Rate

Figure 2.17

H-P Filter–Based Long-Run Trend of Productivity

Figure 2.18

H-P Filter–Based Long-Run Trend of Housing Starts

Figure 2.19

H-P Filter–Based Long-Run Trend of Broad Dollar Index

Figure 2.20

H-P Filter–Based Long-Run Trend of Consumer Confidence

Figure 2.21

H-P Filter–Based Long-Run Trend of Industrial Production

Figure 2.22

Unemployment Rate: 1983–2015

Figure 2.23

Labor Force Participation Rate: 1983–2015

Figure 2.24

Average Hourly Earnings: 1983–2015

Figure 2.25

PCE Deflator: 1983–2015

Figure 2.26

Unemployment Rate: 1983–2015

Figure 2.27

S&P 500: 1983–2015

Figure 2.28

Housing Starts: 1983–2015

Figure 2.29

Industrial Production: 1983–2015

Figure 2.30

PCE Deflator: 1983–2005

Figure 2.31

Unemployment Rate: 1983–2005

Figure 2.32

S&P 500: 1983–2005

Figure 2.33

Housing Starts: 1983–2005

Figure 2.34

Industrial Production: 1983–2005

Figure 2.35

Unemployment Rate: 1983–2005

Figure 2.36

Labor Force Participation Rate: 1983–2005

Figure 2.37

Average Hourly Earnings: 1983–2005

Figure 2.38

PCE Deflator: 1983–2008

Figure 2.39

Unemployment Rate: 1983–2008

Figure 2.40

S&P 500: 1983–2008

Figure 2.41

Housing Starts: 1983–2008

Figure 2.42

Industrial Production: 1983–2008

Figure 2.43

Unemployment Rate: 1983–2008

Figure 2.44

Labor Force Participation Rate: 1983–2008

Figure 2.45

Average Hourly Earnings: 1983–2008

Chapter 3

Figure 3.1

10-Year Yield on June 2, 2014

Figure 3.2

High-Yield Spreads

Figure 3.3

Baker-Hughes Rig Count

Figure 3.4

Federal Reserve Balance Sheet

Figure 3.5

U.S. Consumer Price Index

Figure 3.6

Unemployment Rate

Figure 3.7

The Beveridge Curve

Figure 3.8

Labor Costs

Figure 3.9

S&P 500 Index vs. Nonfarm Payrolls

Figure 3.10

S&P 500 Index vs. Nonfarm Payrolls

Figure 3.11

AR(1) Forecast Variance

Figure 3.12

FHFAHPI/Per Capita Income

Chapter 4

Figure 4.1

New Home Sales and Prices

Figure 4.2

Rise of E-Commerce

Figure 4.3

Oil Futures Contracts

Figure 4.4

Swiss Exchange Rate

Figure 4.5

Thailand Currency and FX Reserves

Figure 4.6

Natural Real Rate of Interest Estimate

Figure 4.7

Existing Home Sales IRF

Figure 4.8

Home Prices IRF

Figure 4.9

Existing Home Inventory IRF

Chapter 5

Figure 5.1

Real GDP and Equipment Investment

Figure 5.2

Potential GDP Revisions

Figure 5.3

Equipment Spending Share Cycles

Figure 5.4

Total Capacity Utilization

Figure 5.5

Current-Cost Average Age of Private Fixed Assets

Figure 5.6

Real Interest Rates

Figure 5.7

High-Yield Spreads

Figure 5.8

Core Capital Goods Orders vs. Equipment Spending

Figure 5.9

Capital Expenditures vs. Internally Generated Funds

Figure 5.10

Index of Economic Polity Uncertainty

Chapter 6

Figure 6.1

Corporate Profits before Taxes and Nominal GDP

Figure 6.2

Nonfinancial Corporate Profits vs. Capacity Utilization

Figure 6.3

GDP Deflator vs. Unit Labor Costs

Figure 6.4

Personal Income Sources

Figure 6.5

Decomposing NFC Ratio

Figure 6.6

Decomposing Corporate Profits

Figure 6.7

CPI vs. Unit Labor Costs

Figure 6.8

Productivity, Compensation Unit Labor Costs: Nonfarm

Figure 6.9

Nonfarm Productivity vs. Corporate Profits

Figure 6.10

Unit Labor Costs vs. Corporate Profits

Figure 6.11

After-Tax Corporate Profits vs. Dividend Income

Figure 6.12

Dividends as a Share of Personal Income

Figure 6.13

After-Tax Corporate Profits vs. S&P 500 Index

Figure 6.14

U.S. Merger-and-Acquisition Volume and S&P 500 Index

Figure 6.15

After-Tax Corp. Profits vs. Bank Loans

Figure 6.16

After-Tax Corporate Profits vs. Baa Corporate Bond Spread

Figure 6.17

Financing Gap

Figure 6.18

After-Tax Corporate Profits vs. Research & Development

Figure 6.19

After-Tax Corporate Profits vs. Business Fixed Investment

Figure 6.20

Corporate Profits Growth Forecasts

Figure 6.21

NFC Ratio Forecasts

Chapter 7

Figure 7.1

Natural Rate of Unemployment

Figure 7.2

Nonfarm Payrolls Trend

Figure 7.3

Unemployment Rate Trend

Figure 7.4

Broad Unemployment

Figure 7.5

Hirings and Separations

Figure 7.6

Quits vs. Layoffs

Figure 7.7

Median Duration of Unemployment

Figure 7.8

Unemployment Rate by Duration

Figure 7.9

The Beveridge Curve

Figure 7.10

Unemployment Rate

Figure 7.11

Part-Time for Economic Reasons

Figure 7.12

U.S. Labor Force Participation Rate

Figure 7.13

Unemployment Rate

Figure 7.14

Involuntary Part-Time Workers

Figure 7.15

Employment by Gender

Figure 7.16

Labor Force Participation Rate

Figure 7.17

Labor Force Participation and Demographic Shifts

Figure 7.18

Labor Force Participation Rate

Figure 7.19

Natural Rate of Unemployment

Figure 7.20

Working-Age Population Growth

Figure 7.21

Trend Employment Level

Figure 7.22

Trend Employment Monthly Change

Chapter 8

Figure 8.1

PCE Deflator

Figure 8.2

PCE Deflator vs. Core PCE Deflator

Figure 8.3

Unemployment and Wage Growth

Figure 8.4

Unemployment Rate and NAIRU

Figure 8.5

Median Inflation Expectations 5 to 10 Years Ahead

Figure 8.6

2016 Core PCE Projections

Figure 8.7

Federal Reserve Balance Sheet

Figure 8.8

U.S. Output Gap

Figure 8.9

Excess Bank Reserves

Figure 8.10

M2 Money Supply Velocity

Figure 8.11

Nonfarm Labor Productivity

Figure 8.12

Personal Income Sources

Figure 8.13

Eurozone Consumer Price Inflation

Figure 8.14

Swiss Consumer Price Index

Figure 8.15

Non-Petroleum Import Prices vs. Dollar

Figure 8.16

Core Goods vs. Core Services CPI

Figure 8.17

World Consumer Price Inflation

Figure 8.18

The Six-Months-Ahead Probability of Price Scenarios in Advanced Economies

Figure 8.19

The Six-Months-Ahead Probability of Price Scenarios in the United States

Figure 8.20

The Six-Months-Ahead Probability of Price Scenarios in the Eurozone

Figure 8.21

The Six-Months-Ahead Probability of Price Scenarios in Japan

Figure 8.22

The Six-Months-Ahead Probability of Price Scenarios in the Global Economy

Chapter 9

Figure 9.1

Appropriate Pace of Policy Firming

Figure 9.2

Net Percentage of Banks Tightening Standards

Figure 9.3

Real 1-Year Treasury Yield

Figure 9.4

10-Year Government Interest Rates

Figure 9.5

Taylor Rule Implied Funds Rate

Figure 9.6

Foreign Private Purchases of U.S. Securities

Figure 9.7

Yield Curve Spread

Figure 9.8

PCE Deflator vs. Core PCE Deflator

Figure 9.9

Real Treasury Yields

Figure 9.10

Tobin’s Q

Figure 9.11

High-Yield Spreads

Figure 9.12

Household Debt Delinquencies

Figure 9.13

Natural Real Rate of Interest Estimate

Figure 9.14

Potential GDP Revisions

Figure 9.15

FOMC Longer-Term Fed Funds Rate Forecast

Figure 9.16

U.S. Treasury Yields

Figure 9.17

Real Treasury Yields

Figure 9.18

Central Bank Holdings of Sovereign Debt

Figure 9.19

Forward Earnings and Corporate Yields

Chapter 10

Figure 10.1

Consumer Confidence Index®

Figure 10.2

Wells Fargo Small Business Survey and NFIB

Figure 10.3

S&P Case-Shiller Home Price Index vs. Equity Prices

Figure 10.4

Global Equity Prices

Figure 10.5

Foreign Private Purchases of U.S. Securities

Figure 10.6

Foreign Purchases of U.S. Securities

Figure 10.7

Foreign Portfolio Holdings of U.S. Securities

Figure 10.8

U.S. Capital Inflows

Figure 10.9

Japanese Interest Rates and Currency

Figure 10.10

Japanese Money Markets

Figure 10.11

European Currencies

Figure 10.12

Percent of S&P Revenues Earned Abroad

Figure 10.14

Portfolio Investment

Figure 10.15

Exchange Rates

Figure 10.16

Swiss Exchange Rate and LIBOR

Figure 10.17

Three-Month Interbank Offered Rates

Figure 10.18

Three-Month-Ahead Forward Rates

Figure 10.19

Total Capital Inflows into the United States

Figure 10.20

Foreign Direct Investment in the United States

Figure 10.21

H-P Filter–Based Trend of U.S. 10-Year Treasury Yield

Figure 10.22

H-P Filter–Based Trend of German 10-Year Bund Yield

Figure 10.23

H-P Filter–Based Trend of Italian 10-Year Government Bond Yield

Figure 10.24

H-P filter–based Trend of U.K. 10-Year Gilt Yield

Chapter 11

Figure 11.1

Unemployment and Wage Rates

Figure 11.2

The Beveridge Curve

Figure 11.3

Potential GDP Revisions

Figure 11.4

Labor Force Participation Rate

Figure 11.5

Nonfarm Labor Productivity

Figure 11.6

Income Growth during Economic Recoveries

Figure 11.7

PCE Deflator vs. Core PCE Deflator

Figure 11.8

Median Inflation Expectations 5 to 10 Years Ahead

Figure 11.9

Alternative Inflation Measures

Figure 11.10

Appropriate Pace of Policy Firming

Figure 11.11

Federal Spending

Figure 11.12

U.S. Top Household Marginal Tax Rate

Figure 11.13

Financial Obligations Ratio Total

Figure 11.14

Nonfinancial Domestic Profits

Figure 11.15

Nonfarm Sector Unit Labor Costs

Figure 11.16

Global Trade Indicators

Figure 11.17

PCE Deflator vs. Core PCE Deflator

Figure 11.18

Core Goods vs. Core Services CPI

Figure 11.19

Nominal Effective Exchange Rates

Figure 11.20

Commodity Research Bureau Index

Figure 11.21

Three-Month Interbank Offered Rates

Figure 11.22

S&P European Banks Select 15 CDS Index

Figure 11.23

High-Yield Spreads

Guide

Cover

Table of Contents

Preface

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Preface/Justification

For the entirety of the current economic expansion, outcomes have fallen short of expectations. Overall economic growth has been below perceived potential. Inflation remains persistently below the Fed's 2 percent target, while long-term unemployment remains higher and wage growth lower than anticipated. Why?

For decision makers, the deviation of actual outcomes from expected carries important lessons for how we model the actual economic environment we face rather than an idealized vision of the economic landscape that is often based on a view of the past.

Meanwhile, on the public policy front, neither fiscal nor monetary stimulus has delivered on their promised results in terms of real economic growth and jobs. For decision makers, there appears to be little guidance about the connections between idealized theoretical conditions of the economy and actual results of the current recovery.

Our challenge is to recognize that, as we saw with both the fiscal and monetary stimulus, the estimates of policy effectiveness vastly underweighted the impact of market imperfections at the time—looking at idealized conditions rather than the real economy. Broad verbal claims of economic policy effectiveness were disconnected from formal analysis of the actual economic conditions facing the economy and decision makers at the time. Hence, estimates of both fiscal and monetary multipliers were wildly overstated. Real-world conditions of very high credit and liquidity constraints, as well as high levels of policy uncertainty, were certainly present.

Unfortunately, we are now in the precarious situation of having readers of economic content and public policy pronouncements stop taking seriously any analysis of current economic conditions that purports to claim any degree of precision.

Our approach here is that we do not start with an idealized economy to draw lessons for decision makers; instead, we examine the economic world as it is—not as we imagine it. Stylized economic models are less useful for real-world decision makers. In this book, we focus on four market imperfections that persist in our economy in the current economic expansion—dynamic adjustment, imperfect information, lags in price movements, and policy uncertainty.

In contrast, idealized economic models often assume conditions of perfect competition. For example, it is often assumed that households and firms instantly react to an exogenous economic shock and move smoothly to a new equilibrium point. Second, the idealized model assumes full and complete information, but economic information is very imperfect and certainly economic policy intentions are anything but transparent. With respect to prices, it is obvious that many prices do not move instantaneously to a new equilibrium when faced with an exogenous economic shock. Moreover, there are many given, administered prices set by governments that interfere with price discovery. Finally, we are familiar with the experience of frequent changes in economic policy and, more fundamentally, uncertainty about what direction economic policy is actually taking.

FOUR CHARACTERISTICS OF A LESS-THAN- PERFECT ECONOMY

1. Economies Are Characterized by Dynamic Adjustments—Things Take Time

We are familiar with the proposition that monetary policy acts with lags, often long and variable lags. In theory, we have also begun to appreciate that the efficiency of countercyclical fiscal policy has been diminished by the recognition of significant policy implementation lags since the 1960s.

As for the private sector, alterations of consumer spending to a change in oil prices or tax incentives take place over time and with no consistent pace. This is also true of business investment, which we explore more thoroughly in Chapter 5.

2. Imperfect Information—What You See Is Not What You Get in an Imperfect Economy

During the past few years we have witnessed a series of examples where the information we see is not quite the reflection of reality.

In 2014, we had an instance where the Institute for Supply Management (ISM) manufacturing index, a key economic indicator, was released, re-released and then re-rereleased again in the same morning to correct a series of errors. This sequence created confusion in the markets, and no doubt, many missed trades and consequent capital gains and losses occurred that would not have been realized if the correct number had been initially released.

We are also very aware that, despite the monthly Bureau of Labor Statistics (BLS) releases and explanations, the public remains confused about the differences between the establishment and household surveys and how we can have job gains and a rise in the unemployment rate during the same month. Moreover, how come the number of jobs can be revised for prior months but not the unemployment rate? Additional series, such as retail sales, are also continuously revised— information remains imperfect.

3. Price Adjustment—Contracts—Hop, Skip, and Jump at the Local Gas Station

Price adjustments are not smooth in the real economy. Therefore, the economic system is in a constant state of disequilibrium, as prices do not reflect the full effect of market forces. Moreover, our forecasts seldom have time to play out, as there is often a regular sequence of market shocks over time. As all of our experience at the local gas station over the past year can attest, price changes are often not very smooth and frequently opposite in direction over short periods of time. Price adjustments reflect the judgments of sellers about the trade-off between customer satisfaction, maximizing profits, and fighting for market share.

Moreover, in the short run, price adjustments are limited by price fixing for many goods and services. Federal- and state-mandated prices are pervasive in areas such as labor (minimum wages), credit (interest rates and ATM fees), and other goods and services (utilities, rent controls, and health care). These pervasive fixed prices/federally mandated prices do not allow fully flexible prices—often in both directions.

4. Economic Policy Inconsistencies—The Parable of Strange Bedfellows

Policy inconsistencies reflect a frequent conflict between economic and political objectives and validate the volatility in the economic policy uncertainty index. Moreover, policy by polling is a growing phenomenon, and yet most of these polls are counterproductive. Frequent political polls indicate that Congress is held in low esteem and yet most congressmen are reelected—quite a disconnect. Such polls contain little information about the actual economic value or effectiveness of policy since the polling sample so often reflects the self-selected viewing or listening audience itself. In addition, the actual policy put in place reflects the influence of an entire policy influence industry—lobbyists, D.C.-based news correspondents, Fed watchers, and D.C.-based political consultants.

Moreover, policy initiatives, such as the Affordable Care Act, are subject to frequent changes that limit the ability of private actors to respond to any tentative, but unclarified, elements of the original legislation. Fiscal tax policy is subject to perennial revisions every legislative session. Trade and environmental policies are altered by federal agencies such that the initial legislation is regularly revised in action, and this thereby increases the uncertainty of the impacts of legislation and thereby limits the willingness of the private sector to react to any initial legislation.

WHY THIS BOOK?

This book is well timed after the experience of the last six years. First, there has been a clear demarcation between the forecasts of policy makers and actual outcomes, and these persistent differences have required time for contemplation. Second, by letting the dust settle, we can better identify three key facets of economic behavior that distinguish the current economic recovery from an idealized recovery and, in addition, from recoveries in the past. Our approach is to provide both some explanation and statistical perspective on the actual economic workings of the economy during the current economic recovery. Waiting for the return to a “normal” economy has become like waiting for Godot.

Instead, given the evidence of structural breaks in the economy, real economic growth has been below prerecession rates. Labor force growth and its associated participation rate have been below the trends of prior economic recoveries. Inflation, despite quantitative easing, has been below 2 percent for all six years of the expansion.

Our value proposition is simple. We apply statistical techniques to economic factors of interest for private and public decision makers in the current expansion and characterize the evolving conditions of the U.S. economy relative to the idealized model of the workings of the economy. We address several statistical techniques to address critical character economic behavior in the context of the post 2007–2009 recession economy. We recognize structural change, not fight against it, and we do not engage in wishful hoping for a return to a simpler, idealized economic landscape.

Our book appeals to a broad audience. We address four economic characteristics that are central to the actual behaviors in the economy. These are dynamic adjustment, imperfect information, lags and disparities in price movements, and, finally, economic policy uncertainty. Then we examine six aspects of the economy, one of which is the labor market, and the implications of the four economic characteristics on the actual behavior in the labor market. We apply a number of statistical techniques to identify and quantify the behavior using SAS as our primary statistical tool. The book is aimed at practitioners and both advanced undergraduate and graduate students interested in techniques to understand and evaluate in an applied manner the current economic situation.

Chapters 1 through 4 identify the fundamental challenge to our economy today—the shift in the behavior of economic growth and the three characteristics that differentiate the current recovery from the idealized model of the economy that failed to provide the guidance necessary to forecast and understand current trends.

Dynamic adjustment, Chapter 2, reflects the reality that developments in the economy take time to adjust to what would be considered an equilibrium. This is certainly true of households and firms as they adjust to economic and political shocks. Here, the role of market frictions is paramount. For example, in the labor market, both employers and potential employees cannot move instantaneously to a new equilibrium in the labor market given these frictions. In many markets there are barriers to rapid adjustment that lead to excess inventories in production, structural and long-term unemployment, and credit rationing. As suggested by Reinhart and Rogoff, the current economic recovery has been limited by financial constraints and the implementation of new financial regulations. Uncertainty and expectations also play a key role in making decisions that determine the path of economic adjustment—the difference between what was expected and what is realized drives much of economic activity.

Chapter 3 focuses on the role of information and, more specifically, the reality of a world of decision making with imperfect information, incomplete information, and less-than-exact economic models. Imperfect information is well exemplified by the repetitive revisions of economic series such as employment, retail sales, and gross domestic product (GDP) that complicate decision making. Incomplete information follows from the missing variables problem we witness every day when we don't have measures for many economic behaviors that we believe are important to understanding the economy. Finally, decision making is subject to many biases but also the uncertainty of whether the precise model we are using for decision making actually matches the behavior of the economy. Current debates on the usefulness of the Philips Curve to forecast inflation are a prime example.

Finally, price adjustments are often portrayed as smooth, with quick and direct moves to the new equilibrium after an economic shock. Instead, as we examine in Chapter 4, price adjustments are not smooth and often reverse directions; “corrections, short-covering” are frequently cited in market commentary.

Moreover, price adjustments take time to play out—they are not instantaneous. Exchange rate misalignment in the late 1990s began to correct with Thailand in May 1997, when the central bank there failed to defend the Thai baht. In August, Indonesia adopted a free-floating regime—after which their currency immediately sunk. Price movements intensified in November as those corporations that had borrowed in dollars sold rupiah to get dollars, driving the rupiah down further. In November, values on the Seoul stock exchange dramatically declined. Economic weakness then led to a lower price of oil, which led to the 1998 Russian oil crisis, followed by the failure of Long-Term Capital Management in the United States and rapid Federal Reserve actions. Our lesson is that price adjustments take place over time and across numerous markets—credit, goods, foreign exchange, labor—generating real effects over time.

Our analysis extends the text into core economic factors that matter as inputs to effective decision making. In Chapter 5, we examine one aspect of aggregate demand—business investment. In this case we examine the role of dynamic adjustment and price movements. In addition, we examine the role of imperfect information as firms estimate the future path of real final sales, interest rates, and economic policy—especially tax policy on the planned investment horizon.

In Chapter 6, we examine the often overlooked role of corporate profits in the macroeconomy, both as a return to capital and as an input to growth. Profits are both an incentive and reward. Yet profits have very high cyclical variation relative to overall economic activity, thereby creating a difficulty in interpreting the information that profits provide to decision makers. Profits cannot be taken in isolation, as corporate profits play a role in the broader economy—representing returns to savers/investors and incentives for investment.

Labor markets set the tone as the second input to growth—and as a measure of the return to labor. In Chapter 7, we highlight the patterns of this economic expansion that has made the behavior this cycle in labor so different than in the past. The heterogeneity of workers, and employers’ expectations has produced a significant amount of imperfect information between bid and offer in the labor market. Meanwhile, we have witnessed the drawn-out adjustment of both employment and the price of labor (wages) that reinforces the view that these adjustments are anything but consistent with the perfect competition model underlying most economic models.

In Chapter 8, we examine the behavior of inflation and focus on the change in price behavior over time, particularly the lack of accelerating inflation in the current expansion despite the declining labor market slack. Our work identifies the importance of structural breaks in the inflation series as a major barrier to developing a simple theory of inflation determination. Meanwhile, we put forward an early-warning system that provides for a distinct three-option outlook for inflation trends.

Combining the views on growth and inflation, our net result is to identify the structural breaks in the behavior of interest rates during the current cycle in Chapter 9. This provides us an excellent example of price discovery as the price of credit—interest rates—frequently overshoots, and then undershoots the expected equilibrium values. We also bring in the dynamic inconsistency character of a low-inflation policy by the central bank. This policy introduces another element of misinformation that increases the range of possible future values of interest rates and also adds to the forecast error.

In Chapter 10, we focus on the capital flows within the open economy model. This reflects the increasing globalization of capital markets as well as the unusual flight to safety incentive for global investors that has kept U.S. interest rates much lower than many forecasters had anticipated. What is also different during this expansion is that U.S. equity markets may also be influenced by the perception of flight to safety flows. We test this hypothesis in this chapter.

Finally, in Chapter 11, we highlight the implications of our three principles of the post–Great Recession economy and their importance for public- and private-sector decision makers. Our approach brings to decision makers three advantages when looking over the economic landscape. First, rather than an idealized approach to benchmarking economic activity, we recognize the character of the post–Great Recession economy that actually confronts decision makers. Second, we identify three aspects of economic behavior that influence the developments we actually see in product, credit, labor, and international capital markets. Third, we present statistical methods to identify the structural breaks and lags that characterize the information/adjustment issues faced by decision makers.

Acknowledgments

We would like to thank all of the people who have supported us through the writing and publication of this book. Special thanks to Alex Moehring and Michael Pugliese, for without their help this book would not be possible. We also wish to express our gratitude for the many people at Wells Fargo who have supported this project including Diane Schumaker-Krieg, Tim Sloan, and John Shrewsberry, as well as the technical support staff at Wells Fargo. Thank you Robert Crow, editor of Business Economics and the referees of that journal, as well as the referees of articles that have appeared in other journals, who have improved the quality of our research over the years. We are grateful for the instructors and students who have come through our lives and taught and inspired us (Nuzhat Ahmad, Kajal Lahiri, Asad Zaman, and Adil Siddique of SUNY-Albany).

CHAPTER 1Setting the Context

Returning from holiday on September 3, 1928, Alexander Fleming began to sort through petri dishes containing colonies of Staphylococcus, a bacterium that causes boils and sore throats.

Fleming noticed something unusual, imperfect, on one dish. The dish was dotted with colonies of bacteria, save for one area where a blob of mold was growing. The zone immediately around the mold—later identified as a rare strain of penicillin—was clear, as if the mold had secreted something that inhibited bacterial growth.

Fleming found that his “mold juice” was capable of killing a wide range of harmful bacteria. Such was the beginning of penicillin and a better life for all of us here.

In economics, it is the unusual, the imperfect, that provides the clues about the way forward—stagnation in the 1970s, tax policy and deregulation in the 1980s, and the financial crisis and subsequent reforms over the past 10 years.

THE PROBLEM WITH UNCRITICAL ASSUMPTIONS IN A LESS-THAN-PERFECT ECONOMY1

Yet in empirical work, economists are too frequently guided by a number of uncritical assumptions on how the world works. First, as economists, we must recognize and discourage straw man arguments that improperly identify the false choices in economic decisions or portray the outcomes of such decisions only in the context of an idealized economic model.

Second, we must be more critical of arguments that fail to recognize the assumption—or violation—of ceteris paribus when the outcomes of economic decisions are quite different when those ceteris paribus assumptions do not apply.

Third, we must be more critical of the simplistic view of the efficient market hypothesis—both information and foresight are not perfect.

Fourth, we must be more critical of the argument that economic markets discount all available current information, but fail to distinguish that markets are not clairvoyant for all future information.

Fifth, we must be more critical to distinguish that private market failures do not automatically imply that government can do better or do something at all.2

Finally, following the line of reasoning of Captain Barbossa, economic rules are more like guidelines rather than rules.3

THE PROBLEM WITH MODELS IN AN IMPERFECT ECONOMY

Economic outcomes rarely come about as seamlessly as predicted by theories and models. As economists, we should be more critical on overly simplistic models that assume away the complexities of the modern economy.

As economists, we should be more critical of irrelevant models that solve problems that no one is seeking to address.

As economists, we should be more critical of models that assume away the essential problem to achieve precise mathematical results in an imprecise world.

As economists, we should be more critical of essays that claim—with surprise—that no one before has looked at this problem.

As economists, we should be more critical about models that assume supply and demand balance out rapidly and unfailingly and that perfect competition reigns in markets.

As economists, we should be more critical of models that cannot assign a probability to a critical event and then rule out that critical event when that event is crucial to a fair assessment of risks. Low-probability events, with high costs, are still very expensive.

As economists, we should be more critical about models that exclude almost all consequential diversity and uncertainty of households and firms—characteristics that in many ways are fundamental to the outcomes of the actual economy. This also includes the failure to include an extensive financial sector in many models.

As economists, we should be more critical of models that are useful only in a trend economy where they are estimated—when recessions, financial instability, and periods of the unusual are the real challenge to examine.

FOUR CHARACTERISTICS OF A LESS-THAN-PERFECT ECONOMY

Dynamic Adjustments—Things Take Time

First, we are familiar with the proposition that monetary policy acts with lags, often long and variable. In theory, we have also begun to appreciate that the efficiency of countercyclical fiscal policy has been diminished by the significant recognition of policy implementation lags since the 1960s. Unfortunately, however, the distinction between temporary and permanent policy changes has been continuously lost in policy making in recent years. Milton Friedman won his Nobel Prize for the permanent income hypothesis, but the failure of the 1968 tax surcharge appears to have been forgotten by today’s policy makers. Temporary, lump-sum tax rebates are simply timing changes—not permanent action—and do not jump-start the economy. Cash for clunkers is a classic recent example. As a result, countercyclical fiscal policy has fallen by the wayside and now the focus of fiscal policy is more on long-run growth—incentives and disincentives for labor, capital, technology, and innovation.

Identifying permanent or temporary changes in economic policy has been made particularly difficult by the significant political election turnovers during the past 20 years. This has led to inconsistent economic policy and a significant shortening of time horizons for decision makers—especially for long-lived investment. In contrast to the Eisenhower vision on infrastructure—the interstate highway system—the focus today is on isolated, one-off, pork barrel projects to jump-start the economy; consider, then, the experience of Japan.

Moreover, one must think critically of the marginal cost/marginal benefit trade-off of individual infrastructure projects, not the blanket adoption of poorly specified spending programs. There must be a distinction between what we want and what we can afford, what is nice to have, and what can be justified by economic choices. Economists make choices—politicians make promises.

Second, dynamic adjustments are not symmetric across sectors of the economy. Capital moves faster than labor, cash moves faster than capital—a lesson in the current economic expansion. Asymmetric liquidity and credit constraints have limited consumption choices despite fiscal stimulus and monetary easing in the current recovery. A 10 percent increase in asset prices does not elicit an equal and opposite reaction as a 10 percent decline in asset prices within the economy. Going down stairs does not elicit the same amount of effort as going up stairs.

Third, adjustments occur not simply to new information, but when that information is different from what was expected. Markets are forward looking and discount expected future outcomes. Changes in asset prices are driven by the difference between expected and realized earnings, employment gains, inflation, and personal income patterns. Earnings, interest rates, oil prices, or regulatory actions by federal agencies or even the Supreme Court, for example, when different from market expectations, elicit significant reactions, and the movements are distinctly asymmetric.

Fourth, prices often overshoot—whether we are looking at exchange rates, interest rates, or commodity prices—oil prices in particular. Overshooting reflects the interaction between a complex of economic forces—not mere speculation. Expectations are not static; they evolve, reflecting the new information that is constantly appearing on our computer screens and the differentials between prices across markets.4

Therefore, our economy is seldom at equilibrium. Instead, there is a steady over/undershooting of prices, as illustrated in Figures 1.1 and 1.2 for inflation and 10-year U.S. Treasury rates since 1982.

Figure 1.1 Deviation from the Long-Run Trend

Source: U.S. Department of Commerce and Federal Reserve Board

Figure 1.2 10-Year Treasury Yields

Source: Federal Reserve Board

However, in many cases, prices are not allowed to completely adjust due to public policy. This creates tension and persistent disequilibrium in the markets—most recently illustrated by Greece. Exchange rates are commonly not allowed to be free—they are often managed—see the recent experience in China. Since exchange rates do not completely adjust, interest rates, inflation, and growth do not completely adjust either—a continued disequilibrium—which often leads to a sudden break such as illustrated by the European Exchange Rate Mechanism (ERM)/British pound in 1992 and the Swiss franc/euro movements in 2015 (Figures 1.3 and 1.4).

Figure 1.3 ERM Breakup

Source: Bloomberg LP

Figure 1.4 Swiss Exchange Rate

Source: Bloomberg LP

In addition, capital is not perfectly mobile—think of Japan in the 1980s and China today—and that limits the ability of interest rates, exchange rates, and the real return on physical capital to adjust and results in pent up demand/supply imbalances in capital flows over time.

Finally, we recognize that many economic series are not mean reverting, as illustrated by the outward shift in the Beveridge Curve more than six years after the labor market began to recover (Figure 1.5) and the U-6 unemployment rate (Figure 1.6).

Figure 1.5 The Beveridge Curve

Source: U.S. Department of Labor

Figure 1.6 U-6 Unemployment

Source: U.S. Department of Labor

Imperfect Information—What You See Is Not What You Get

In recent years, we have witnessed a series of examples where the information we see is not quite the reflection of reality. In mid-2014, there was an instance where the Institute for Supply Management (ISM), a key economic indicator, was released, re-released, and then re-rereleased again in the same morning to correct a series of errors. This sequence created confusion in the markets, and no doubt, many missed trades and consequent capital gains and losses that would not have occurred if the correct number had been initially released.

We are also very aware that, despite the monthly Bureau of Labor Statistics (BLS) releases and explanations, the public remains confused about the differences between the establishment and household surveys. How can there be more jobs and a rise in the unemployment rate in the same month? Moreover, how come the number of jobs can be revised for prior months but not the unemployment rate? Additional series, such as retail sales, are also continuously revised—information remains imperfect.

An Eagle That Chases Two Fish Catches Neither

In public policy and in public discussions, there is persistent confusion between relative and absolute prices. Media coverage does not make the distinction between real and nominal values—weak nominal retail sales can coexist with solid real consumer spending. As illustrated by Lucas in his 1972 paper, decision makers cannot distinguish if a price change reflects a relative price change or a change in the aggregate price level.5

Public and professional discussion continues the confusion between real and nominal prices—real wages, real interest rates, and real exchange rates drive real behavior in multiple markets, yet we continuously cite changes in nominal wages, nominal interest rates, and nominal exchange rates as drivers of economic activity.

Economic information is only one example of imperfect information. Tax and spending policy, and often nonpolicy in Washington, reflects a constant changing of the rules and rent-seeking behavior that reduces the efficiency of the economy. Tax and spending policy is constantly being changed. Uncertainties about highway funding make long-term decision making impossible. Tax cuts are phased-in and can easily be altered along the way. Obamacare, Dodd-Frank, and the many Basel Accords all generate rules—often vague and in bits and pieces—reducing the certainty of long-run credit and financial allocation decisions. Imperfect information generates imperfect decisions.

In monetary policy, the price we pay for committee-based policy making is imperfect information on the direction of monetary policy. There is a trade-off between more voices and greater transparency. There are practical trade-offs and weighing problems with multiple goals.

In labor markets, the search costs for information, as illustrated by research by Mortenson6 and Phelps,7 reflect reality in many economic sectors and the reality that nominal values can impact real economic variables—imperfect information is not neutral.

To illustrate, Figure 1.7 gives visual evidence about the ongoing debate about the persistently weak reported real gross domestic product (GDP) in the first quarter relative to the rest of the quarters since 1985. Figure 1.8 illustrates the mixed message of the discrepancy between GDP and gross domestic income (GDI).

Figure 1.7 Real GDP Changes—CAGR

Source: U.S. Department of Commerce

Figure 1.8 Gross Domestic Product vs. Income

Source: U.S. Department of Commerce

Imperfect information is obvious when we analyze the labor market. Which unemployment rate is the focus of monetary policy and financial markets? If the unemployment rate is the focus, then what added value is there to having a labor market index? Should we read the existence of a labor market index as suggesting that the unemployment rate is imperfect—as both the target of policy and a fair reading of the labor market? Our analysis indicates that the labor market index does provide some additional guidance on credit quality in the increasingly complex labor market of the twenty-first century.8

State-Dependent Pricing

Evidence suggests that economic agents follow a strategy of state-dependent pricing such that there is no simple pricing rule, but that pricing reflects the perceived state of the economy and is not simply dependent on time. What is interesting is that this is the type of pricing policy currently being followed by the Federal Reserve with respect to the federal funds rate.9 Target pricing, rather than optimal pricing, appears to more often explain market behavior. This same pattern appears consistent with monetary policy and indicates that monetary policy, under certain conditions, can have real economic effects when price adjustments are not uniform and instantaneous.

Inflation inertia in price adjustments allows for monetary policy shocks to have long-lasting effects when some prices are predetermined. Once again, if prices are initially predetermined, but not all firms adjust prices in response to a monetary shock due to sticky information, then real economic effects are the result.10 Sticky information results from the observation that it is costly to obtain and process information—so firms do not continually update prices—they choose a path for prices. This allows for the real effects of changes in monetary policy in the short run.

ECONOMIC POLICY INCONSISTENCIES—THE PARABLE OF STRANGE BEDFELLOWS

Policy inconsistencies reflect a frequent conflict between economic and political objectives and validate the volatility in the index of economic policy uncertainty (Figure 1.9). Moreover, policy by polling is a growing phenomenon, and yet we view many of these polls as counterproductive. Frequent political polls indicate that Congress is held in low esteem and yet most congressmen are reelected—a disconnect. Such polls tell us little about the actual economic value or effectiveness of policy since the polling sample so often reflects the self-selected viewing or listening audience itself.

Figure 1.9 Index of Economic Policy Uncertainty

Source: Baker, Bloom and Davis11

Moreover, the actual policy put in place reflects the influence of an entire policy influence industry—lobbyists, D.C.-based news correspondents, Fed watchers, and D.C.-based political consultants—often involved in rent-seeking behavior that may have little positive influence on real economic growth.

Furthermore, policy initiatives, such as the Affordable Care Act, are subject to frequent changes that limit the ability of private actors to respond to any tentative but unclarified elements of the original legislation. Fiscal tax policy is subject to perennial revisions every legislative session. Trade and environmental policies are altered by federal agencies, and the initial legislation is regularly revised in action, thereby increasing the level of uncertainty of the impacts of legislation, limiting the willingness of the private sector to react to any initial legislation, and dragging out the response of economic actors. The long history of tariff policy in the United States has been a study of politics above economics.