Growthology

Jobs Update: Unhappy Times are Here Again

Interesting data on the U.S. employment situation today. The payroll number (-467,000 jobs in June) is bad enough that it should chill the chatter about green shoots, mainly because it is no longer "less bad" than the month before. (Vanity "I told you so" link here).

I'm sorry I can't offer my usual picturing employment chart. New MS Excel software is not allowing me to screen capture the graphic. (Curse you, Steve Ballmer!)

And yet, I still want to share an update on the severity in the change in the unemplyment rate down to the last decimal point. According to the BLS, "Since the start of the recession in December 2007, the number of unemployed persons has increased by 7.2 million, and the unemployment rate has risen by 4.6 percentage points."  That represents a 0.1 increase, right? Not so bad.  But if you look at the 3-decimal change, it is a 0.150 increase. This, actually, is the "less bad" story worth noting, since unemployment rates tend to decelerate very quickly in a turnaround, based on historical behavior of the series.

Let's update the comparison of this recession to the double recession of the early 1980s

U.S. UNEMPLOYMENT RATES AND CHANGES IN 2 RECESSIONS
2007-        1980-                                    
9.507        10.750      Peak (so far)                 
4.902        6.271        Recession Start        
4.380        5.606        Trough
4.605        4.479        Change from NBER Start (so far)      
5.127        5.144        Change from Trough (so far)  

What this means is that (1) it is now the worst postwar NBER recession in terms of increasing unemployment rate but (2) not quite the worst in terms of the rate defined by the time series trough, barely. If initial jobless claims continue to come in over 400,000 per week, I would not be surprised at all by another half-point jump in July to a rate over 10 percent.

Political analysis. David Leonhardt really nailed a great article in the NY Times ("A Forecast with Hope Built In").  Way too much optimism by White House economists:

To make the case for a big stimulus package, they released their economic forecast for the next few years. Without the stimulus, they saw the unemployment rate — then 7.2 percent — rising above 8 percent in 2009 and peaking at 9 percent next year. With the stimulus, the advisers said, unemployment would probably peak at 8 percent late this year. We now know that this forecast was terribly optimistic. 

Ironically, the harshest critics of Obama are also overly optimistic. The White House wants to believe the stimulus is working. The critics want to believe the stimulus wasn't necessary because the economy is getting better already. Both are probably wrong. The stimulus is, in fact, poorly timed for relief in 2009, but the recession will unfortunately last long enough that the timing problem be moot.  There's still the question of effectiveness, and it will be interesting to see how that debate plays out for the next 18 months ... or more.

Forgive the typos. My keyboard is on the fritz. (Ballmer must be watching!!!)

That's Why We Need More Entrepreneurs

Scott Shane recently joined the New York Times as a blogger for the site's new You're the Boss blog and in his most recent post used a series of charts to show that the United States is actually becoming less entrepreneurial than we would like to pretend.

Professor Shane, a professor of entrepreneurship, has been an outspoken skeptic of entrepreneurial capitalism, casting doubt on the extent and benefits of entrepreneurship. His latest line of research concerns genetics and entrepreneurship, identifying "the influence of genetic factors on the variation across people in opportunity recognition." This, Professor Shane purports to demonstrate, is heritable and independent of environment, as are occupational choices in general, such as teacher or manager or self-employment. (For a critique of opportunity recognition, see this recent paper: Download Creative Discovery Innovations June 2009.)

Notwithstanding potential sampling errors, the heritability of personality traits is a breeding ground for questionable claims. As the eminent Samuel Bowles has pointed out, "data from modern economies suggest that personality influences individual success, but the effects are quite modest." Moreover, "the correlations between parental and offspring measures of personality are strikingly low." The world periodically endures genetic determinism fads, and they rarely end well. 

Plus, if entrepreneurship is solely determined by genetic inheritance, why even have professors of entrepreneurship? 

In his latest post, however, Professor Shane is onto something: whether measured by the number of new employer firms started each year or the number of new establishments, the rate of entrepreneurship has fallen over the past two or three decades. Shane uses Census data that the Kauffman Foundation has helped fund, and I published charts on the falling establishment entry rate in a recent paper. And the share of Americans working in giant firms (those with more than 10,000 employees) has slowly but steadily risen in the past decade.

But there are a few points Shane fails to make. As one of his commenters notes, there has been a rebound in new firm and establishment creation since 2002. One of the datasets only runs through 2005 and when new Census data are released in August, we should know whether or not this rising establishment formation trend continued. With regard to new firm creation (nb, employer firms, not self-employed consultants or personal services), Shane's data run only up to 2007. But the Kauffman Index of Entrepreneurial Activity showed a slight uptick in new firm creation 2008. It will also be interesting to break all of this down by industry.

So what does this mean? We've actually seen a steady increase in the number of new firms started over the past few years. Shane's point is that while absolute numbers may increase, they fail to keep pace with population growth and so the rate, firm starts per capita, actually falls. That's right. But this only highlights the crucial need for more new firms, for more entrepreneurs. As we've noted before, using that same Census data, looking back over the past thirty years, if we had taken startups out of any given year, net job creation for the overall economy would have been negative in most years. No new firms, no new jobs. No one can escape, moreover, the great lesson of economic history that entrepreneurs are disproportionately responsible for radical innovations.

But the message is much broader than this: the real source of economic growth lurking in here is firm growth. This signals market success, generates jobs, and brings with it increasing returns to ideas. So even if the rate of entrepreneurship fluctuates on an annual or decennial basis, this doesn't mean that there aren't entrepreneurial firms growing to scale during that time. This, in fact, is precisely the pattern we would expect to see: a high rate of new firm creation followed by a period of falling entrepreneurship as firms fail, consolidate, and grow. This will (or should, provided barriers to entry are kept low) be followed by yet another period of high rates of entrepreneurial activity.

Understanding the Depression Index

A week ago, I presented a new index - what I call the Depression Index - in an article at RealClearMarkets. This post explains the index in more detail.

I developed the measure to help get a grip on how bad the macroeconomic situation in the U.S. actually is, having made this same point among colleagues: "This recession is fundamentally worse and different than anything since the Great Depression for one reason (and maybe more). The only comparable spikes in unemployment in modern history happened when the central bank caused interest rates to rise, episodes in 1974 and 1980-82. This time, the Fed is pushing rates in the opposite extreme, with the same outcome." I decide to quantify my argument, but extended the logic to consider the other policy tool, counter-cyclical fiscal policy (deficit spending and lower taxes). It is also often used to fight recessions, but this tool has also been stretched to the extreme as well.

The Depression Index compares three broad measures of capacity: The Fed Funds rate, the annual budget deficit rate (annual deficits as a percentage of Gross Domestic Product), and the basic monthly unemployment rate. This first chart shows each series independently:

 

We can see that the FFO and URATE were quite stable and closely related around the 2-7 point range during 1990s and in the 5-10 point range in the mid to late 80s. They have diverged sharply now, as has the deficit rate. If anyone is interested, here is the spreadhseet with all the data and source links.

When you combine the three series, you get the depression index:
Depression Index = Fed Funds - Budget Deficit (Surplus) / GDP - Unemployment Rate

 

The current index is negative 23.1, twice as low bad as any time on record (Note: FFO data extend back to 1954). What does this mean? Well, it is easy to mock the index and suggest that the central bank just raise the FFO to 23.1 and all will be well. That works for me, as long as you are happy with the consequence of nuking the American economy. Not the point. What the index tells me, at least, is simply that policy capacity is overstretched. I tend to be dismissive of actual "depression" talk, but this index honestly makes me recognize that the macro economy is in an extraordinarily abnormal situation, and normal analytical tools, models, forecasts may not be worth very much. It also suggests the macro economy is fragile enough that any additional shocks will not be cushioned and instead cut into economy capacity severely.

Two objections to the index occur to me. One, fiscal policy is meant to be counter-cyclical but has a lag, as does monetary policy. Timing is a fair point, but difficult to resolve. A remedy would also obscure the present situation. A second criticism is that the deficit is less salient as a measure of policy capacity than budgetary debt. I am tempted to consider that, but again, it feels like there is some boundary to the amount of deficit financing that can be executed in a single year, making it a fair measure of immediate capacity.

In any case, we can consider a 2-component depression index that leaves aside fiscal policy. Consider this next chart:

Here again, we see an unprecedented policy-economy overstretch. The unemployment rate has rarely exceeded the fed funds rate by more than 4 points, touching beyond 6 just once in the summer of 1958. But now the gap is just over 9 points. In other words, our present situation defines what economists call being "out of ammo."

Unfortunately, the most recent labor data established two ominous milestones. First, the May numbers  mark the 17th recessionary month, which makes this the longest NBER declared recession (two prior "longest" recession were 16 months in duration). There's always the possibility that the NBER says a year from now that the economy started to recover in May or June, but I would not bet my job on it. Second, the unemployment rate net change of 4.5 points is the biggest in modern history. And both of these milestones are probably not endpoints.

The Stimulus Sun God

Six weeks ago, Michael Cembalest, CIO of J.P. Morgan Global Wealth Management, sent out his regular "Eye on the Market" newsletter, which included a stunning chart. Comparing the current economic "rescue mission" with past recessions (as of April 22), Cembalest displayed monetary and fiscal stimuli, with the Sun deities representing the present policy response:

All you can really say about this is, wow.

Cembalest began the newsletter by recalling that "ancient sun worshippers were mostly unaware of the astronomical forces at work guaranteeing that the sun would rise every day, whether they offered a sacrifice or not." This could probably apply to most economic policymakers, who often seem to think that, but for their efforts at managing and steering the economy, all growth and activity and innovation would come to a halt and we would all pitch into poverty.

Depression Index

Our very own Tim Kane has a nice empirical piece up at Real Clear Markets today. Tim makes crystal clear just how stark things are right now in the economy.

Nice work, Tim!

Unemployment vs. Jobs

The view that the latest employment news is good rests on the observation that the rate of decline in payroll jobs has slowed. I would not put much confidence in this data.

 

Consider the following counterpoints:

1. Payroll numbers are notroiously unreliable until final revisions are completed (monthly revisions occur for 2 months after the initial report, and an annual revision is done that corrects data stretching back multiple years).

2. The payroll data includes an unknown number of "phantom jobs" due to double-counting workers who change jobs during the month (my research here; BLS confirmation here). Since the rate of turnover tends to slow during the early phase of a downturn, and rise again during a recovery, it seems likely that the highest declines in January and February were exaggerations.

3. Aggregate Hours data show no deceleration, as noted by Jeff Frankel (HT Paul Krugman).

4. The Unemployment rate data show no deceleration. This is especially relevant because these data are almost never revised (I think we can call it "tweaked"). Consider the chart above, which contrast the change rate in unemployment compared to the the payroll jobs (in percent terms).

The chart above shows way too many upticks in the unemployment rate for me to start looking for green shoots. The monthly correlation between these two series is -0.57 which would probably be higher if not for the constant U rate fluctuation between -0.1 and 0.0 in growth periods. The 6-month moving averages of the series have a correlation of -0.87. So in the chart above, knowing only one series gets revised and the other does not, what should we expect? It's too early for me to say conclusively, but my guess is that the payroll numbers are likely to be revised downward and/or continue in deep negative territory.

One other depressing observation: There have been 39 instances since January 1948 when the change in the unemployment rate was 0.4 or more. How many have occurred in this recent recession?  Nine. That includes six of the last six months.

Unemployment Rise is the Worst Ever* (a correction**)

The increase in unemployment announced by the government is genuinely historic, more than I realized when I first reported the numbers. The rate of unemployment has increased by 4.5 percentage points since December 2007, the first month of the recession.

*There is no other U.S. recession that experienced an increase in unemployment this large since the government has kept accurate records (i.e. since the Great Depression in the 1930s). None. The only comparable period was the double recession of 1980 and 1981-82, when the increase peaked at 4.5 percentage points.

**It turns out that I had not updated revised numbers in the database I use, so the charts I have been producing in recent months have reported current unemployment rate changes that were too low by 0.1 percentage points. To clarify, I would like to report not only the 1-decimal unemployment rate (used in BLS reports), but the 3-decimal rate calculated using the reported number of unemployed persons divided by the size of the civilian labor force from the CPS.

The May 2009 unemployment rate can be calculated out to 3 decimal points as 9.357 percent (which the BLS rounds up to 9.4). In December 2007, the declared first month of the recession, it was 4.902.  The change is 4.455 percentage points. However, if we use the unemployment trough instead, which was 4.380 percent in December 2006, then the trough-to-current change is 4.977 percentage points.  Now let's compare these numbers to the 1980-82 era, which was until now the worst recession in modern times.

U.S. UNEMPLOYMENT RATES AND CHANGES IN 2 RECESSIONS*
2007-        1980-                                    
9.357        10.750      Peak (so far)                 
4.902        6.271        Recession Start        
4.380        5.606        Trough
4.455        4.479        Change from Start    
4.977        5.144        Change from Trough

Picturing Unemployment, May 2009

 

In May, the U.S. unemployment rate spiked by another half percentage point.  Since the recession started in December 2007, the unemployment rate has risen by 4.5 points (correction: earlier post said 4.4). The only episode with recessionary change this big was the 4.5 point increase during the double 1980-82 recessions. This spike in unemployment has been recorded over 17 months, exactly half the time, and number of recessions, needed to cause as much damage then. 

We are experiencing the deepest and swiftest recession in the U.S. since the Great Depression of the 1930s. It is definitive.

Oh, You Mean That Poverty Rate

This morning Matt Yglesias did a brief post on the course of American poverty over the last half-century in response to Robert Samuelson's rather bold claim that the war on poverty failed. Yglesias (and Ezra Klein) point out that the poverty rate has plummeted since 1959, with some ups and downs in the intervening years. He posted this chart, implying that the drop was entirely due to LBJ's War on Poverty:

Pretty impressive, and pretty conclusive. Also pretty inaccurate. The trend is right, but if we're going to have a discussion about poverty, we at least need to use the right data. Here is what the official government data look like for people living below 125% of the poverty line:

So the trend is similar, though these numbers are more striking (from one third to about 17 percent!). What about families, which seems to be the chart Yglesias uses? 

(See below). The poverty rate for famiilies has halved since 1959, again with ups and downs but a pretty steady downward trend.

As Yglesias notes, the poverty rate tends to rise during recessions and fall during times of strong growth. Yet it strains credulity to think that the dramatic fall since 1959 is due entirely to the War on Poverty. Government programs played a role, obviously, but how large of a role?

First, Yglesias glosses over the steep drop in poverty that began in 1959: the first piece of legislation in the War on Poverty was passed in August of 1964. So let's say 1965 was the first year in which the War on Poverty began to make a dent in poverty. By 1965, the percentage of people living below 125% of the poverty line had already fallen from 31% to 24%, a rather remarkable fall in such a short time span. A similar seven-point drop occurred from 1965 to 1969, which likely had a lot do with the War on Poverty. 

But the earlier drop plainly couldn't be due to the War on Poverty; more likely, it had to due with economic expansion, which characterized most of the 1960s. Thus, economic expansion probably had a lot to due with the steep drop in the latter half of the 1960s. The statistical trend for families in poverty is similar. Moreover, if the War on Poverty is to be credited with the decline in poverty (even the decline that occurred before it came into existence, which would be the most remarkable achievement in the history of government), what are we to make of the relative plateau of the poverty line after the 1960s? Both poverty rates examined here hit nadirs in 1973, at 15.8% for individuals below 125% and 8.8% for families in poverty. Government programs obviously were key.

Yet the rates rose again with periodic declines through the the next two decades: did the War on Poverty cease to have an impact? Government programs weren't exactly rolled back in the 1970s, and the rates clearly follow the overall economy through these years. Poverty reached a postwar low in 2000, at the height of that expansion: but welfare programs were trimmed in the 1990s. Did this help reduce poverty just as the original War on Poverty did? If so, then the War on Poverty's effectiveness is somewhat, but not completely, undermined. If not, then maybe there is another explanation.

The major explanation for poverty's fall is one Yglesias and others acknowledge: economic expansion. This doesn't mean the War on Poverty had no effect: the steep drop in the late 1960s clearly indicates that it did. But there were other trends at the time that also factored in, namely, the civil rights movement and the gradual increase of full economic participation. 

This isn't to deny that poverty persists as a social issue that demends attention. Clearly, it does. Yet any discussion of poverty is incomplete if we confine ourselves to simply the poverty rate (even the correct one). We cannot ignore consumption patterns, differential inflation, and the actual dynamics of income in the U.S. An in-depth examination of these, not a superficial look at a one-line trend, would give a much fuller picture of poverty. 

Lincoln's Industrial Policy

Paul Kedrosky has a good essay in the most recent Washington Monthly, the provocative thesis of which is: "So while it's true that our best hope for future growth is riding on America's entrepreneurs, the best hope for our entrepreneurs may be riding on government."

In describing how economic crises can often produce rather enlightened public policy, Paul highlights an oft-overlooked characteristic of President Abraham Lincoln--his economic policies. Understandably, Lincoln is usually remembered in the context of war and slavery and political philosophy, but his Second Annual Message to Congress was basically a far-sighted industrial policy that helped lay the foundation for an era of inspired entrepreneurial capitalism. (Lincoln's economic insight has not gone completely unremarked upon, of course; Michael Novak provided a brilliant meditation on it in The Fire of Invention.)

Atlantic and Pacific telegraphs; the Pacific Railway Act for the construction of a transcontinental railroad; uniform currency; development of the West's mineral resources; canals--all were at the heart of Lincoln and the Republicans' economic policy. Granted, the South's secession played no small part in opening up the legislative road--before the Civil War, the future Confederate states had basically acted like a gigantic reactionary obstacle to everything from economic development to women's rights. With Confederate legislators gone, the new Republican party helped boost the American industrial revolution. 

Paul also mentions the Morrill Act, which Lincoln signed in 1862 and is one of the most frequently cited Congressional achievements of the nineteenth century. To a certain extent this is true, but it is also overblown. The Morrill Act helped put many of the existing small-time state schools on the road to national importance, but its effect was limited by a shortage of resources. It was really the Hatch Act of 1887, establishing the agriculture extension system, and the Second Morrill Act of 1890, providing money for the first Act and adding discrimination clauses, that pulled higher education and industry into a tight and enduring embrace. As higher education historian Frederick Rudolph wrote several decades ago:

"[T]he growth of a body of applied agricultural science, the experiment stations, farmer approval, and federal and state financial assistance all fed upon one another."

One of professors summed all this up with what I still think is one of the best phrases used to describe what government economic policy should (ideally) do: releasing the energy of people to create. Things like the Hatch Act and the Bayh-Dole Act cannot anticipate the nature and scope of the far-reaching effect they will eventually have since they're usually passed in response to a discrete issue. (In the latter case, university-industry linkages had increased markedly in the 1970s and companies like IBM were constantly pushing against the cumbersome commercialization process. In a historical analogy to general incorporation in the 1800s, Congress finally created a general platform for university commercialization. Incidentally, "platform" is another wonderful term for describing what economic policy should be about.) Likewise, the gradual separation of military and civil government in Europe helped, as John Keegan has written, free up the energies of people to create and innovate, resulting in the Industrial Revolution.

So the question for policymakers, always and particularly in times of crisis, should be: where are the points at which a specific policy or repeal of policy can release individual energy? This need not presume any particular knowledge on the part of policymakers, but it should prompt a more nuanced understanding of economic complexity. 

A Chimerical Dow 14,000?

Maybe I'm alone on this, but I was genuinely surprised by these extraordinary numbers from last week's Buttonwood column in The Economist:

"In America, Smithers & Co, a consultancy, says that net corporate buying of shares peaked at an annualised rate of around $1 trillion in late 2007. Companies were buying far more of their own shares than anyone else did. But the buying spree was unsustainable. Smithers calculates that American-owned companies were paying out some 70% of their profits at the peak, if you include dividends and buy-backs. They have since slashed dividends and will have to start issuing shares as well. Instead of borrowing money to pay back shareholders, companies now need to raise equity to pay back creditors."

Picturing Unemployment: Time to Call a Depression?

The business media have been on the lookout for "green shoots" amid the constant signs of recession, and this morning's release of the government's April Employment Situation report is inspiring some bizarre adjective pairings (David Leonhardt calls it "Dreadful, Yet Encouraging" ... imagine if he was describing your health). It reminds one of Ronald Reagan's favorite joke: Is there a pony in all this manure?

A more honest question is whether (or when) it will be time to call the current recession an outright depression. With another monthly half-point spike in the unemployment rate, I am afraid it is a close call and poised to become an easy call in 60 days. Here are three charts to make the case.

The first chart should be familiar, the unemployment rate from January 1948 to April 2009. The unemployment rate, which stands at 8.9 percent as of this morning's Labor Department announcement, is a ratio of the number of unemployed people (13,724,000) to the number of civilians in the labor force (154,731,000). As you can see, only three times in postwar America has the unemployment rate risen above 8 percent -- in May 1975 when it peaked at 8.982 percent and in December 1982 when peaked at 10.849 percent.

Two Aprils ago, the unemployment rate was 4.5 percent. One April ago, it had risen to 5.0 percent, which was considered a mildly alarming harbinger. This April, the rate is 8.9 percent, essentially double what it was two years ago, but representing an acceleration that is historic. For anyone who thinks this recession is comparable to '91 or '01, realize that the spike in unemployment is twice as bad. This second chart shows the net change in the unemployment rate, benchmarked from the first month of the recession in each case. There are two surprises. The last two recessions look like twins: intensity for 9 months, peaking around +2 percent 24 months after the start, and declining gradually for the next 24 months. In contrast, this recession is still in the intensity phase (with monthly increases of 0.2 to 0.4 percent), and we are 16 months in. 

Economists have recognized for some time that this recession is qualitatively worse than any downturn of recent vintage. The proper comparison is to the double-dip 1980-82 recession and the 1974 recession. So here is the third and final chart, again comparing the net change in the unemployment rate of the current downturn to 1980 and 1974. Note that the peak change.

 

In this chart alone, it is clear that the current peak of 3.9 is arguably the worst post-war employment experience. While the 1974 recession peaked at 4.2, its downturn (also 16 months) was preceded by a year of growth. In contrast, the 12 months preceding the official recession start in December 2007 were marked by job losses and decline. As for the 1980 recession, it has been my long practice to count the double-dip as one downturn. Official accounts say these were two distinct events, so the 4.5 peak is actually not an official peak. In other words, this recession is already the worst postwar downturn.

The length of a recession must also be considered. Every post-Great Depression downturn has lasted 16 months or less. As of April, the current recession is 16 months long, so next month will arguably mark this as the longest since the 1930s. Duration matters because past experience suggest that each month of downturn requires roughly a quarter of recovery. The rule of thumb: each monthly unemployment spike which average 0.3 percentage points is balanced by 3 months of 0.1 point improvements. My crude rule implies that even if a turnaround arrives in May, it will be 4 years for the economy to return to full employment.

So is it a depression or a recession? I do not know if the 21st Century Depression will happen, but I am sure that talk of green shoots is foolish. If the net unemployment rate change is higher than 4.5 (i.e. a 9.5 percent level or higher), then the media will emphasize that it is the worst downturn in 80 years. Worse yet, 3-4 more months of severe job losses will indicate the government efforts to arrest the downturn have failed, which will be reflected in ugly public attitudes. It could be a very depressing summer.

Picturing GDP, Advanced Q1 2009

Here are two charts of data on U.S. GDP growth rates based on government data released this week:

 

 

Consecutive quarterly declines at rate of negative 6 percent are unprecedented in modern U.S. economic history. The comparison to the early 1980s do actually show that there was a similar back-to-back decline of this magnitude exactly 27 years ago during the 4th quarter of 1981 and the 1st quarter of 1982.  Jim Hamilton's analysis on this is very good, and he hints the recession seems to be moving "according to historical pattern" especially in light of the early uptick in consumption. 

I believe this recession is darker than the GDP numbers suggest, and policy is the difference. The Federal Reserve was doing everything it could to cause the early 1980 recession, and it is doing everything it can to stop this one, with the same result. This observation is not a criticism of the Fed, rather a recognition of the severity of this contraction. And like Menzie Chinn, I don't feel we've felt the second wave of this downturn yet - the globalized demand shock - and the downturn in trade numbers in his words "are so large that they are difficult to reconcile with standard models." We will know a lot more for certain in 90 days, and as monthly data comes in. Buckle up, and hold your breath.

 

When Education Becomes an Economic Burden

In their new book and in their prior work, Claudia Goldin and Lawrence Katz have convincingly demonstrated the enormous boost the U.S. economy received in the last sixty years from increasing investments in education. For the last two decades, anxiety has risen that the United States has reached some sort of education plateau or decline and that economic growth will accordingly suffer.

A new McKinsey report, highlighted by Thomas Friedman the other day, appears to prove that this is indeed the case. Had the United States kept pace with our own prior achievements and more recent stars like Finland and South Korea, our GDP today would be $1 to $2 trillion larger. That might seem like a drop in the bucket in a $14 trillion economy, but how much has the Federal Reserve spent thus far on its various firefighting moves? Oh, right, $1.2 trillion. And bailouts? Um, $1 to $2 trillion. 

OK, so what: surely we can make all this up through faster growth? Well, right, about that, see economic growth has become increasingly dependent on education over the past three decades. That knowledge-based economy everyone's always talking about? It's for real, and it requires concomitant investments in not just knowledge creation, but the ability of people to codify and, most importantly, use that knowledge. I just happened to be reading Dominique Foray's fabulous Economics of Knowledge when I ran across this McKinsey report. The juxtaposition is like finding out when McDonald's breakfast ends: "total mind blow." 

I'm not usually disposed to let one report or one apparent trend scare me, but considering the nature of knowledge in the abstract, the history of American education and growth, and the sorry state we find many of our schools in today--well, it's a tad daunting.

I make no claims to be an education expert, and I know I keep coming back to this, but I simply can't help thinking about the "high school movement" with regard to these issues. Goldin and Katz are again the authorities here. The nature of knowledge, in general terms, hasn't really changed in the last century, but it's economic importance, the way we use it, and the way we propagate it, have changed radically. This should have clear implications for our educational system.

What those are, I'm not in a position to say, but it becomes more obvious every day that we need some serious institutional innovation in the realm of education, akin to the rise of secondary schools that arose with the industrial economy. Technology has a role to play here; alternative models like KIPP, too.

Any brilliant ideas out there?

What Does it Feel Like to Live Through History?

A colleague recently suggested that what the United States and global economies are experiencing is no mere cyclical contraction of ordinary proportions. It is, instead, a large-scale structural shift in the underlying character of economic activity. There does appear to be, at all levels, a recognition that what some have called the "Great Recession" is a transition, that the U.S. economy on the other side of this looks much different from what came before. This perhaps helps explain the ambition of President Obama's inaugural budget.

Structural changes do periodically occur: the last severe recession, in the early 1980s, marked a distinct break with the industrial economy and the rebirth of entrepreneurial capitalism. The Great Depression and World War Two sped the concentration of manufacturing output in giant firms--in the early 1930s, large companies (of 10,000 or more employees) represented only 10 percent of manufacturing output. By 1950, thanks to wartime contracts, that had jumped to one-third. Government also played a much larger economic role by 1950. 

What was probably the farthest-reaching structural change of American history came in the last third of the nineteenth century. The average citizen in 1900 lived in a fundamentally different economy and society than in 1850. Communication and transportation advances revolutionized life--it simply wasn't conceivable to send messages or goods across the country quickly before the telegraph and railroad. The nature of economic activity, moreover, came to be characterized by not just corporations led by managers, but corporations of theretofore unimaginable size and scope. 

We look back on those periods today and can readily perceive the changes because we know how things turned out. But what does it feel like to live through a historically significant structural change? Well, it turns out that it feels pretty historic. There are headlines we probably never thought we'd see ("Detroit's Fate Sealed in West Wing"). There are government deficits the size of which few probably ever bothered to even consider ($1 trillion!). And while we may not yet be at the point of a Ghostbusters-style apocalypse ("Human sacrifice, dogs and cats living together... mass hysteria!"), some things seem downright batty. What were the Vegas odds eight months ago on Paul Krugman turning against Obama?

In the midst of such history-shaping markers, there are two darker feelings afoot. One is distress over the decline of what are perceived to be staples of American life, e.g., the Detroit auto companies and newspapers. The other is anxiety that nothing of equal merit or heft will arise to replace these and other sectors, including finance, which played a larger and larger role in the U.S. economy over the past two decades. Where will the next wave of jobs be? Will we all be consigned to low-end service jobs?

The standard lexicon of economics, replete with equilibrium and multipliers, seems to offer little insight into these structural changes. Even the term "structural shift" feels antiseptic. Joseph Schumpeter has made frequent posthumous appearances on behalf of his famous term "creative destruction." New companies and industries incessantly arise to replace those that die or are destroyed. Not surprisingly, Schumpeter's analysis was based on that last great structural shift of the late 1800s and early 1900s. Still, however, any descriptive term using "destruction" doesn't exactly convey feelings of warmth.

But Schumpeter did point out that any set of economic arrangements, however permanent and insuperable it appears, is always transitory. Any competitive advantage a company may achieve is always challenged--the ground is constantly shifting beneath their feet.

Economies, in this way of seeing, are like kaleidoscopes--this was the insightful observation of G.L.S. Shackle, a mid-twentieth century economist who has since been relegated to the academic dustbin. Everything in an economy is constantly in tumult, some sectors falling, some sectors rising--at certain points it all seems to come into focused order. Only, of course, to disperse again.

Sometimes we can perceive this--another shift today appears to be a transfer of power from the West to emerging countries, particularly in finance. Often, however, we simply cannot perceive the long-term changes that become the basis of the next set of kaleidoscopic order and mess. The reason is that every seemingly stable economic order begins as a chaotic mess of experiments, of variations. Clay Shirky points out that this is already occurring in the newspaper industry.

At these times, at varying degrees in different sectors, we can't tell what will eventually settle down or for how long. The most promising thing we can do from a policy standpoint is somehow encourage such variation. But of course this is the glory and agony of capitalism, reflecting the reach of human capability and our allergies toward change and uncertainty.

Voices from the Present and Past

"The problem may be that we've used only economists to try to solve our economic predicaments."

--Mark Buchanan, The Crash-Test Solution

"Like theology and unlike mathematics, economics deals with matters which men consider very close to their lives. . . . Accordingly, one of the most important and difficult of the responsibilities of the economist is to resist the authority of the accepted."

--John Kenneth Galbraith, American Capitalism

The President's budget presents an "impossible burden" and will "ultimately destroy the American business system." As a result, business is now in an "unremitting battle against totalitarianism."

The U.S. might be on the "back road to socialism."

These last two statements could, of course, have been uttered at any point in the last several months, and in fact many pundits have come quite close to their tenor if not the exact language. Actually, the first dates from 1948, from the National Association of Manufacturers; the second, from the Chamber of Commerce in 1950.

Innovation by Inches and Decades

A handful of interesting points on innovation this morning. First up is a link (via Tyler Cowen) that describes the Depression years of the 1930s as the most innovative in recorded history, a conclusion from Alexander Field's September 2003 paper in the AER:

The hypothesis does not imply that all of the effects of the advances registered in the decade were immediately felt in the productivity data .... Rather, it draws our attention to the probability that progress in invention and innovation in the 1930’s was significant, in ways not well appreciated ....

This is not as surprising as it seems, given that progress is defined as the growth rate of MFP (multi-factor productivity). One should expect that a severe reduction in output would cut the least productive capacity (labor and capital) first. A more severe downturn yields a more severe MFP increase. Likewise, you might think that the most booming of years would reflect low MFP growth. The paper includes data tables on compound MFP growth rates which indeed show this:

The weakness of growth in 1972-79 is well known, and explanations for it range from critical (new regulatory burdens hampered GDP growth) to apologetic (quality improvements in safety and the environment resulting from 1970s regulations are unmeasured output).

Measuring Innovation

A new line of research is exploring if GDP has been correctly including intangible value in a broader sense. Fields comments on this, but the "innovaion metric" movement is bigger still. Ed Prescott, for example, believes the intangible value of things like brands deserve much more attention. A commission created by the Commerce Department and headed by Kauffman's Carl Schramm explored the measurement of innovation with recommendations for improving such, published in this 20-page report in January 2008.

It must be said that the economists and staffers at the Bureau of Economic Analysis are constantly improving the measurement of GDP. Our thanks to them. In fact, I discovered today this study: "Toward Better Measurement of Innovation and Intangibles" of measuring innovation, published in January 2009 by BEA and published on its main page:

Expenditures on software, for example, have been treated as investment in the core accounts since 1999. And in 2006, BEA launched a research and development (R&D) satellite account, to explore investment in R&D and its larger economic effects.

My prediction: the measure of R&D will be extremely helpful, but will also reveal that the bulk of growth is still mysterious. Growth by innovation may itself be intangible and far deeper in human creativity than can be captured by research budgets.

So does all this mean the depression of 2007-2017 will be perversely good for the long-term economy. It would be nice to think so, wouldn't it?

ALERT: Americans to Secede from Humanity

This just in:

After three or four centuries during which citizens of the United States partook in that great narrative of innovation known as human civilization, Americans have suddenly stopped innovating. Biologists and anthropologists, anachronistically noting that innovation is a defining human characteristic, have duly concluded that Americans have thus effectively ceased to be human.

What are the causes of this crisis, in which the United States' "position is slipping" relative to the rest of the world? Laziness? Ignorance? Short-sightedness? Dastardly foreigners stealing our humanity? Yes, yes, yes, and yes!

The propensity to panic, of course, is as innate as the creative impulse. Two observations:

Am I naive to observe that many of those calling for a government-led national innovation strategy are--sometimes, not always--the very people who would benefit from, say, increased R&D funding or a more central role for venture capital?

It is striking that most of the recommendations for spurring American innovation, while claiming to be future-oriented, actually look backward. Imagine if, in the wake of World War Two, the U.S. had decided that future prosperity depended not on federal R&D funding, but a greater stress on prewar research modes, mostly privately funded. Or if, in the 1980s and 1990s, we had collectively decided that large corporate research labs were our only hope--forget start-ups, forget university spin-offs, forget entrepreneurs not dependent on R&D. Likewise today: is it really that clear that a return to prior modes of innovation--more federal basic research money, more venture capital--is the only way for us to innovate? (One of the biggest changes in the nature of innovation often seems to pass unremarked: the end of the Cold War. The Cold War was a huge spur to government (defense) research as well as large numbers of students majoring in engineering.)

I'm not saying that the long-term prospects for the U.S. economy are in tip-top shape, or that our innovation ecosystem lacks room for improvement. (Marc Andreessen makes a compelling case that innovation is "alive and well.") But, given the continuing shift of the American economy into knowledge-intensive services (not well captured by traditional measures of innovation), the rising importance of social production, and the more nebulous (and numerous) pathways of innovation outside VC and R&D, the panic seems overblown.

The Agony and Irony* of Taxes

Since the release of President Obama's budget preview there's been a lot of noise made over the question of taxes, specifically relating to two issues. First, the federal government's long-term fiscal problems, which Tim wrote about yesterday. The second issue is the question of what impact higher taxes will have on entrepreneurship.

There's no doubt that Uncle Sam is flirting with budgetary fire--the numbers being thrown around about the long-term deficit are almost beyond belief. And quite frightening. It seems likely that some combination of higher tax rates and trimmed entitlements will be unavoidable. But it is also doubtful that higher taxes can make much headway against the enormous mountain of government debt, particularly given the towers of debt that households will continue to struggle with. California, moreover, is Exhibits A through Z as to the effects of relying solely on higher taxes to prop up the governmental edifice. 

Thus, it would seem that some sort of entitlement restructuring will end up being the only conceivable way to boost fiscal health. (I must admit, however, to being a tad mystified at the proposal to make Pell grants an entitlement--the rationale of making college more affordable for more people doesn't hold water against the evidence that rising tuition costs have been, in part, a product of expanded federal aid.)

The second tax issue--the effect on entrepreneurship--is much more ambiguous and thus emotionally-freighted. Will higher taxes on those with incomes over $250,000 dampen the entrepreneurial spirit? There is certainly reason to think it will: lots of small businesses, for example, file individual income tax returns and thus would face higher taxes. (Secretary Geithner maintains that this would be an incidentally small number.) The always-perspicacious Jim Manzi makes a persuasive case that higher taxes will in fact affect the probability calculations made by prospective entrepreneurs and dissuade many from taking the plunge.

Yet that can't be the whole story. For one thing, William Nordhaus has calculated that entrepreneurs capture only about two percent of the surplus they generate--consumers (society) capture the rest. Entrepreneurs take risks, to be sure, but it just doesn't seem quite right that they go through the analytical  probability calculations that Manzi outlines. In many cases, they are explicitly pursuing "psychic rewards," knowing that the pecuniary payoff might be less than that.

In a larger sense, let's put the whole tax issue in perspective: taxes might actually be one type of undergirding for entrepreneurship, so the dampening effect of a slight uptick in tax rates may be overstated. Last month there was a fantastic essay in The New Yorker on the struggles of free-market economists in Iran against the statist Islamic regime, which doesn't seem to understand anything close to basic economics. By depending almost exclusively on oil revenues, the Iranian government does not have any incentive to cultivate productive entrepreneurship--the citizenry depends on the government. In countries like the United States, the government depends on the people and entrepreneurs, and taxes are the mechanism of that dependency. This, needless to say, is much more salutary for economic growth and democracy.

*with apologies to Alkaline Trio

Power is Power is Power

The McKinsey Quarterly has just published a special edition, "What Matters," and Carl Schramm and I co-author an essay, "The right way to regulate."

I don't know whether or not we actually lay out the "right" regulatory path, but our writing scope was broad and we used it to explore questions of finance, its relation to entrepreneurship, the role of government in the face of complexity, and the raw issue of presidential power. The last topic, radioactive for the last eight years and simmering below the surface in the prior three decades, does not seem to have been much of a public concern of late.

This is entirely appropriate: crises aren't known for bringing out one's inner constitutional scholar. Eventually, however, constitutional issues unavoidably arise and this recession should be no different. We observe in the essay that President Obama, inheriting the aggresive unitary executive philosophy of the Bush-Cheney administration and now assuming radical fiscal authority (the stimulus, the second half of TARP, the next bank rescue plan, the new budget proposal), enters office as pretty much the most powerful president in American history. 

Political inclination matters little here--we observe in the essay that the strong U.S. economic performance over the last two centuries has occurred during a time of continually rising governmental size and power. There's a lot packed into that observation: size can be a poor proxy; policy orientation matters more; pecuniary issues can be relative, etc. So irrespective of how you view the President or how you view the proper government response to the meltdown, the scope of executive power at this point in time is beyond astounding. Breathtaking, perhaps.

As a final note, I want to point out that the McKinsey "What Matters" collection includes a lot of interesting essays that I'll be further exploring in this spot over the next several days. Those in the "Innovation" section look especially tempting for critical analysis.