Friday, September 21, 2012

Money: It's all made up!


This post will be more colloquial in style than most of my posts. Apologies in advance.

It's just made up money

The main thing that differentiates the Federal Reserve Bank from other banks is that it can create money from nothing. This bothers a lot of people. Mitt Romney is apparently one of those people.
We're just making it up. The Federal Reserve is taking it and saying, "Here, we're giving it." It's just made up money, and this does not augur well for our economic future. (Source)
The candidate seems troubled by the notion that the Fed buys Treasury securities by simply creating the money it needs to pay for them. Romney has exceptional business experience and probably a pretty good grasp of economics. He has two degrees from Harvard and has been a governor. But he doesn't get monetary economics. That's understandable--business experience doesn't necessarily teach a person a lot about monetary economics, which is a very macro-level thing and can be pretty counterintuitive. But I think the general public is capable of grasping this, so here goes.

The key point that Romney is missing is this: it's all made up! The money floating around the US economy was all conjured out of thin air at some point. This isn't unique to Fed purchases of Treasury debt; every time a central bank does anything, it is either creating money from nothing or magically eliminating it from the world.

A common response to this revelation--that it's all made up--is something like, that's what you get when you have "fiat" money instead of tying money to something which has "inherent value" (gold is a common suggestion). But guess what: A gold standard would still have the government creating money out of thin air!

Suppose we abolish the Fed and replace it with a gold standard. Our wise Republican leaders decide that the dollar should be worth 1/1500th of an ounce of gold (i.e., gold is worth $1500/oz). This isn't some free marketeer's paradise. The gold standard is implemented by having the government promise to buy or sell gold at $1500 per ounce in unlimited quantities. The government is fixing the price of gold rather than letting the market decide what it should be. What does this mean? Well, if I dig a hole and discover an ounce of new gold, I can take it to Uncle Sam and get $1500 for it. In simple terms, this means Uncle Sam will fire up the presses, print up a fresh batch of Benjamins, and hand them to me in exchange for my gold. Thanks, Uncle Sam.

So it's all made up! Uncle Sam conjured that money out of thin air! And by the way, the event I just described may cause inflation (yes, you can still get inflation under a gold standard).

Paul Ryan has said we need "honest money." I have no idea what that means, but I know that a gold standard, or whatever, isn't any more "honest" than our current policy.*

The key point is this: if the government is going to be in the business of controlling money--whether through a central bank which targets inflation, as most developed countries have, or through a central bank which sets a gold standard, or a silver standard, or a commodity-basket standard, or a Junior Bacon Cheeseburger standard--if the government is going to control money, it is going to be conjuring it out of thin air some of the time. Gandalf would have made a great central banker (but not Dumbledore**). The only alternative to this is free banking--getting government out of the currency business entirely and leaving money up to private actors. That's not going to happen any time soon, and indeed Romney has not advocated it.

It's all made up, folks. That's how central banking works.

But does it not "augur well for our economic future"? That depends on the stance of monetary policy. By that I mean, is money too tight, or is it too loose? Romney seems to be implying that it's too loose, and the Fed is making it looser, so bad things are going to happen. People fall into the trap of thinking money creation, or the current level of the money supply, or even the nominal interest rate, are indicators of the stance of monetary policy. In Mitt Romney's mind, the fact that the Fed has created trillions of dollars means that money must be too loose.

But the money supply is a bad indicator of the stance of monetary policy. If I told you that tomorrow Wendy's is going to make 1 million Junior Bacon Cheeseburgers, would you say that Wendy's is making too many or too few JBCs? I have no idea. I need to know how many people are going to want a JBC tomorrow. If only 100 people want one, Wendy's made too many. If 10 million people want one, Wendy's made too few (but if they're smart, they'll raise the price until only 1 million people want one).

Money is no different. You can't just look at the money supply, or the rate of growth of the money supply, and think you have measured the stance of monetary policy. The best way to measure the stance of monetary policy is to look at inflation (or expected inflation) and growth in nominal GDP (or expected growth in nominal GDP). As Scott Sumner frequently points out, lately money has been tighter than at any time since Herbert Hoover! And indeed, even after the Fed announced QE3, market indicators of inflation expectations did not indicate excessive monetary looseness.

Sure, all these asset purchases by the Fed may lead to somewhat higher inflation. But it's very unlikely that it will get so high or unmanageable that the economy will be at risk.

But they're monetizing the debt!

It's true that recent and current Fed actions have involved creating money to purchase Treasury securities, and other stuff. Romney, after talking to one expert and ignoring the broader consensus of economists, complains (same source as above):
The former head of Goldman Sachs, John Whitehead, was also the former head of the New York Federal Reserve. And I met with him... You know, we borrow this extra trillion a year, we wonder who's loaning us the trillion? The Chinese aren't loaning us anymore. The Russians are loaning it to us anymore. So who's giving us the trillion? And the answer is we're just making it up.
First of all, who cares if Whitehead used to work at the Fed? His opinion obviously does not represent the views of people who are, you know, actually running the Fed. Regardless, I'm not so sure about Romney's claim about who is willing to lend to us. Like everyone in politics, Romney dramatically overstates the importance of China for financing US deficits; of course, China matters a lot, but China only holds about $1.1 trillion out of the total $16 trillion national debt. But that has gone up over the last 5 years--Chinese appetite for US debt hasn't disappeared.

More importantly, should it bother us that the Fed buys lots of US debt? In a word, no. Not right now. Not when inflation is averaging below 2 percent. Setting aside concerns about availability of safe assets for collateral and risk aversion, if the Fed can buy US debt without causing lots of inflation and effectively forgive that debt (since the Fed returns all profits to the Treasury), why not do it? It's about as close as you can get to a free lunch. Reduce the burden on future generations while simultaneously stimulating the economy. What's not to like?

The common response--which Romney gives--is that once the Fed quits buying assets, interest rates will have to go up. Sure. They'll eventually go up. Markets don't seem to be counting on rates going up dramatically in the future, but maybe they're wrong. Regardless, why should we care? Who cares*** if eventually rates go back up after we were able to spend several years borrowing for almost nothing and having the Fed cancel a bunch of our debt?

When inflation is low and unemployment is high, it's a perfect time for the Fed to monetize some debt.

I don't mean to suggest that monetary policy has no costs or tradeoffs; when we get a real recovery I'll be as hawkish on inflation as anyone. I'm just saying that in the current environment, the benefits probably exceed the costs (in expectation).

*Someone might argue that since the bank notes created are redeemable for gold, they are somehow more honest, or cannot be said to have been created out of thin air or something. This is not relevant to my point as long as dollars have purchasing power; and it's fairly obvious that dollars can have purchasing power even without gold backing. If you don't believe me, let me know when I can stop by and take all your dollars off your hands. Also, if history is any guide, under a gold standard there's still no reason to believe your banknotes will always be redeemable for gold.
**Okay, so maybe he would. I'm not being entirely precise here.
***This is abstracting from elasticities of government spending to interest rates. I'm sure those matter, but I think they're second-order here.

Friday, September 7, 2012

What's the REAL unemployment rate?

Source: Wikimedia Commons

Today the jobs numbers for the month of August are being released. Inevitably, I will see people claiming that the headline unemployment number "is not the real unemployment rate." The real rate, according to them, is much higher; and they often suggest that authorities are intentionally feeding us a misleading number for political reasons. Are these skeptics right?

More precisely, what is the "real unemployment rate"? I'm going to suggest that there is no such thing, and I'm going to explain a few of the ways we measure labor market conditions. Each has benefits and limitations which are relevant to the discussion about the state of the economy. This will be a short guide for non-economists.

A lot hinges on how we want to define "unemployed." To different people and at different times, that word might refer to anyone without a job (in which case, happily retired people and stay-at-home spouses would be "unemployed"), anyone without a job who is actively seeking work, or anyone without a job who wants one. Perhaps it should include those who have part-time jobs but desire full-time work. It might even refer only to people who have been searching unsuccessfully for work for at least some amount of time or people who were fired or laid off from their job (i.e., they didn't leave voluntarily). Since there is no common definition of "unemployed" that satisfies everyone's needs, the Bureau of Labor Statistics (BLS) attempts to measure several versions of unemployment.

Each of these indicators is derived from a random sampling of about 60,000 households, conducted by the BLS and the Census Bureau, called the Current Population Survey (CPS). The CPS and its products are subject to response error, sampling error, and seasonal adjustment error (topics for another post, perhaps); so it's probably foolish to get excited about small movements in any of the unemployment rates I describe below as they may just be statistical noise.

Headline/official unemployment (U3)

The unemployment rate most often cited in the media is called the "civilian unemployment rate." It is defined as the number of people in the "labor force" who do not have work, expressed as a percentage of the total number of people in the labor force. The key restriction that bothers many people is that "labor force" is defined somewhat narrowly as civilian adults (16+) who are available for work and are either employed or have actively searched for a job within the past four weeks. People who have been temporarily laid off are also included. People who don't have jobs and are not looking for work are not included in this definition of "labor force," and this is why some people claim that the "real" unemployment rate is much higher.

But this number doesn't just exist to give politicians cover. It serves a useful purpose for those who are trying to diagnose problems in labor markets. Discouraged workers who have given up the job search aren't actually in the labor market, so if we want to know something about whether the labor market is clearing--whether it is efficiently matching job seekers with employers--then we need an unemployment measurement that is limited to people who are actually participating in the labor market. In fact, this is a decent way to sum up the headline unemployment rate: it attempts to measure how well the labor market is clearing.

There are additional reasons for caring about the headline unemployment rate. Unlike some other popular measures, we have been collecting the standard unemployment statistic in a reasonably consistent way since 1948. It's immensely helpful to be able to compare labor market clearing conditions across time. Finally, because of its usefulness for measuring labor market clearing, the standard unemployment rate has long been used by economists for finding helpful economic relationships which can inform policy.

The use of this rate in headlines and policy discussions is not new or unique to the political leadership of a certain party. This is the number we've used for decades--and it's compliant with international standards.

So when people complain that this is not the "real" unemployment rate, they're really just saying that they don't care about what this number measures. Often, these critics care less about labor market function than they do about broader economic misery.

Unemployed, marginally attached, and part time for economic reasons (U6)

This measure is the one that journalists, thinking they're very clever, like to discuss when asserting that the headline number is a smoke screen. But it's not a secret; it gets released by the BLS along with the headline number, and you can find time series data for U6 from a variety of websites (like FRED).

U6 is the broadest measure of employment problems in that it counts the most categories of people; to qualify as "unemployed" (more precisely, underutilized), a person must be unemployed (as defined in the headline rate), underemployed, or marginally attached. Underemployed people are those who have work but do not work as many hours as they would like. Marginally attached workers are those who want a job and have searched within the past year but have given up (and have not searched for work within the last month).

This number helps us get an idea of how much labor the US economy could supply in better economic conditions; it also gives us an idea of how many people are hurting economically because of bad labor market conditions. So it is useful for knowing just how far we are from satisfactory economic outcomes. In that respect, it is an important number.

However, like any statistic, U6 has its drawbacks. It is too broad to tell us much about immediate labor market clearing. It is also a new number--the BLS began collecting U6 in 1994--so we lack long time series for comparing business cycles over time. Finally, by using such a broad measure of underutilization, we lack the ability to pin down the different issues plaguing labor markets.

So the U6 measure does not fully satisfy our need for a good description of labor market conditions; but for those who want a single estimate of how many people are unsatisfied with the labor markets, this one might work.

More restrictive measures (U1 and U2)

There are two unemployment indicators that give rates lower than the headline number. U1 counts as underutilized only those who have been unemployed (by the headline definition) for at least 15 weeks. U2 counts as underutilized only those who are unemployed (by the headline definition) due to involuntary separation from their last job (i.e., those who quit their last job do not count). Since even booming economic times are characterized by a constant flow of people between jobs, these measures are useful for distinguishing between those who have good labor market prospects but are just between jobs temporarily (or voluntarily) and those who are actually in trouble.

Other broad measures (U4 and U5)

Finally, U4 and U5 bridge the gap between the headline number and the extremely broad U6 measure. U4 includes those who are unemployed by the standard definition along with discouraged workers--those who searched for work within the last year but gave up because they believe no jobs exist for them. U5 includes the standard unemployment definition and all marginally attached workers--those who have become discouraged for any reason. Again, these measures have useful purposes, helping researchers, policymakers, and commentators distinguish between reasons for job-search discouragement.

Six unemployment rates, seasonally adjusted (click for larger image)
"UNRATE" is the headline number (U3)

Final thoughts

There is no way to perfectly measure the state of the economy, and there is certainly no way to summarize it in one number. The BLS attempts to provide a broad and deep picture of the employment situation that allows us to drill down on the nature of labor market problems (and we can supplement these statistics with a variety of other data releases to get a clearer picture). The US statistical agencies are well respected worldwide for good reason. They exercise political independence and seek to approach data collection and summarization using best practice from statistical science. That's true even if some data releases contradict your ideological priors or local anecdotal evidence.

There is no "real" unemployment rate, nor are any of the indicators we have useless; what matters is choosing the right number for the right purpose.