Saturday, March 16, 2019

The 2020 (Antonio Fatas) Recession

Antonio Fatas has an interesting post up where he looks at low unemployment as a predictor of rising unemployment and recession. Yes, you'd expect that to happen. As Fatas says, "there is reversion to the mean in unemployment rates". But there is more to the story, and Fatas digs it out:
The result might sound obvious and mechanical: once unemployment rate is low, there is only one way for unemployment to go: up. This is true but what matters is whether a persistent period of low and stable unemployment is possible. In the case of the US the answer is no.
And again:
In the case of the US, history suggests that “full employment” is not a sustainable state and that once we reach such a level a sudden increase in unemployment is very likely.
As opposed to Australia, for example, which has "sustained a low unemployment rate for decades." See? It got interesting, didn't it.

Fatas reports regression results which show that, for the US, "low unemployment rates are particularly good at predicting the tail risk of large increases in unemployment (recessions)... Interestingly, the same phenomenon is not present in other countries (such as Australia)."

Then he asks: Why?
The academic literature tends to emphasize two set of variables: those associated to macroeconomic imbalances (such as inflation) and those associated to financial imbalances. Interestingly, the introduction of these variables in the quantile regressions above makes the above effect go away (see Fatas (2019)). In particular, once we control for credit growth, it is not any longer the case that low unemployment is a good predictor of the tail risk associated to recessions (we still observe a reversion to the mean but we do not obtain a larger coefficient for the p90 quantile).

"This result," Fatas says, "suggests that recessions follow periods of low unemployment because imbalances are built during those years." Imbalances related to credit growth in particular: That's what he seems to be saying. So maybe low unemployment leads to rising unemployment and recession, not because of the low unemployment level but because of high credit growth -- or, rather, because of the financial cost associated with the relatively high level of debt that develops during a period of high credit growth. I can see that.

Fatas follows up with a zinger:
What is interesting is that the evidence shows that this is always the case, that the US economy has never managed to sustain a low rate of unemployment without generating the imbalances that lead to a recession.
He concludes that recession is "around the corner."

When Antonio Fatas said "history suggests that 'full employment' is not a sustainable state" for the US, my first thought was what we looked at the other day, Stephanie Kelton saying "MMT would set public spending always to the level required to achieve full employment, and then accept whatever deficit may result."

If Fatas is right, is the economic force he describes strong and independent enough to interfere with a plan like Kelton's for full employment?

If, as Fatas seems to say, credit growth during the recovery creates embedded costs that make recession inevitable, we might see sustained rapid credit growth under Kelton's full employment, along with rising financial costs that would drive public spending ever higher in the effort to achieve and sustain full employment. I'm not making a prediction here; just test-fitting some puzzle pieces. Irresistible force meets immovable object. What gives?

My second thought was to look at US unemployment to see if it really does appear that we've never had a persistent period of low and stable unemployment:

Graph #1

Eh, two years in the early 1950s, two in the mid '50s, three in the latter '60s, and maybe two in the latter '80s. Other than that, falling unemployment seems to give way immediately (when the time comes) to rising unemployment. You can even see it in recent months on the right side of the graph.

And the "persistent" periods that I find are not very persistent: two years, three on the outside. Compared to Australia, where, as Fatas says, "by the year 2000 unemployment reached a low level that has remained mostly flat for years."


So I added unemployment for Australia to the graph:

Graph #2

Yikes! It's higher than US unemployment from 1983 to 2003! Then it runs with ours till 2007 when we start rising into recession. Australian unemployment spends 2008 bottoming out, then rises.

Fatas sees Aussie unemployment running low and "mostly flat" since 2000. I see a one-year period (2008) as their "persistent" low.

Sure, Australia seems to have missed the "Great Recession" spike that we saw in 2008-09. Maybe that makes their unemployment rate appear low. But it has been persistently above 5% since 2009, and has reached above 6%. I'm a little disillusioned.

It is true that the Aussie rise from 5% to over 6% was not sharp and sudden the way the increases are in the US during recession. Maybe that's what Fatas was looking at. But if he's thinking that "low" unemployment is anything under 6.5%, then the US had a persistent low from 1962 to 1974. And that shoots a hole in the theory that "the US economy has never managed to sustain a low rate of unemployment".

That persistent US low, as it happens, occurred when the total-debt-to-GDP ratio was low and stable at 1.5. Which brings us back to "credit growth" creating the embedded costs that make recession inevitable. But credit growth wasn't a problem in the US in that period, what with inflation driving the GDP numbers higher as fast as debt was growing.

There was a recession during that 1962-1974 period. (Fatas said: "the US economy has never managed to sustain a low rate of unemployment without generating the imbalances that lead to a recession.") But the 1970 recession wasn't a "credit growth" recession; that recession was the Fed's way of fighting inflation. So also was the 1967 recession that we almost had, and so was the 1974-75 recession that terminated the 1962-1974 period.

The US history of 1962-1974 supports Fatas's view that low unemployment (or, really, rapid credit growth (or even more really, the financial cost associated with the high level of debt that develops during a period of rapid credit growth)) may be what leads to the recession that ends the period of low unemployment.

Personally, I find that conclusion just about right.

There remains one point to consider, and that is the point Fatas makes in his post titled The 2020 (US) Recession, which ends with the thought that
If history is an indicator of future crisis, and given the current low level of unemployment, a recession is likely to be around the corner.

I still like the Change in Total Nonfarm Payrolls as a recession indicator.

Graph #3: Monthly Change in Total Nonfarm Payrolls, and the H-P Trend
Click the Graph for a Larger View
To get the Hodrick-Prescott I exported the FRED data to Excel and used Kurt Annen's VBA code. The plotted line is default blue on the FRED graph. The dashed red line is Excel's plot of the same data and the black line is the Hodrick-Prescott. It uses a smoothing factor of 14400 for the monthly data. To show the H-P on the FRED graph with recession bars and all, I used PAINT.NET to erase the background of the Excel graph gif file, and overlaid it on the FRED graph. It's fun to do that once in a while.

Notice that the H-P almost always falls before a recession. Since the 1980 recession, it always falls for a couple years before the recession starts. It's not falling now.

The most recent "change in payrolls" number was low by an order of magnitude: 20 rather than around 200. Definitely an eye-catcher. But one month's data point is not a trend. A second one is a Red Alert. The third one could be a trend. But so far, there is no hint of recession in these payroll numbers.


The Arthurian said...

Fatas: "In the case of the US, history suggests that “full employment” is not a sustainable state and that once we reach such a level a sudden increase in unemployment is very likely."

Mark Thoma, July 2017 at The Fiscal Times:
"The inevitability of another recession is evident in a graph of the unemployment rate. Notice that, before 1970, it was common for the unemployment rate to reach a low point and then hover around that point for several years. For example, the unemployment rate was around 4 percent for an extended period in both the mid to late 1950s and 1960s. But since 1970 the unemployment rate has behaved differently. Instead of reaching a low point and then leveling off for a period of time, it has tended to “bounce” off the low point and almost immediately begin rising again."

Thoma and Fatas seem to differ on when this pattern started, but they agree that unemployment, when it stops going down, starts going up again. It doesn't stay low for long.

The Arthurian said...

"...when it stops going down, starts going up again. It doesn't stay low for long."

Maybe this is a sign of something wrong with the economy. Especially as Thoma says that the pattern started in the 1970s.