The misleading tool for the missing job

"All the business of war, and indeed all the business of life, is to endeavour to find out what you don't know by what you do; that's what I called 'guessing what was on the other side of the hill.'", reminded Field Marshall Arthur Wellesley, the first Duke of Wellington. To achieve the 'what-you-do-know', the Duke didn't guess; instead he employed spies in his war with Napoleon on the Iberian peninsula.

In the field of economics, we don't have to be as crafty as the Duke. It's enough to rely on just three easily available indicators to know the true state of the economy. Even our indicators should be as simple as possible. The more indicators and the more complex they are, the greater the possibility of us being lost in the mass and confusion of details. For example, most economists rely on the M1, M2 and M3 metrics to measure money and when they couldn't correlate those metrics with inflation, deflation or GDP, they tweak them by using moving averages that cover several months' metrics. If only they had used total credit, the trend would have been obvious from the start.

Not only in the economics profession but also in the business world, the increasing trend towards dependency on a multitude of charts and indicators is numbing most of our senses. Thankfully, there are still pockets of expertise in which human senses are still valued. A good test of a ship captain is whether he can navigate the vessel without the use of any instrument. His judgment of bearing, distance and speed must be sound. Similarly, a good manager can quickly sense the state of employee culture by simply observing the workplace environment or he can tell whether a factory is making money by just walking around the factory floor. If he were to wait for an employee survey or a production report to discover the answer, that would badly reflect on his competence.

We have already reviewed  two of our three important metrics: the total credit and the Case-Shiller 20-city composite home price index. The last metric in our list of indicators that matter is the Labour Force Participating Rate (LFPR). I only discovered the importance of this metric when searching for the cause of the protest movement in the US that emerged in the mid 1960s and lasted until the early 1970s (see 'The protests, 45 years on').

To understand this metric, we need the big picture on the labour force. A recent issue of The Wall Street Journal has an excellent graphic at left that puts the various civilian population components in their proper perspective.

The US population in this context includes all members of the population aged 16 and over. Unlike the LFPR in other countries which covers only the working age population, the US LFPR also includes those above 65. A major part of this population participates in the labour force, whether employed or unemployed, as depicted by the two green boxes. Unemployed here means they are in search of jobs in the four weeks prior to the labour force survey.

There is also a smaller category of people which by choice or circumstance does not form part of the labour force. These people are permanently not in regular or part-time employment. They also include those who have stopped searching for a job in the past four weeks prior to the labour force survey. These various categories are represented by the cream coloured (or pinkish hue) area.

Now the main issue here is why we should rely on the LFPR instead of the employment or unemployment numbers. Let's bring up the unemployment chart. This one from The Economist at left shows that there is no obvious pattern that can be discerned. Can you predict how it's going to unfold in the coming months or years? Almost impossible; there's an equal chance of it going up or down. However, one pattern that sticks out like a sore thumb is the long-term unemployment line graph which accelerated sharply since the start of the current recession in 2008. Although past unemployment rates had been higher than the current rates, the rise in past long-term unemployment was modest. That should've alerted us that this recession is atypical and that the unemployment now is not cyclical but structural.

Let's take the LFPR chart, from The Wall Street Journal, that covers the same period as the above unemployment chart. Note the obvious difference between this chart and the previous. With this chart, you'd have no problem predicting where the line is heading. Because the line graph in this chart cannot turn on a dime, you can figure out the turning point months ahead.

Now we can explain the movement in the labour force components shown in the first chart. The movement between employment and unemployment, i.e., the two green boxes, is pretty fluid. It can go either way depending on the state of the economy. But the shift between the green and the cream areas can only be unidirectional.

As a result of this one-way traffic, the unemployment rate can be showing improving metrics even though the job market is deteriorating. When the unemployed give up looking for jobs, i.e., become non-participating, both the numerator (the unemployed) and the denominator (the participating labour force) decrease. Thus the improvement. In the case of the LFPR, the same situation would reduce the numerator (the participating labour force) while keeping the denominator (the aged 16 and above population) unchanged. Thus the declining LFPR. Note that a lower figure is good news for the unemployment rate but negative for the LFPR.

We can use the analogy of reverse osmosis (RO) to explain why the flow is one way. In RO, two factors cause movement from one side to the other: pressure and concentration. Right now in the green area, the pressure, to cut costs through retrenchment, is so strong that the movement is mostly from green to cream. Businesses are relying on technology to cut headcount while maintaining production at the same or even higher level. At the same time, a high concentration of baby boomers (those born in 1946-1964) has started to retire (see left chart from The Economist). So over the next 18 years, the baby boomers will migrate in a big wave to the non-participating section.

But the interesting bit about the declining LFPR is the cohort that is disproportionately hit is the one in the 16-24 age bracket (see lower panel of the LFPR graphic above). What most of those in this group have done is to take up additional study loans to further their studies hoping that by the time they graduate, the job market will have improved. How they're going to be utterly disappointed. They'll soon realise that they're jumping from the frying pan into the fire. The job market will still be moribund but worse, the loans that they've burdened upon themselves will take years to repay.

However there are others who, faced with this inextricable situation, plead disabled in order to claim disability benefits. In fact, disability claims have increased significantly during this recession, up by 22% since December 2007. There are also instances of those committing petty crimes in order to get free food and medical in jail. Funny that the losers in the monopoly board game also would find much relief when they get sent to jail. At least, in jail, you get sheltered from the economic horrors of the real world.

This final chart at left from dshort.com is presented just to prove that any indicators that include employment or unemployment as its numerator or denominator can be safely ignored. The blue graph is the employment-population ratio while the red is the unemployment rate. Since employment and unemployment are two sides of the same coin, the two line graphs are just mirror images of one another.

So with indicators as with anything else, less is more. The simpler, the better. The quicker you can grasp the pattern, the greater your ability to predict future trends. Least of all, you don't want to appear silly like Donald Rumsfeld with his known unknowns and unknown unknowns.

Grossly Distorted Picture

Continuing our review on the indicators that matter, we'll revisit our second most important economic indicator, that is, the Case-Shiller 20-city composite home price index. This index is a 3-month moving average of house prices lagged two months. So the recently published index for January 2012 is in fact an average of November, December 2011 and January 2012 home prices. The Case-Shiller may be a laggard but it compensates for the delay with accuracy.

This index at left confirms that home prices are still setting new rock bottom records despite the spate of favourable economic news on other fronts. In a depression, house prices can collapse by at least 50% from their peaks, last reached in the US in April 2006. The country with the worst performing state of real property is now Ireland where prices have gone down by 57%. In the US, the drop is a whisker short of 34%. That means prices have another 16% to fall from their peaks, or about 25% if based on current prices.

To be sure, Ireland had a mad building frenzy. The US also had a similar craze but of a refinancing variety. Going by the slow pace of property price drop, thanks to Obama's massive deficits, the prices will only hit bottom by the end of 2017. There's still a long way to go before we can see a real normal. Of course, reality will arise much sooner since the US government does not have that much stamina for sustained massive deficits.

With a new wave of foreclosures that is expected to set a more rapid pace than those of the past four years, house prices will be more depressed in 2012. Unlike in the past in which the subprime mortgages were the prime target, this time it's the ordinary mortgages that will be hit. In the fourth quarter of 2011, more than one in four homeowners were under water. Moreover, last year was the year in which proceedings were initiated and this year will be one in which settlement has been reached, allowing the banks to begin foreclosures. Sales of foreclosed homes will increase to 1.25 million this year from 1.0 million last year.

Because of the way it is calculated, the Case-Shiller index provides a pattern that is not distorted by short-term fickleness. Compare this with the US GDP growth for the fourth quarter of 2011 which registered a healthy quarterly annualised growth of 3%. Some commentators have stupidly claimed that recovery is in the pipeline. Although the GDP itself is saddled with quirky ways of computation, these are nothing compared to the ridiculous massaging of the annualised number.

The picture on the left depicts two versions of the quarterly GDP, and both are correct. You can guess which is the more suitable measure simply by looking at the shape of the two curves. The blue line is the quarterly GDP computed year-on-year (YoY), that is, Quarter 4, 2011 over Quarter 4, 2010. The quarterly GDP for this is 1.6%. The recently announced GDP for the same quarter at 3.0% is based on the growth of Quarter 4, 2011 over Quarter 3, 2011 (QoQ). This yields a 0.7% growth which then is compounded four times to annualise it. This method of computation generates a highly distorted trend, totally unfit for uncovering pattern. In statistics, you must smooth highly distorted measurements through the use of a longer time span or you can compute a moving average like the Case-Shiller index. With the red line, the pattern is uncertain but not so with the blue line.

Since almost 71% of the US GDP is made up of personal consumption, house prices do play a significant role in influencing GDP growth. Homeowners with substantial home equity as a result of the housing boom, used that equity to take on more debt loads. Now the process has reversed itself with homeowners paying back for the sins of their over indebted past. With home prices still struggling to pick up, it's little wonder that the household sector is not contributing to any growth. As for corporations, they are sitting on a large pile of cash, not rushing to invest in an environment with plenty of capacity to spare.

Obama, relishing on seemingly improving indicators, seems more confident of his reelection prospects. But lots of surprises are around the corner waiting to pounce on him in the coming months. Foremost of all is his deficit spending. If you want to know the real cause of the movements since 2009 in the Case-Shiller house price index and the quarterly GDP, the YoY version, that is, just watch the federal government deficit growth (chart above). The two metrics lag the federal debt growth by one year. The deficit spending growth is slowing and the CS house index has moved accordingly. You can guess how the soon to-be-announced GDP number for Quarter 1, 2012 will turn out.

Already, corporate profits are forecast to grow at the slowest pace since the third quarter of 2009. With the federal debt as the main driver of growth since the beginning of the depression, the stock indices (see that of the S&P 500 from Bloomberg at left) have also charted a too well predictable pattern. April appears to be the pivotal month in which all indices turn on their heads.

It's the nature of compound growth that it thrives on ever bigger numbers in subsequent periods. So for Obama to perk up the GDP, his deficit spending must keep on escalating. Many obstacles lie ahead at the end of 2012: expiry of Bush tax cuts, the $1.2 trillion automatic spending cuts and the end of the payroll tax cuts. All these will lead to a substantially reduced deficit.

Finally, if you want to crystal-gaze into the future, the following three charts (from The Economist) using decadal averages from the 1930s to the 2000s afford indisputable long-term trends. Of course, you may argue that the 2000s is the turning point after which all measures will pick up. But remember, this depression will turn out worse than the 1930s Great Depression, and the indicators so far have yet to plumb depths deeper than those of the 1930s. As the indicators start notching new record lows, prepare for a new reality that will upend politics and economics.