16 April 2016

What explains changes in the labour participation rate?

Tens of papers or blog posts have been written in an attempt to explain why the labour participation rate in the US has been low after the recession. Among other factors, the aging of the workforce and disability have been advanced as explanations. However, an obvious reason seems to have been overlooked: low wage rates.

The graph below shows YoY changes in the civilian labour participation rate vs YoY changes in the real median household income between 1984 and 2014, the period for which data on the real median household income are available. It is clear that the two graphs follow roughly the same path.

In microeconomics the concept of economic profit is widely used. To entice a car company to enter the motorcycle market the mere existence of accounting profit in the new market is not sufficient. Profits in the motorcycle market, after considering all costs, must be higher than in the car market. Opportunity costs must be taken into account before making a decision.

It is the same in the labour market. At first sight it may seem odd that an individual should choose to earn no wages rather than some wages, however low. But when a household is regarded as the basic economic unit it makes sense. For instance, if childcare costs are higher than the wage for a new job, it makes economic sense for one parent to forego the job and take care of a child or children.

Category: Economics


05 April 2016

Who benefits from low interest rates?

In the Keynesian imagination lowering interest rates spurs companies to increase investment and output and consumers to plunk down money on big ticket items like cars and houses.

Japan has held interest rates close to zero levels for the better part of two and a half decades and the glorious recovery, which according to theory should have happened a long time ago, is nowhere in sight. Ditto for Europe and the US, though for shorter periods.

Could the theory be wrong and do low interest rates have quite the opposite effects? The graphs below are illuminating.

The first shows corporate profits after tax for the finance and insurance industry from 1998 to 2013. There is nothing surprising about it. For the greater part of the period it shows that when interest rates are lowered financial profits go up.

The next graph is more surprising. It shows that for the greater part of the period from 1954 to 2016, manufacturing employment rises with the Fed Funds Rate and falls when the Fed Funds Rate falls.

The final two graphs illustrate the same point.

These graphs go further to establish the point we made in a previous post: that raising interest rates from very low levels helps increase the supply of loans to the real economy by making investment in financial assets unprofitable. See Higher interest rates benefit the real economy.

Category: Economics


13 March 2016

Why are US companies not investing?

US companies are sitting on piles of cash. And the Fed has held interest rates close to zero almost since the start of the Great Recession. And yet companies seem very reluctant to invest. The reason is not far to seek as I mentioned in a previous post Loan Growth During and After Recessions

If consumption were absolutely flat companies would invest just enough to replace worn out fixed capital. It is only when consumption is growing that companies invest more than this. And when, as during and after a recession, consumption has fallen companies would not even seek to replace depreciated capital. This was what Paul Samuelson wrote about in his famous accelerator paper of 1939. Investment in Period t is a function of consumption in Period t-1.

The graph below shows YoY change in Private Nonresidential Fixed Investment v/s YoY change in Personal Consumption Expenditure. There can be little doubt that it agrees with Samuelson's equation.

And why are consumers not consuming? I have explained in great detail in my book Macroeconomics Redefined

Category: Economics


10 March 2016

Does raising the Fed Funds Rate raise inflation?

The three graphs below show inflation (Consumer Price Index for All Urban Consumers) vs the Effective Federal Funds Rate for three periods: 1954 to 1975, 1976 to 2000, and 2001 to 2015. Readers are invited to judge for themselves which came first: the chicken or the egg.

Category: Economics


07 March 2016

Higher interest rates benefit the real economy

It is conventional wisdom that higher interest rates hurt the real economy because they raise the cost of loans and thus reduce the demand for them. This also explains the clamour for lower rates whenever the economy runs into trouble.

It may therefore surprise economists to learn that the facts point the other way. The graph below shows the YoY change in Commercial and Industrial Loans (for all commercial banks) v/s the Effective Federal Funds Rate. From 1973 onwards it shows that commercial and industrial loans respond positively to a rise in interest rates.

This may seem very odd. But the explanation is actually quite simple. Very low interest rates benefit the financial sector at the expense of the real economy. When interest rates are raised money moves from financial asset markets into the real economy.

When the Fed sees this effect it concludes that money supply is expanding and continues to raise rates, when what is happening is quite the opposite (as my previous post showed). At a certain point in the upward trajectory of interest rates the financial asset markets collapse leading to a recession.

Category: Economics


Philip George
Debunker of Keynesian, monetarist and Austrian economics

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