The Phillips curve is still dead

Greg Mankiw posted a clever graph a month ago, which he titled "The Phillips Curve is Alive and Well."

No, Greg, the Phillips curve is still as dead as Generalissimo Franco.

The lines, in case you can't see them are the employment-population ratio 25-54, and the average hourly earnings of production and nonsupervisory employees. Wait a minute, the Phillips curve, as it appears in contemporary macroeconomics, is a relation between inflation, a coordinated rise in prices and wages,  not real wages or hourly earnings, and unemployment or the output gap, not the employment-population ratio. How does the traditional Phillips curve look? Here is unemployment vs. CPI inflation

and here is inflation vs. the GDP gap:



Here is "core" (less food and energy) inflation vs. unemployment:

Except for one little blip in the depths of the 2009 recession. The Phillips curve is dead. (Long live the Phillips curve, the crowd sings nonetheless.) Inflation trundles along, ignoring unemployment or the output gap.

What's going on? Primarily, I think Greg goes deeply wrong in looking at average hourly earnings, or wages for short. The whole art and magic of the Phillips curve is about inflation, the rise in both prices and wages.  Greg's graph is perfectly sensible microeconomics. The labor market is tight, demand for labor is high, you have to pay people more to get them to work. The rise in wages is a rise in real wages, a rise in wages relative to prices.

Similarly, one might imagine tight product markets, with strong demand, as a time that output prices and measured inflation would rise relative to wages.

The puzzle and promise of the Phillips curve is the idea that tighter labor markets, traditionally measured by the unemployment rate, correlate with higher wages and prices. That takes more doing. Typically, you have to think that workers are fooled into working for what they think are higher real wages, and only later discover that prices have gone up too. And you have to think that firms rather mechanically raise prices passing on higher labor costs, and keep selling things when they do. Despite the intuitive appeal of tight markets leading to rising prices and wages, that simple intuition is wrong to describe a correlation between tight markets and both prices and wages, which is what the Phillips curve is and was.

The employment-population ratio is a little bit curious but less so. Much modern labor economics doesn't focus on unemployment.

What is happening should be cause for celebration by the way -- real wages are rising. From growth to inequality to the hand-wringing about declining labor share, it's hard to find anything bad to say about that!

Greg's "Phillips curve" also does not extend backwards. Here's what happens if. you push the data slider to the left on Greg's graph, going back to the 1960s rather than start in 1990:




Greg's correlation is absent in the heyday of the Phillips curve. Greg's alive Phillips curve was born in 1990.  (What you're seeing is, of course, the rise in labor force participation, particularly among women, until 1990.) That's why the traditional (ex ante!) Phillips curve really was about gap measures

The conventional inflation-unemployment Phillips curve also died just about contemporaneously with the Generalissimo:

The negative correlation which Phillips noted around 1960 turned to a positive, or stagflationary correlation in the 1970s. One nice negatively correlated data point in the disinflation of 1982 is it.

The policy world, including the Fed, ECB, and related institutions, continues to believe in the Phillips Curve, and as causation not just correlation: tight labor markets cause inflation. But its evident death is causing some unsettled feelings for sure.

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Catching up on Greg's blog, I also found a lovely and sage quip:

Washington Post columnist Robert Samuelson argues "It’s time we tear up our economics textbooks and start over." He uses my book as a prime example. Perhaps not surprisingly, I disagree. My summary of Samuelson's article: Economics textbooks should be more like economics journalism, says an economics journalist.

There is so much "starting over" in the air -- modern monetary magic on the left, neo-mercantilism on the right -- that understanding long settled questions is indeed what education should be about. (And not just the sharing of untutored opinions.)

Textbook writers, on the other hand, emphasize those things that are true, important, and unknown to the typical reader (an 18 year old college freshman). Newness has little relevance. The lessons of Adam Smith do not apply only to the 18th century, the lessons of David Ricardo do not apply only to the 19th century, and the lessons of John Maynard Keynes do not apply only to the 20th century. They are timeless ideas that may not make good news stories but should be central to introductory economics. Just as Newtonian mechanics should remain central to introductory physics.

Well, I think Keynes will go the way of phlogiston, but I agree with the point, and anyway a good 19th century scientist should know what phlogiston is.


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Update:

Or maybe we should call it the Phillips Cloud. Here is the traditional inflation vs. unemployment graph, for the 1990-today sample and then the whole postwar period

Some economists run a regression line here, and proclaim the Phillips curve to be flat. They conclude, unemployment is incredibly sensitive to inflation -- just a bit more inflation would make a lot of jobs. I conclude it's just mush.

The rent is too damn high

NPR covered the Democratic candidates' plans to address housing issues:

[Julian] Castro would provide housing vouchers to all families who need help. Right now, only 1 in 4 families eligible for housing assistance gets it. He would also increase government spending on new affordable housing by tens of billions of dollars a year and provide a refundable tax credit to the millions of low- and moderate-income renters who have to spend more than 30% of their incomes on housing.

I'm actually surprised it's as much as a fourth. Most government programs outside medicare and social security attract tiny fractions of the eligible people. Watch out budget if people catch on.

Massachusetts Sen. Elizabeth Warren calls for a $500 billion federal investment over the next 10 years in new affordable housing....  

[New Jersey Sen. Cory Booker] would also provide a renters' tax credit, legal assistance for tenants facing eviction and protect against housing discrimination... 

Sen. Kamala Harris has also introduced a plan for a renters' tax credit of up to $6,000 for families making $100,000 or less. 

New York Sen. Kirsten Gillibrand has signed on to both the Harris and Warren plans, which have been introduced as legislation.

In sum, they're piling on to pay your rent or mortgage.

The economic foolishness of all this is painful. Housing is not a single good. It's location, location, location, and also size and condition. This isn't about homelessness. Everyone lives somewhere, so the point is to subsidize larger, better, or more conveniently placed housing. Or, to free up money for people to spend on other things.

Economics is about incentives. If the government pays for all your rent past 30% of your income, that's a big incentive to rent a huge apartment and not to earn any extra income. =

"Affordable housing," doesn't mean affordable housing, in the same way affordable hamburgers mean affordable hamburgers. It's a catchword for "below-market rate" housing, usually mandated by zoning boards, but now I guess to be paid for by the government. But when you give away something for, by definition, less than the market rate, that means people line up for it. Like scarce rent-controlled apartments, is one more impediment to people moving for better opportunities.  

Econ 101: What happens if you subsidize demand, but do not unleash supply?

Prices go up. Period. It ends up entirely in the pockets of current property owners. There is a good case this happened already. To earn a gazillion dollars in tech, you need to move to the Bay Area. There are only so many houses, so the great gains in productivity end up in the pockets of existing landowners.

Aha, you will answer, but they have a fix for that: rent control, now sweeping the nation. We know where that leads.

They also answer, as above, the Federal government will start building houses and apartments.

I guess millenials are too young, and nobody reads any history any more, but, we and especially Europe have tried this one over and over, to catastrophic failure. Go visit the sites of housing projects, now thankfully torn down, in Chicago. They look like Chernobyl. Go visit the cruddy outskirts of European cities, with government built cement apartment blocks. This is our vision for the "middle class?"

In sum, the candidates promise to repeat for housing the immense success of subsidies and supply management and provision that the the government has just accomplished for health care, insurance, and education.

It's usually a good idea to figure out what's broken before we start fixing things. That idea never seems to occur to anyone in politics when talking about economic policies. Where is the market failure in home and apartment building? Why is the private sector not building more housing? The answer is pretty obvious -- zoning, building codes, insane permitting processes and so forth.

So, the government restricts supply, and prices go up. Then it subsidizes demand, and prices go up some more. Then it puts in price controls. So the plan seems to be to bring the government's huge success with health care and health insurance to the housing market.

One tiny ray of light: 

New Jersey Sen. Cory Booker would provide financial incentives to encourage local governments to get rid of zoning laws that limit the construction of affordable housing. 

Zoning laws largely keep poor people away from rich people and enforce a lot of racial segregation.
But again, "affordable housing" means "housing allocated by politics," and "housing you'd better not leave once you get it, and better not earn too much either." I wish the article just said "limit the construction of housing, which makes it unaffordable!"

The usual coexistence of subsidy and restriction plays out almost comically in the "gentrification" issue, politicians wanting to be all things to all people:

"It is not acceptable that, in communities throughout the country, wealthy developers are gentrifying neighborhoods and forcing working families out of the homes and apartments where they have lived their entire lives," [said] Vermont Sen. Bernie Sanders,..

Warren would also give grants to first-time homebuyers who live in areas where black families were once excluded from getting home loans. "Everybody who lives or lived in a formerly red-lined district can get some housing assistance now to be able to buy a home," Warren told attendees at the She the People Presidential Forum in Houston this spring.

Technically, "Everybody" includes white millennials. I wonder how she will stop that.

Calfornia's SB50 proposal to force  local zoning to allow development near transit had a similar feature. Yes, we allow development everywhere -- except in poorer neighborhoods most in need of development, which are protected from the evils of new Starbucks and Whole Foods popping up.

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These are tough times to be an economist. As a matter of technocratic policy, this is not hard stuff. Physicists don't have to write blog posts because the candidates want to enshrine the phlogistic theory of heat. Doctors don't have to rail about HHS policy on four humor management. Somehow we are left railing against fallacies understood since the 1700s.

It is, of course, no better on the right. The benefits of free trade and migration have also been known since the 1700s. It is just, sadly, that there is no debate on the right at the moment.

This is a real weakness of the American  political equilibrium, that in a reelection year all the new ideas and analysis come out of the party in opposition. It would be a great time for the Republican Party to try to come to terms with what Trumpism means, how it relates to traditional conservatism, and to hash out ideas like this. Alas, that will not happen.

One is tempted to dismiss all this as rhetoric that will settle down in the general election. But I don't think one should take too much comfort. Trump ended up doing a lot of exactly what he said he would do. Politicians often do.

On this, I found fascinating a tidbit from Dan Henninger in WSJ, covering a poll of Democrats conducted by Fox News.

Fox asked these Democratic voters whether they wanted “steady, reliable leadership” or a “bold, new agenda.” Steady and reliable crushed bold and new by 72% to 25%. 

Anyone consuming the media every day the past year would have concluded that the Democratic left’s “bold, new agenda” had taken over the Democratic Party lock, stock and barrel. Most of their presidential candidates obviously thought so. 

How else to explain why Sens. Warren, Harris and Cory Booker instantly saluted Bernie Sanders’s socialized medicine or, even more incredibly, the antic Alexandria Ocasio-Cortez’s multitrillion-dollar Green New Deal? Recall how Nancy Pelosi, whose 70-something sense of political smell is still more acute than her juniors’, called it “the green dream, or whatever.” 

In fact, when Fox asked these Democrats what they most wanted from their candidate, 74% chose “unite Americans” against just 23% who want to “fight against extreme right-wing beliefs.” Looks like there’s a silent majority inside the Democratic Party, unmoved by the propaganda of social media. 

These are the parts of the Fox poll, surfacing a nostalgia for steadiness and unity, that should upset the Trump campaign, not Mr. Biden’s 10-point lead 16 months before the election. 

Mr. Henninger did not add that Mr. Biden is the one who should be listening hardest. He is currently drifting fast to the left.  The poll tells us that this time, my friends, the answer is not blowin' in the wind. I hope more people listen.

Real estate ups and downs

In a delightfully YIMBY "Americans Need More Neighbors" the New York times gets it almost all right.

Housing is one area of American life where government really is the problem. The United States is suffering from an acute shortage of affordable places to live, particularly in the urban areas where economic opportunity increasingly is concentrated. And perhaps the most important reason is that local governments are preventing construction.

It goes on, even noting flagrant progressive hypocrisy

Increasing the supply of urban housing would help to address a number of the problems plaguing the United States. Construction could increase economic growth and create blue-collar jobs. Allowing more people to live in cities could mitigate inequality and reduce carbon emissions. Yet in most places, housing construction remains wildly unpopular. People who think of themselves as progressives, environmentalists and egalitarians fight fiercely against urban development, complaining about traffic and shadows and the sanctity of lawns. 

It noticed the sordid racial past of zoning restrictions

... many residents said they were surprised to learn that single-family zoning in Minneapolis, as in other cities, had deep roots in efforts to enforce racial segregation. Cities found that banning apartment construction in white neighborhoods was an effective proxy for racial discrimination, and the practice spread after it was validated by the Supreme Court in 1926. 

Heavens, it even allows for the freedom to spend money, as long as it's not subsidized

People should be free to live in a prairie-style house on a quarter-acre lot in the middle of Minneapolis, so long as they can afford the land and taxes. But zoning subsidizes that extravagance by prohibiting better, more concentrated use of the land. 

Usually I would expect the NYT to jump on the opposite bandwagon and prohibit such houses.  The NYT even realizes that more market-rate apartments is the best way to provide more low priced housing

OK, the Times being the Times, it has to argue for some vast new subsidy,

 Governments need to provide subsidized housing for people who cannot afford market-rate housing. 

But here too, it gets a lot right. The bulk of the long oped is not about repeating the disaster of public housing projects, or more "affordable housing" mandates. It's just about build -- move the supply curve to the right. Berating its own a little more, it recognizes substitution and depreciation

...advocates for affordable housing should be jumping up and down and screaming for the construction of more high-end apartment buildings to ease demand for existing homes. Those new buildings are filled with people who would otherwise be spending Saturdays touring fixer-uppers in neighborhoods newly named something like SoFa, with rapidly dwindling populations of longtime residents.

Today’s market-rate apartments will gradually become more affordable, just as new cars become used cars. 

Meanwhile, in progressive political reality, and lest you get too optimistic, the Wall Street Journal, in a spectacularly mis-titled article, covers New York State's new rent control law. The title is "New York Passes Overhaul of Rent Laws, Buoying Wider Movement to Tackle Housing Crunch"  It's not an overhaul, it's a massive expansion, and it will not tackle the housing crunch, but it will make it spectacularly worse.

The New York legislation brings increased power to tenants in roughly one million rent-regulated apartments in New York City. It makes it more difficult for the owners of those apartments to increase rents, while enabling more tenants to sue landlords for rent overcharges. Also, tenants around the state will have more protections against eviction.

Proposals to limit rents are advancing in a number of state legislatures, including in California, where a statewide cap on rent passed the California Assembly in May, and in Oregon, which passed the nation’s first statewide rent control in February, limiting annual rent increases to 7% plus local inflation.

The times will probably get its way on housing subsidies, already a popular idea here in California. Imagine a subsidy for any house or rent above 30 percent of your income, plus a continued block on new construction.

It's interesting that economists spend a lot of attention on the minimum wage, and less on rent control plus housing supply restrictions. I guess nobody has made a big stir with a diff in diff regression claiming that rent control doesn't shrink housing supply. Perhaps someone should, just to ge the outrage going.

And, if you're wondering about the wealth tax, it's here. A limit on rents is a pure tax on the landlord's  property, transferring its value to the current renter, but destroying much of that value along the way.

Futures forecasts

Torsten Slok at DB updates this lovely graph on occasion. Here's what it means. Fed fund futures are essentially bets on where the Federal funds rate will be at various points in the future. Thus, you can read from the dashed lines the market's guess about where the federal funds rate will go -- assuming that the bets are priced to have an even chance of winning or losing.

Reading it that way, the market was systematically wrong from 2009 to 2016. It's something like springtime in Chicago -- this week, 40 degrees and raining. Next week, 75 and sunny. Week after week after week. In 2017, the market finally changed expectations to say, no, fed funds rates are not rising -- just in time to miss the actual rise in federal funds. Now, as in the blue line, market forecasts say there will be a big decline. But, as Torsten points out, why would the market be right today?

So what does this graph mean? Are market practitioners really that dumb? After all, there is a lot of money to be made here. When the graph is upward sloping -- as the entire yield curve was upward sloping from 2009-2016 -- and so long as rates don't rise, you can make a fortune borrowing short and lending long. And vice versa. In short, the difference between forward rate (right end of dashed lines) and spot rate (current fed funds rate) does a lousy job of forecasting where the spot rate will go -- and thus, mechanically, is a good signal of the extra return, positive or  (lately) negative you will get by holding long-term bonds.

The pattern is actually widespread and longstanding. Starting in the late 70s and early 1980s, Gene Fama wrote a series of papers on it, short term bonds, money markets, foreign exchange,  and (a favorite of mine) long term bonds (with Rob Bliss). Campbell and Shiller also found it in long term bonds, which Monika Piazzesi and I extended.  Piazzesi and Swanson show the pattern in federal funds futures.

There are three potential stories:

One: the market is dumb. People are dumb. Well, that's a nice story that can "explain" just about anything. But if you're so smart why are you not rich. Behavioral finance isn't that empty, and searches for common patterns in dumbness. However this graph is the opposite of the usual behavioral claim, extrapolative expectations, excess belief in momentum.  If there is a rejectable hypothesis in behavioral finance, this graph seems to reject it. (I welcome corrections to that statement in the comments.)

Two: there is a risk premium and it varies over time. For most of 2009-2015, the economy was depressed. People needed a good promised return, a coin more than 50/50, to hold the risk of long term bonds.  Once we exit the recession, the opposite pattern holds. Long term bonds should pay less than short term bonds, and maybe now the yield curve is finally waking up to that pattern. Naturally, I'm attracted to this story, but I admit it's a bit strained late in the upslope period.

Three: exit and entry to recessions is something like a rare event, a Poisson process. Such a process is like computer failure. The chance of the event is always the same, and does not increase as the length of time goes by. Recovery could happen any time. In a second paper that's what Piazzesi and I seemed to find for this pattern in bond markets. The market forecasts are right, in fact, and we just got 7 tails in a row. That is a speculative idea, and needs quantification.

Whatever the story, here is the fact: futures prices are not good forecasts (true-measure conditional means) of where interest rates are going. That fact is true not just of Fed Funds futures, but interest rates in general.

Update:

Torsten sends along an updated chart, going further back in history.

Institutionalized nonsense

When, last week, the Treasury issued its currency manipulation report, I thought it was a joke. Treasury put Germany and Italy on its "monitoring list" of countries suspected of "currency manipulation."

Germany and Italy are, of course, part of the Euro, the whole point of which is that they cannot, individually, "manipulate" their currencies, whatever that means. It is precisely this inability to devalue -- to "manipulate" the Drachma to regain "competitiveness" (another meaningless term) -- that conventional wisdom bemoaned of Greece.

I had a little chuckle, envisioning some frustrated mid-level Treasury economist bemoaning the trade and currency idiocy floating around Washington, putting this little message in a bottle to see if anyone noticed the reductio ad absurdum.  If so, hello there, somebody noticed.

But then  read the report.