The Fed has a dual mandate to promote stable prices and maximum employment.  With current inflation near the Fed’s long-run target of 2% and unemployment well above estimates of its “natural rate,” Fed chairman Ben Bernanke and NY Fed President William Dudley have understandably stressed their commitment to the second part of the mandate.  Indeed, the Fed’s recent pledge to hold interest rates near zero through 2014 reflects their concern that unemployment will only decline slowly in the coming years, unlike in previous recoveries.  Dudley has stressed the post-crisis decline in the labor force participation rate (LPR) in support of this view: had the LPR not, he said in March, “declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.” The implication is that the current unemployment figures present too rosy a picture of the state of the labor market.  Upward pressure on the unemployment rate will emerge as the LPR returns to normal.

We think Dudley’s analysis is flawed.  As the large figure above shows, today’s LPR is precisely where its post-2001 trend line suggests it should be. There has indeed been a sharp decline in the LPR since the crisis, but this has merely erased the pause over the four years prior to the crisis, which was driven by robust demand for workers during that period—illustrated in the small upper right figure on unit labor costs. But the broader picture is one of a steadily declining LPR as the population ages, illustrated in the small lower left figure.

In short, if the Fed pursues its low-rate pledge with the expectation that the LPR will naturally return to 2007 levels it is likely to underestimate inflationary pressures coming from an improving labor market.  It will therefore hold rates too low for too long.

Dudley: The National and Regional Economic Outlook
Macroblog: A Take on Labor Force Participation and the Unemployment Rate
Talking Points Memo: Why Labor Force Participation Does and Doesn’t Matter
Real Time Economics: Fed Debates Falling Labor Force Participation

Since 2009, labor’s share of income in the United States has plummeted while personal dividend income as a percentage of disposable income has soared. This is not surprising for the early stage of a recovery in which firms are earning more with less and the stock market has been buoyant. The divergent trends between the two over the last 30 years, however, is notable and important. The small upper-right figure shows that dividend income as a percentage of after-tax corporate profits leapt markedly and permanently in the early 1980s. This corresponds with a general upward trend in corporate profits as a percentage of gross domestic product since that time; a time in which labor’s share of income has fallen almost continuously. Dividend income, not surprisingly, accrues largely to the stock-owning wealthy, as the small bottom-right figure shows. The fuller picture is one of growing inequality; one for which the globalization of business is frequently fingered as a primary culprit. But globalization itself makes the data difficult to parse. When an American firm uses components provided by foreign firms they appear from the data to have no labor content.

Mallaby: Inequality May Lead To Rage Against the Machines
Cleveland Fed: Behind the Decline in Labor’s Share of Income
Financial Times: Pay Gap a $740bn Threat to U.S. Recovery
Orszag: As Kaldor’s Facts Fall, Occupy Wall Street Rises

With a pair of new laws in 2008 and 2010, Congress fundamentally changed the student loan market, making the U.S. government the sole supplier of Federal student loans, rather than just the ultimate guarantor.  In itself, this does not affect the government’s net debt, because it acquires assets—student loans—which carry a market value.  This new direct lending does, however, add to the gross debt held by the public.  The $1.4 trillion in direct federal student loans that will be outstanding by 2020 will amount to roughly 7.7% of gross debt.  This is 6.3 percentage points higher than it would have been had the scheme not been nationalized.  To the extent that one worries about debt from the perspective of a “fiscal crisis,” in which government borrowing costs soar without warning, gross debt is more important than net debt, as student loans are not assets that can be readily sold to reduce borrowing requirements.

Liberty Street Economics: Grading Student Loans
Slate: Student-Loan Debt, School by School
Orszag: Winds of Change Blow Away College Degree
Video: Addressing the U.S. Deficit Problem

In a now-famous August 14, 2011 New York Times op-ed, billionaire Warren Buffett called for tax rates to be raised “immediately on taxable incomes in excess of $1 million, including, of course, dividends and capital gains.” The key word here is “taxable.” In Buffett’s case, his taxable income is a mere 0.9% of his income held within Berkshire Hathaway, of which he owns 22%. His share of its 2010 pre-tax income was $4.2 billion dollars, taxes on which amounted to over $1.2 billion—a 29% rate. This income would be subject to tax again at the personal rate if it was taken out of the company, but since he has generously pledged to give away his fortune he would avoid the tax he wants to increase. As the bottom figure above shows, when all taxes are accounted for the U.S. tax code—however poorly designed—is in actuality considerably more progressive than Buffett’s storyline suggests.

Buffett: Stop Coddling the Super-Rich
Spence: Mind over Market
Geo-Graphics: The Payroll Tax Cut and U.S. GDP Growth
Foreign Affairs: The Future of History

China’s economy slowed from a growth rate of 10.3% in 2010 to 9.5% in 2011 (and a 2000s peak of 14.2% in 2007), prompting fears that China could trigger a global slowdown.  Yet at 10% of world output, 2.5 times what it was in 2001, the Chinese economy is now so large that it will continue to make a significantly rising contribution to global growth even if its own growth rate continues to fall off moderately.

Haass: China’s Greatest Threat Is Internal
Mallaby: Conflict and Confusion: China’s Currency Policy
Foreign Affairs: The Inevitable Superpower
Working Papers: The Future of the International Monetary System and the Role of the Renminbi

Many U.S. policymakers, not least at the Federal Reserve and the Treasury, continue to pin hopes for a robust economic recovery on the housing market.  They should consider that one demographic particularly badly hit by its collapse has a long memory.  That’s because they’re young.  They’ll be around for a long time, and will bear its scars financially and psychologically. As the figure shows, the change in homeownership rates from the 1996 trough in the Case-Shiller Price Index to its 2006 peak was by far the greatest among the under-30s.  Total household homeownership rates increased 3.4 percentage points over this period, to 68.8%.  For 25-29 year olds, however, the increase was a much higher 7.1 percentage points – to 41.8%.  For under-25s, it was 6.8 percentage points – to 24.8%.  The rise in homeownership among the young was particularly remarkable given the much lower base from which it started.  What effect did the housing bust have on them?  Household balance sheets among the Facebook generation were the hardest hit: between 2007 and 2009, half of those under the age of 35 lost over 25% of their wealth.  A quarter of those under 35 lost over 86% of their wealth.

Orszag: Winds of Change Blow Away College Degree
Video: Debt-Driven Doldrums or the Promise of Prosperity
Chart Book: The Economic Downturn in Historical Context
Interactive: Household Balance Sheets

U.S. annualized real GDP growth of 1.2% through Q3 2011 was driven by personal consumption, accounting for 91% of it.  Yet only 44% of personal consumption growth was driven by higher incomes.  The other 56% was accounted for by unsustainable items: a decline in savings (36%) and the payroll tax cut (20%).  The latter will expire in two months time unless Congress acts to extend it again.

Orszag: State Lawmakers Can’t Find Common Ground Either
Foreign Affairs: The Democratic Malaise
Analysis Brief: Can Washington Fix Its Debt and Deficits?
Video: World Economic Update

“It is time for a breakthrough to a new Europe,” German Chancellor Angela Merkel said on November 9th.  “That will mean more Europe, not less.” Merkel wants a stronger fiscal union with strict controls on eurozone national budgets.  Yet to date EU fiscal policy, such as it is, has meant ill-considered pro-cyclical spending programs – as shown in the graphic above.  Greece was and is a large recipient of EU transfers, yet those transfers collapsed by 1.3% of Gross Domestic Product (GDP) after it was forced to cut back on its contributions to EU-subsidized projects in an effort to slash government spending.  This additional fiscal squeeze hurt growth; Greek GDP fell an annual average of 3.5% in 2009 and 2010.

Reuters: Italy At Breaking Point; Fears Grow of Euro Zone Split
Mallaby: Franco-German Misstep on Eurozone
Steil: Why Draghi Can’t Be Bernanke
Video: Europe Update

Imagine life insurance contracts that wouldn’t pay off if officials declared heart attacks to be “voluntary.” Welcome to the world of sovereign credit default swaps, or CDSs.  When the Greek debt deal was announced on October 27, the eurozone leadership insisted that the banks were taking a 50% write-down “voluntarily,” meaning that Greek CDS contracts would not be triggered.  This was done to protect official creditors like the ECB and IMF, to avoid rewarding speculators, and to prevent possible financial contagion.  In response, Greek CDS prices plunged 20 percentage points.  Policymakers didn’t seem to care, but they should.  Those who bought CDSs believing that they were prudently insuring their bond holdings now face unexpected losses.  Sovereign CDSs have lost so much credibility that the troubled investment bank Jefferies felt it necessary to state publicly that it was not using them.  This credibility loss has spread to other sovereign CDSs, as shown in the bottom part of the figure above: the correlation between PIIGS debt spreads and CDS prices has plunged, indicating that CDSs are no longer viewed as reliable sovereign credit risk insurance.  Using CDS prices as a measure of default risk is now like setting your watch to a defective clock.  Yet the market is unlikely to die owing to Basel III bank capital regulations, which still treat CDSs as meaningful offsets against certain types of sovereign credit exposures.  This gives banks a perverse incentive to hold them just to reduce their capital requirements.  Given the permanent political distortion that Europe has introduced into the sovereign CDS market, it would be best now if the market could simply be shuttered.

Steil: ECB Limitations in Addressing Eurozone Crisis
Conference Call: Can the Eurozone Be Rescued?
Analysis Brief: Resolving the Eurozone Crisis
Backgrounder: The Eurozone in Crisis

On September 21st the Fed announced that it would be selling $400 billion in short-term Treasurys and buying $400 billion in longer-term Treasurys to replace them – a maneuver titled “Operation Twist.” Atlanta Fed president Dennis Lockhart explained what it would mean for the economy: “It means lower interest rates – a lower cost of borrowing – across a whole spectrum of loan maturities.” Is he right? Well, China, Russia, and Brazil have conducted their own version of Operation Twist over the past several years, replacing roughly $330 billion in short-term Treasurys with long-term ones. The 10-year Treasury rate went sideways over that period, as shown in the figure above. Whereas the BRIC* Twist may have put some modest downward pressure on longer-term rates, other factors overwhelmed it. Don’t expect much from the Fed’s similar-sized version.

* There are no reliable data for India.

Lockhart: The Economy and Monetary Policy—The Latest “Twist”
Federal Reserve: Maturity Extension Program and Reinvestment Policy
Backgrounder: The Role of the U.S. Federal Reserve
Spence: How to Reverse the Global Economic Slowdown