TCS Daily


I Love LUCY

By Arnold Kling - August 8, 2003 12:00 AM

"...one could instead define expansions and recessions in terms of whether the fraction of the economy's productive resources that is being used is rising or falling (in which case the behavior of the unemployment rate would be a critical guide to whether the economy was in expansion or recession)...[this] might lead to the conclusion that the recent recession lasted much longer than 8 months and that it might not have ended yet.
--
National Bureau of Economic Research (NBER)

 

The NBER's business cycle dating committee officially stated that the latest recession began in March of 2001 and ended in November of 2001. This approach leads to three characterizations of the recession.

 

1. It was brief.

2. It was shallow.

3. It is over.

 

All of these statements are false. The recession was deep, it was long, and it is still underway. Economists and others who rely on the NBER and on indicators such as GDP growth, interest rates, or stock prices have been misled. The economy is weaker than many people realize.

 

Everybody Should Watch LUCY

 

As the NBER pointed out in the statement quoted above, one approach to evaluating economic performance is to examine measures of capacity utilization. For example, the latest reading of the Federal Reserve Board's measure of capacity utilization in the industrial sector is far below normal.

 

I think that an even broader estimate of capacity utilization can be constructed by using data from the Bureau of Labor Statistics. My goal is to estimate the extent to which the labor force is working at capacity. We might call this the Labor Capacity Utilization Index, or -- using some poetic license with the acronym -- LUCY. When LUCY is 100 percent, the economy is running at full throttle. When LUCY is far from 100 percent, the economy is sputtering.

 

I measure labor utilization as hours worked in the nonfarm private sector, based on the index calculated by the Bureau of Labor Statistics. I measure labor capacity as the sum of men and women aged 16 and over. I took the ratio of utilization to capacity and divided it by its peak value in December of 1999 to get a maximum of 1.0; then I multiplied by 100 to get an index that can be interpreted as percent utilization of labor capacity.

 

How has LUCY behaved? During the long recovery of the 1980's, labor utilization rose from just under 80 percent to just over 91 percent, but then from June 1990 to March 1992 it drifted down to 87.2 percent. From there it expanded until December of 1999, when it reached 100 percent.

 

Labor utilization was still as high as 98.5 percent in January of 2001. From March of 2001 through November of 2001 -- the respective dates for the beginning and the end of the recession, according to the NBER -- labor utilization fell from 97.8 percent to 94.5 percent. Since November of 2001, labor utilization has plunged still further, to 90.3 percent in July of 2003. In other words, the drop that LUCY has taken so far during the "recovery" exceeds the decline that took place during the recession. NBER, you've got some 'splainin' to do!

 

Productivity-Cushioned Recession

 

Growth in real GDP has been positive in recent quarters, leading pundits to call this a jobless recovery. I think that a better term would be productivity-cushioned recession. That is, although labor demand has been declining, the economy has eked out positive growth in real GDP because of remarkable gains in productivity.

 

In fact, the most striking feature of today's economy is the strength of productivity growth. Almost a year ago, economist Brad DeLong pointed out that productivity growth was triple the norm for this stage of the business cycle.

 

If you did not know that productivity was growing at 4 percent per year, then a growth rate of real GDP of 2 to 2.5 percent would be considered satisfactory. However, taking into account high productivity growth, 2.5 percent GDP growth is terrible. LUCY, the measure of labor utilization, is not thrown off by faster productivity growth. The NBER, which still looks at GDP growth without taking into account productivity, has been fooled.

 

Policy Implications

 

LUCY is telling us that we are not in the midst of an economic recovery. Labor utilization has declined every month this year. Contrary to the NBER and conventional wisdom, this recession is long, deep, and ongoing.

 

The first implication of this analysis is that the economy is a long way from potential. Even if a recovery were to begin next month, it would take years to eliminate all of the slack in the labor market. The last time LUCY was at today's level of 91.3 was March of 1994, and it took over two years to reach 95. It was not until the end of 1997 that labor force utilization reached 98 percent. Thus, the soonest that we are likely to see a high level of economic performance is early 2007.

 

The second implication is that monetary policy probably could be more expansionary. The current thinking at the Fed seems to be to let up on the gas as long as real GDP is rising. However, that means that the Fed is no longer applying stimulus, even though LUCY is low and falling.

 

The third implication is that we are going to see large Budget deficits for at least three or four more years. Politicians are not going to have the will to cut spending or increase taxes while the economy is in the toilet. Nor would a budget balancing be wise with so much labor market slack.

 

In general, economists, pundits, and politicians need to adjust their focus on the economy. From the perspective of capacity utilization, the economy is low and still sinking.

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