The real issue here is what the recovery will look like. Are we stuck in a quagmire of persistently high unemployment (the plank) or are we going to see a sharp rebound (the hockey stick).

I vote for the plank.

The Jobs Numbers

Despite the snow, the unemployment rate held steady. Only 36,000 jobs were lost from non-farm payrolls. Temporary jobs increased again and temporary jobs are a good leading indicator of full time jobs. All of this is good news.

On the bad news side let me list some issues:

1. The unemployment rate did not drop. Are we stuck in the high 9% range?
2. The all-in rate which counts people that are marginally attached and working in part-time jobs (not by choice) increased to 16.8%.
3. Temporary jobs have been increasing for quite a while. Usually, they are a leading indicator – but they haven’t been (so far) in this cycle. Things might be different this time.
4. Duke-CFO Survey was released Wednesday. CFOs forecasted a lethargic 0.2% employment growth over the next 12 months. That will do nothing to the unemployment rate.

The Case for the Hockey Stick

Let me consider eight factors that have been mentioned by a leading economic consulting house.

1. Corporate profits will robustly grow, perhaps, 30% in 2010

This is definitely good news and credible. Remember that non-financial corporations (and excluding the autos) were in generally good shape before the melt down. Corporations have been reducing their leverage since 2002. There is plenty of cash on balance sheets. The recession has led to unprecedented productivity gains. CFO’s expect a further 3.2% productivity gain in 2010. They will spend. Capex will jump by 8.9%. R&D by 3.7%. Advertising by 3.4%. But, as I mentioned, not on employment. I can’t see how you can have a hockey stick recovery with 9-10% unemployment. By the way, the Duke-CFO survey puts earnings growth at 14.3% in 2010.

There is another important point but related point here. Where has the profit growth come from? Mainly cost cutting. The layoffs and restructuring costs that were taken in 2009 are now paying off in 2010. The key is sustainability. You cannot indefinitely cut costs. Growth depends not just on productivity but demand for the product. The profit numbers we are seeing are largely driven by the big bath in 2009 and the realization of cost savings in 2010.

2. Credit markets have greatly improved

Depends on who you are. Yes, credit spreads have dramatically decreased. It is a lot cheaper for large firms to go to the bond market because the spread they must pay over government bonds is a lot less. However, the problem is that corporate bond market is not accessible to small and medium sized businesses. SMB usually rely on bank lines of credit not the capital markets. The Duke-CFO survey showed that 70% of small and medium sized businesses said that credit conditions were worse than 2007. In other words, they face a continued credit crunch. Small and medium sized firms are the drivers of employment growth. It is hard to see a robust recovery if these firms are still being frozen out of the bank lending market.

3. Global short rates are low and low rates lead a recovery by one to two years

It is true rates are low. But why are they low? They are low because the economy is in recession. They are only a leading indictor of recovery in the sense that a recession is a leading indicator of a recovery. A recession is always followed by a recovery. Yes, there will be a recovery. The question is what it will look like. Low short rates are not particularly informative.

4. The yield curve is steep and has been for quite a while

I’ll write a whole blog on this one of these days. The predictive power of the yield curve was first documented in my dissertation at the University of Chicago in 1986 – so I have a bit of knowledge about this. The yield curve has accurately forecasted every recession since 1969 – without a false signal. Inverted yield curve means a recession will follow (at least so far). However, there is only so much you can ask from the yield curve. It provides very little information about the shape of a recovery. I would interpret the current reading as telling us that a double dip is unlikely (over the next year).

5. The Fed and the Administration are fully aware of the downside

Uhh, I guess so. This refers mainly to the Rogoff-Reinhart idea that once the size of government debt to GDP gets sufficiently large, it stunts future GDP growth. This is based on their careful study of 200 years of financial crises. However, I see no indication that the Administration or Congress wants to take steps to reduce this drag. The Fed has no power over fiscal policy. Indeed, most of the talk in DC is about additional spending which would make the debt to GDP situation even worse.

6. Sub-optimal growth is politically and socially unacceptable and if it occurs there will be more policy responses

But that is exactly the problem. More bailouts and more spending on short-term employment does not lay the foundations for future growth opportunities. Indeed, you can argue the reverse. When the government deploys capital, it is effectively taking it away from consumers and corporations. It is taken away via means of taxes or by their borrowing (future taxes). It comes down to who you believe has the best shot of creating growth opportunities.

7. The global economy is surging and will drag the U.S. along

Let’s be clear here. Emerging markets are surging. The bulk of the global economy is not surging. Europe is in a very low growth mode. Japan will unlikely see any meaningful growth over the next five years. Canada is in relatively good shape mainly because of their sensible financial regulation and their refusal to subsidize housing through mortgage interest deductibility. We are really talking about emerging markets. The demand for U.S. exports from these markets has moderated an already very serious recession. However, the global economy is not surging. There is a big divergence between the prospects of developed and developing countries. It is a tough case to make that the global economy will make the difference for the hockey stick.

8. Emerging markets will potentially grow at 7% in 2010.

This is really the same point as #7. Yes, the U.S. has benefited from emerging markets growth. This is a plus for the recovery but it is not enough to meaningfully reduce the unemployment rate.

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So-called “neuromarketing” takes the tools of modern brain science, like the functional MRI, and applies them to the somewhat abstract likes and dislikes of customer decision-making.

Though this raises the specter of marketers being able to read people’s minds (more than they already do), neuromarketing may prove to be an affordable way for marketers to gather information that was previously unobtainable, or that consumers themselves may not even be fully aware of, says Dan Ariely, the James B. Duke professor of psychology and behavioral economics at Duke.

In a perspective piece appearing online in the journal Nature Reviews Neuroscience , Ariely and Gregory S. Berns of Emory’s departments of psychiatry, economics and neuropolicy, offer tips on what to look for when hiring a neuromarketing firm, and what ethical considerations there might be for the new field. They also point to some words of caution in interpreting such data to form marketing decisions.

Neuromarketing may never be cheap enough to replace focus groups and other methods used to assess existing products and advertising, but it could have real promise in gauging the conscious and unconscious reactions of consumers in the design phase of such varied products as “food, entertainment, buildings and political candidates,” Ariely says.

“Neuromarketing: the hope and hype of neuroimaging in business,” Dan Ariely and Gregory S. Berns. Nature Reviews Neuroscience.

Millions of lives are lost around the world each year to accidents, terrorist attacks, wars, epidemics and natural disasters. What’s more, the prediction is that climate change will increase the number and intensity of some of these events.

Newly published research from suggests that the way people – whether members of the public or policymakers – react when faced with human fatalities is highly dependent on the distribution of death tolls they are typically exposed to.

The findings could have important implications for multi-lateral donors, national governments, aid agencies and the press in terms of planning for, fundraising for, reporting on and responding to such emergencies.

Reactions to tragic events depend largely on the size of their associated death tolls. A disaster involving millions of victims tends to produce a bigger response than one that affects tens of thousands of our fellow humans.

Previous research has shown, however, that people tend to show a diminishing sensitivity to the numbers of lives involved. As an event’s death toll increases, each additional death seems less shocking, so that, for example, we appear to care less about the last thousand people to die in a large-scale disaster than the first thousand fatalities.

Despite its grave implications, the reason for this tendency has until now not been well understood. Namika Sagara of Duke University’s Fuqua School of Business, and Christopher Olivola of UCL have published research in the Proceedings of the National Academy of Sciences explaining what may cause such diminishing sensitivity.

The study demonstrated that our motivation to act is based on our memory of similar events and a comparative, rather than absolute, evaluation of human death tolls. It suggests that reactions to fatalities are fundamentally relative and dependent on personal history.

According to the researchers, we evaluate the seriousness of a disaster by first drawing on a sample of comparable events from our memory to obtain a set of comparison death tolls. We might, for example, compare an event with other disasters that we have seen in the news or heard about from talking to family, friends, or colleagues. Then we compare the event with all those we have drawn from memory. The ‘‘shock’’ associated with a target death toll is simply its relative rank-position within the set of comparison events rather than some fundamental value on a scale of human fatalities.

This new research stresses that our responses will be shaped by the environment we live in – in particular the frequency with which we observe small or large death tolls in the news and in our day-to-day lives.

In a series of studies, the researchers show that our diminishing sensitivity to human fatalities seems to follow from the fact that death tolls are distributed in such a way that most deadly events involve very few deaths, while a few events involve very large numbers of human fatalities. As they show in one experiment, this sensitivity is malleable and can be altered by exposing people to varying distributions of death tolls.

Another implication of this research is that sensitivity to human fatalities will differ predictably across countries, as a function of the distribution of death tolls they are typically exposed to. In a country such as the UK, which is unused to mass deaths, a medium-scale disaster will seem really shocking, but the shock value will quickly start to blur as the numbers increase so that large-scale events will seem indistinguishable.

However, in a country where mass deaths are more common, a medium-scale disaster may seem less shocking but people will be more sensitive to differences in magnitude between large-scale events because they have observed many more of them.

In line with this prediction, Olivola and Sagara compared respondents in India, Indonesia, Japan, and the US, and found evidence of greater diminishing sensitivity to fatalities in the latter two countries (which tend to experience relatively fewer large-scale disasters) than in the former two.

“On a theoretical level, this research fundamentally challenges the view that the value we place on human lives is governed by stable underlying disutility functions. On a practical level, it advances our understanding of people’s reactions to humanitarian crises and other deadly events. For example, it would seem that wealthy nations which have the resources to help those countries most affected by mass deaths also have populations that are most likely to show a diminishing sensitivity to human fatalities. We hope this knowledge will ultimately help save many lives,” explains Olivola.

First, the Euro-bomb could explode anytime.

Second, the U.S. government dropped a bomb in telling us that the employment losses during the current recession are far worse than people had believed.

The Euro Bomb

The EU is in a lose-lose situation. If they rescue Greece, then other countries will have their hands out like Spain, Portugal, and Ireland. There could be others too. I doubt the main players (Germany and France) will have the stomach to bailout so many countries. The fundamental problem is that it is very difficult (near impossible) to have a currency union without a political union. While Euroland rules were established (size of deficit, government debt), they were (and are) routinely violated and there is no way to enforce – because of the lack of political union.

You create moral hazard problems. Countries will borrow and spend with the expectation that the system will bail them out. Sound familiar? If the large countries even marginally violate the rules (size of deficit, debt), then this energizes the smaller countries to brazenly violate the rules of the game.

If the EU does nothing, then the Euro will likely fall apart (or at least lose some member countries)

The real question is how deep Germany and France will want to reach into their pockets to keep the Euro going.

The Jobs Bomb

Unemployment dropped by 0.3% to 9.7%. Good news, right?

At the same time, the data were “revised”

We now know that at least 8.4 million jobs have been lost in this recession. Just last month, we thought it was 7.2 million. With the stroke of the Bureau of Labor Statistics’ pen, 1.2 million jobs vanished. Poof.

Let put this in perspective. The drawdown in people employed (non-farm payrolls) in this recession has been -6.11% (from December 2007, the month of the economic peak to today). In the 2001 recession, the drawdown was -1.21% (peak to trough). The 1990-1991 recession was only -1.13%. 1981 was more serious with a -3.08% drawdown. The recession of 1980 was only -1.07%.

Think of it this way. If we add up the employment losses over the past four recessions combined together, it sums to a -6.49% drawdown. We are dangerously close (-6.11%) to having this recession being as bad (in terms of jobs) as the previous four recessions!

Was there any good news?

Yes.

While the Establishment Survey suggested that nonfarm payrolls fell by 20,000, the unemployment rate is based on a different survey.

The Household Survey suggested fewer people were unemployed. That’s why the rate dropped. To be clear, the civilian labor force increased from 153.059 million to 153.170 million (denominator) and the unemployed decreased from 15.267 million to 14.837 million (numerator). Dividing the two numbers produces 9.687% unemployment.

There were many other small pieces of good news including: (i) greater participation rate (people re-entering labor force rose from 64.6 to 64.7); (ii) small increases in number of hours worked and average wage; and (iii) increase in temporary employment (which is usually a leading indicator of permanent employment growth).

The biggest good news is the trend. The employment situation is stabilizing.

My fears

• Usually, temp jobs are a leading indicator of growth in permanent jobs. This time might be different. Given the longer-term economic uncertainty, companies are satisfied rolling through temporary employees.
• We might see increased CAPEX without much employment growth. Companies are in the process of replacing and/or refurbishing their depleted capital equipment. Such expenditures may lead to labor savings. As such, it is unrealistic to think of hiring back all the laid off workers.
• The long duration of unemployment will lead to workers’ skills becoming stale. While companies have lots of job applicants, they might have fewer qualified applicants because of depreciated skills.
• There will not be enough growth to get us into the +300,000 monthly range for non-farm payrolls additions (we need +100,000 per month simply for population growth and 300,000 to get back all the current recession jobs lost in three years). This means that unemployment rate will be stuck at a very high level for a very long time.
• The continuing credit squeeze on small and medium sized business will defeat the recovery. Most of jobs are created by small and medium sized businesses and these firms are still severely constrained in getting credit.
• There is great economic uncertainty as a result of the extreme leverage in the U.S. economy. Corporations have reduced their leverage. Consumers have made considerable progress in increasing their savings. However, that is all offset by an exploding government debt. We are approximately at a situation where total (consumer, corporate and government) debt is 350% GDP. In the 1990s, it was about 250%. In the 1980s, 175%. In the 1950s, 60s and 70s about 150%. The previous peak was about 300% in 1933. Such a dark cloud on the horizon magnifies risk. Add to this the fear of increased taxes. Higher risk means less investment, slower employment growth, and upside prospects for the U.S. economy.

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Why don’t we just admit that the current financial and regulatory system is dysfunctional?

We face two fundamental problems.

First, we need to clean the financial system — close weak banks more aggressively, encourage bankruptcies/foreclosures, and free good assets held by poorly financed owners. Small and medium sized businesses with quality projects are not getting loans. This problem will not be solved by tax breaks or targeting some incentives. We need structural change.

Second, the current regulatory system failed us. It needs to change. Our system is comprised of three federal agencies: the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve, as well as 50 state banking departments! I am not even including the Office of Thrift Supervision and all of the Savings and Loan Institutions nor the National Credit Union Administration which supervises all the credit unions.

There are state chartered banks as well as national chartered banks. As a result of the historical maze of changing regulations, we have over 7,000 banks. There is no economic reason for 7,000 banks. It is inefficient both for the bank in providing the lowest cost and highest quality services to their customers. It is a nightmare to regulate.

What is most alarming is that none of our leaders have stepped up with bold proposals to revamp our financial and regulatory system.

To analyze these issues, let’s go back to the President’s speech of January 21, 2010 proposing two regulatory ideas.

The January 21, 2010 Speech

The President’s first proposal had to do with banks running speculative operations:

First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward.

I agree with the President on this one. I made this exact point in Davos in 2005. Indeed, I made the point directly to Senator Richard Shelby who, at the time, was the Chairman of the Senate Banking Committee.

Essentially, this means the partial repeal of the repeal of Glass-Steagall. It is partial because banks would still be able to trade risky assets for customers – but they would be prohibited from running their own proprietary trading operations. More on this later.

This proposal is now known as the Volcker rule (former Chairman of the Federal Reserve). The president said:
It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the Volcker Rule, after this tall guy behind me. Banks will no longer be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit unrelated to serving their customers.

The second proposal was directed at non-banks:

There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy.

This one I do not like. Again, I will elaborate below.

It is worrisome that it took one year to come forward with such bare bones reforms. We need to push deeper.

U.S. Banking History 101

The Glass-Steagall Act of 1933 separated prohibited commercial banks from doing investment banking.

There was plenty of motivation. The U.S. economy had crashed into a Great Depression. Before the Act, many banks had practices that we would consider unethical today. For example, if the Investment Bank division held stock in a troubled company, the troubled company might get a cheap loan from the Commercial Bank division. In addition, stock that the Investment Bank held was often promoted to customers of the Commercial Bank.

All of this ended with Glass-Steagall.

By the way, the official name of the bill was The Banking Act of 1933 — and it did other important things, like establish the Federal Deposit Insurance Corporation.

In 1999, the key provisions of the Act (the separation of commercial and investment banking) were repealed by the Gramm-Leach-Bliley Act. A major proponent of the repeal was then Treasury Secretary Larry Summers. The repeal had broad bi-partisan support. The final bill passed the House (362-57) and Senate (90-8) and was signed by President Clinton.

The repeal opened aggressive expansion of commercial banks into much riskier investment strategies.

In some ways it put us back to pre-1933. Remember one of the complaints was that banks were making cheap loans to support companies that they were investing in. Fast forward to 2008. Banks were using customers’ deposits (cheap capital, and government guaranteed) to invest in their own highly speculative investments.

It is clear that we are not going back to pre-1999. Deputy Treasury Secretary Neal Wolin made said on January 25, 2009, that the new regulations are directed at the banks own prop desks. That is, banks will still be allowed to trade in risk securities for their own customers.

All FDIC-insured banks are quasi-government institutions. It does not make sense for banks to be making highly risky bets with capital that is made cheap courtesy of the U.S. taxpayer. In addition, it does not make sense for massive bonuses to be paid out when these institutions win their bets but when the bets go sour to rely on government subsidization (zero interest rates, guarantees) and bailouts.

However, it is but one piece of the problem.

Scope of Operations

The other issue is the “too big to fail”. The President proposed putting a cap on the size of financial institutions (non-banks). The idea being that no one firm should be so large to put the system at risk.

I don’t like this idea (at least applied to the current U.S. situation). Let me elaborate.

• If we measure a particular financial institution’s assets (or liabilities) relative to GDP, we really don’t have a size problem. In countries like the U.K., Beligium, Switzerland, you have individual banks that have liabilities that greatly exceed the country’s GDP. We don’t have anything like that.
• If you like the idea, where do you draw the line?
• Even if the idea is implemented, the problem is not one particular institution – the problem is with contagion. There is no difference between one big financial institution failing and a contagious reaction of many smaller banks failing. A cap on size does nothing to mitigate a systemic event.
• It will likely constrain the ability of our financial industry to compete globally.

The main problem is that it does not address the underlying issues. Lehman’s failure would not have been avoided with such a measure (Lehman was an investment bank). It wasn’t the size of Lehman that caused the problem.

Lehman failed because it took big risk. They were betting on heads and it turned out tails. Big risk means potentially huge rewards but also commensurate losses. They lost.

Lehman’s demise and the near demise of many other financial institutions might have been avoided if there was a different approach to regulation.

The immediate mess of the aftermath of Lehman was largely a result of the Chapter 11 procedures being ill-suited for financial institutions. That can be changed.

Proposals

1. Transfer all jurisdiction over banking to a single central authority. That is, only national banks should be chartered. This is the way banks operate in other developed countries. Currently, we have the OCC supervising about 3,000 banks and state banking departments responsible for over 5,000 banks.
2. OCC and FDIC should be consolidated. The Federal Reserve should remain independent.
3. Encourage consolidation of the many small banks (this is easy to do because many of them are insolvent but allowed by the FDIC to keep operating). There are many natural economies of scale that both reduce costs to customers, improve service and provide a natural hedging of risk for the bank (you do not want all your customers concentrated in one area of the country).
4. Make banks fess up to the real value of their troubled loans. There are reports that FDIC staff have instructed many banks to restructure troubled loans into short-term interest-only loans. This is a terrible strategy. It assumes a robust recovery. However, the very fact that financial institutions are housing these assets that have little value – decreases the chances that they can make loans to quality borrowers. To be clear, these actions reduce the chance of a robust recovery. It simply delays the pain. Surely, we learned something from Japan’s disasterous strategy in the 1990s.
5. Set up a Resolution Trust entity to house the troubled assets of failed financial institutions. I estimate that there are at least 1,000 institutions that should be closed. The financial system is not healthy until we greatly reduce the troubled loans on the balance sheets of our financial institutions. Again, we cannot continue to follow the Japanese playbook of the 1990s.
6. Reserve requirements must be strongly procyclical. That is, in good times, banks must greatly add to their reserves. This provides a cushion in bad times. Our current system does not recognize this simple intuition.
7. Investigate another layer of insurance called by Flannery “reverse convertible debentures” and Kashyap and Stein as “capital forbearance certificates”. Read about it here.
8. Any financial institution that benefits from the explicit or implicit support of the U.S. taxpayer should be regulated. For example, AIG. The AIG disaster lead to a $162 billion bailout that cost each working American approximately $1,000.
9. A new system of regulation should be streamlined (not redundant) and designed to achieve the objectives (reduce and control risk) and the lowest possible cost to the financial institution. The regulator should provide an atmosphere that encourages rather than stiffles innovation on the part of financial firms.So, I am not calling for more regulation — I am calling for less regulation but more effective regulation. It is reasonable that part of this regulation should include steps to protect consumers with common sense items such as no liar loans, no ninja loans, no prepayment penalties, transparent interest rate/fees for loans/cards, etc.
10. Much of our problems are due to an explicit subsidization of the housing sector. This comes in many forms. Most Americans are so used to the deductability of mortgage interest that they don’t realize, in almost all other countries, there is no deduction. In addition, more than 90% of new mortgages are being underwritten by Federal agencies. Finally, the government has been active in the mortgage market in buying mortgage securities, thereby pushing interest rates lower. We need to re-examine all of these subsidies. The highest priority questions: (i) Should we abandon mortgage interest deductability? and (ii) Should the government be the insurer of almost all new mortgages issued?

Crisis and Leadership

A financial crisis and a recession exact a terrible human toll. It is not just about 10% of the labor force being out of a job. Millions more are not counted in the official numbers because they have given up looking for a job. Additional millions are living in fear they will soon lose their job.

I don’t think anyone doubts that a well functioning financial system is critical to the future growth prospects of our economy.

Right now, the system is broken.

In summary, we need a two pronged strategy. First, we need to cleanse the financial system. Given the current regulatory system, we need a new strategy that swiftly purges the weak financial institutions. Our current strategy of keeping zombie banks going damages the economy’s future growth and employment prospects. We need to send the message that the government is not the lender of last resort for too big to fail organizations. Second, we need a bold change in the way that we regulate our financial institutions.

Regulatory reform alone is not sufficient.  The moral-hazard effects of government explicit and implicit bailouts will overwhelm the good effects of improved regulation. We need both cleansing and a fresh approach to regulation.

While a crisis has many downsides, it also provides an opportunity. It is one of the few times that bold, system-wide, changes can be implemented. The Banking Act of 1933 is a good example of bold legislation.

Am I naive?

Perhaps. However, someone needs to step up. We need more than cosmetic changes.

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The Spin

It is amazing that most jobs stories featured upfront the revision to November’s Non-Farm Payrolls. November was revised to +4,000 from the original -11,000. A net gain. However, October was revised downwards – a complete wash.

The fact is that we lost a surprising 85,000 Non-Farm Payroll jobs. A widely respected economic consulting group expected +50,000. The market expectation was about flat.

I am convinced the situation is much worse than we are led to believe.

Unemployment 101

Non-Farm Payrolls data comes from the Establishment Survey. It showed a decrease in payrolls of 85,000 in December.

The widely reported Unemployment Rate comes from a different source – the Household Survey. The rate is defined as the number of unemployed, 15.267 million, divided by the civilian labor force, 153.059 million, which equals 9.997% or 10.0% as reported. To be clear, the Non-Farm Payrolls data do not enter the calculation of the Unemployment Rate.

But the Household Survey shows a far worse situation. In December, employment dropped by a staggering 589,000. But, confusingly, unemployment also dropped by 73,000. Overall, the size of the civilian labor force shrunk by 661,000.

What is going on?

First, the decrease in the civilian labor force “explains” why the unemployment rate did not change. We are dividing the number of unemployed by a smaller number.

Second, and more importantly, is to understand the reason for the shrinking size of the civilian labor force. It is shrinking because people are becoming discouraged and have dropped out of the labor force. These people are not counted in the numerator (unemployed) or the denominator (labor force).

Let’s take a closer look.

The Marginally Attached and Discouraged

There are 2.486 million workers in December 2009 that are classified as “Marginally Attached”.

The BLS definition of “Marginally Attached” is: “These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months.” These individuals are not counted as “Unemployed” because they failed to search for work in the past four weeks.

In December 2007 (the beginning of the recession), there were only 1.395 million “Marginally Attached”. In November 2009, there were 2.323 million “Marginally Attached”. Over the last month, 153,000 additional people became “Marginally Attached”.

There are 929,000 individuals that are classified as “Discouraged” in December 2009. The “Discouraged” are a subset of the “Marginally Attached”.

The BLS definition of “Discouraged” is: “Persons not currently looking for work because they believe no jobs are available for them.”

Over the past month 68,000 additional people were classified as “Discouraged”.

Again to be clear – neither “Discouraged” nor the broader “Marginally Attached” are included in the numbers. Does that make sense to you?

Not to me.

If we add the Discouraged into the calculation the unemployment rate is 10.5%. If we include the broader category of “Marginally Attached”, the rate goes to 11.4%.

Finally, there are a large group of persons that are working part time — but don’t want to work part time. Suppose you work 10 hours a week but you really want to work 40 hours a week. It seems to me that you are 3/4 unemployed. However, the widely reported numbers do not include these underutilized people.

The BLS does report the U-6 rate which includes all “Marginally Attached” and all Part-Time that want full time work. They don’t do the fractional calculation that I suggest for the part-time persons. As a result, this rate is somewhat overstated.

In December 2009, the U-6 or “all in” rate, was 17.3% up from 17.2% in November.

So, the situation is worse than one would think.

More Sobering Data

The number of people unemployed for more than 26 weeks rose in December 2009 to 6.130 million persons from the previous month’s 5.901 million. At the beginning of the recession, this statistic was only 2.612 million.

The average number of weeks unemployed increased to 29.1 weeks in December 2009 compared to 28.6 weeks in the previous month. At the beginning of the recession, this statistic was only 16.5 weeks.

Why Analysts are Fooled by the Trend in Initial Claims for Unemployment Insurance

The trend in Initial Claims for Unemployment Insurance has been favorable. The most recent week saw “only” 434,000 new claims. The four-week average was 450,250. This is a big improvement from January to June 2009 where the rate was averaging well above 600,000 per week (actually more than 700,000 in January).

While this is good news, it does not immediately translate into lower unemployment. This is despite the strong historical correlation between initial claims and unemployment.

Why? There is an “omitted variable”. Claims can decrease but unemployment can increase. Reduction in unemployment depends on people getting jobs. The statistics I quoted above suggest people are not getting jobs.

Yes, fewer people are being added to unemployment rolls — but this just increases the level of unemployment at a slower rate.

Here is another way of looking at it. While it is good news that fewer are applying for unemployment insurance, it is bad news that those already getting insurance can’t find work – or are taking longer to find work. The good news is nixed by the bad news.

The way to see this is to look at people rolling off the state insurance programs into the Federal Emergency program. While there are reporting delays, in the week of December 19, the EUC had 5.143 million beneficiaries. This was up 235,626 from the previous week and sharply higher than last years’ 1.922 million.

Finally, there are people that have exhausted EUC and now have no benefits. These people are not tracked in the data (or at least I don’t know if these data exists).

Don’t Forget the Growth in Population

As I mentioned in my last posting, the working age population is growing by at least 100,000 persons per month. This means to simply hold the unemployment rate, we need to add 100,000 to Non-Farm Payrolls. In addition, we have 7.2 million jobs to create, to get back were we started in December 2007.

No matter how you cut the data, this is bad news. It will likely take five years and no hiccups to get back were we started.

Is there any Good News?

Yes.

1. Initial claims are decreasing.
2. A number of surveys are showing improving conditions
3. Temporary employment has been increasing which is a prelude to permanent employment growth

This good news is consistent with an economy bottoming out. However, 2010 will be a transition year and not much of a recovery year. Unemployment will remain subbornly high. We will see a surge in mortgage and other debt defaults. While economic growth might be above average, it will not be enough to quickly get us back to pre-recession levels.

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Summary of the release

In November, the Establishment Survey showed that only 11,000 jobs were lost. There were some favorable revisions to October and September data.

The BLS also reports Household Data and there can be big differences between the Household and Establishment Surveys. For example, October, the Establishment Survey showed a decrease in nonfarm payrolls of (revised) 111,000. However, the Household data suggested a staggering increase of 558,000 to the ranks of the unemployed. In November, the news was much better on the Household Survey. The Household Survey showed that unemployment decreased by 325,000.

To get the unemployment rate, you take the Household Survey unemployment (15.375 million) and divide by the civilian labor force (153.877 million) and you get 10.0% (actually, 9.9992% — so we technically lost the ten-handle!)

There was other good news. The all-in unemployment rate (U-6) dropped from 17.5% to 17.2%. Temporary hiring (a good leading indictator continued to increase (adding 52,400 to the rolls). Finally, the average work week increased by 0.2. This means more money in the pockets of consumers.

All of this is good. However, there are some issues (which I am sure you expect from me).

Hiring and Firing

At some point, you cannot fire any more people and hope to have a viable business. The rate of firing has decreased. For a sustainable recovery, we need the rate of hiring to increase.

Participation

The participation rate has decreased from 66% in December 2007 (start of the recession) to 65% in November 2009. In numbers, there were 79.32 million not in the labor force in December 2007 and 82.866 million not in the labor force in November 2009. This is important. Population has been increasing. Lower participation is not a sign of economic health.

Duration of unemployment

At the beginning of the recession, the duration of unemployment was 16.5 weeks. Currently, it is 28.5 weeks. Note that the 28.5 weeks in November is an increase from October’s 26.5 weeks. Here is another way of looking at the data. In December 2007, 17.5% of the people looking for work were unemployed 27 weeks or greater. In November 2009, that proportion had more than doubled to 38.3% of the labor force being out of work for 27 or more weeks.

Seasonal factors

Seasonal factors are based on the average historical behavior in different months. The idea is to strip out variation due to the business cycle. For example, the fact that retail sales plunge every year from December to January has nothing to do with the health of the economy. In addition, these seasonal factors change through time and can be influenced by large observations — like we have seen over the past 18 months. Hence, we need to be especially cautious with the seasonally-adjusted data. That said, the not seasonally adjusted data also showed an improvement.

Why the inconsistency with ADP?

The ADP report on Wednesday suggested 169,000 job losses. For the past year, the ADP has been over-estimating job losses – but not by 158,000. The 158,000 miss is roughly double what their average overestimate is. Again, this is another reason for caution.

Re-entrants

There are many that have given up looking for jobs. They will wait it out until conditions improve – like now. As a result, we will see a surge of people looking for jobs (i.e. re-entering the actively seeking work and unemployed). You have heard me make this argument before – but in the context of housing (the other key to a recovery). Many people want to sell their house but have taken it off the market because of frustration. They are waiting for markets to improve. Once the market improves and the wave of now-hidden inventory hits the market, a new downward pressure will be exerted on prices.

Mix of jobs and sustainability

There are 77 sectors that the BLS follows. Jobs were lost in 48/77 and there were gains in 29/77. The leading gainer was Administrative and Support Services. The category of Durable Goods jobs was the second biggest loser ranking 76/77. We need capital investment to increase to provide the foundation for a sustained recovery. This is key. The focus should be on not just getting a positive read on any particular month’s nonfarm payroll. We need the sort of investment that will lead to long-term, quality, job creation.

How long will it take to get back to where we started

Let’s do the math. First, the preliminaries. We have lost 7.2 million jobs. I went to the Bureau of the Census and pulled down file NP2008_D1.xls which shows the U.S. population by each year of age projected out many years. I added up the range of 16-65. The increment in this age group in 2010 is projected to be 1.844 million. Most of these people will be seeking work. I am being conservative here (if we count 16-70 years, the numbers increase to 2.177 million). Let’s say the participation rate is 65% (and it is way more empirically). This means that roughly 100,000 new people are entering the labor force every month.

Now we are ready to do the math. The question is the following: how many jobs need to be created, on average, every month over to put 7.2 million people back to work in three years. You take the 7.2 million and add 3.6 million (36 months times 100,000 average new entrants) and you get 10.8 million. 10.8million/36=300,000.

So, to be clear, November 2012, if we have averaged 300,000 jobs created every month for 36 months, we will have put the 7.2 million people that lost their jobs back to work.

This seems extremely unlikely. Over the past 20 years, i.e. 240 months, there have only been 55 months where non-farm payrolls have grown by more than 300,000. Over the past 10 years, only there have been only 4 months where we had more than 300,000 jobs created. Yet, we need 300,000 on average for the next 36 months to get back to where we started.

Indeed, nonfarm payroll growth has averaged more than 300,000 in only two years in the past 20 years: 1994 and 1984.

Well, if you don’t like 300,000 per month for three years, you need to add additional time to get those jobs back. For a five year horizon, roughly 200,000 jobs need to be created every month.

Note this analysis assumes no double dip and is very conservative on the number of people entering the labor force.

No matter how you look at it. We are in it for the long haul on the unemployment front. The persistent unemployment will feed back into slower growth over the next several years.

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One of the most obscure organizations in the federal government is the U.S. Preventive Services Task Force which began in 1984. While convened by the government, the group is comprised of outside experts in medicine, health services research, and epidemiology.1 The task force’s job is to review the evidence around primary care services and to make recommendations to physicians about the quality of the evidence to support specific recommendations for what services should or should not be included as part of routine clinical practice.

The group’s efforts are very disciplined and scripted. Specific services are assessed on the basis of the risks and benefits to ascertain the potential “net benefit” to patients, with recommendations graded A through D (a grade of I means there is insignificant evidence to make a recommendation). A grade of A indicates high probability there is substantial benefit, B indicates high probability of moderate benefit or moderate probability of substantial benefit, C is a recommendation against a service with at least moderate evidence that the benefit is small, D is a recommendation against a service with a moderate or high evidence that there is no benefit or that the harms outweigh the benefits. The probability estimates in these statements are based on the quality of the evidence in the clinical literature on these topics.2

This group recently performed a periodic update of its 2002 recommendations for breast cancer screening.3 The task force conducted an evidence review to assess all of the new clinical studies on breast cancer screening since its last report, and it commissioned a decision analysis of different screening strategies for breast cancer to assess the net benefit or harm for each strategy.

Findings included: 1) there is convincing evidence that mammography reduces breast cancer mortality in women age 50-74 (with the greatest benefit for age 60-69) with a relative risk of 0.85 (0.75-0.96); less convincing evidence for women age 40-49 (but with the same magnitude of benefit); and evidence of net benefit for women over age 75 is lacking. Evidence was also lacking for teaching breast self-examination, clinical breast self-examination in women of already have mammography screening, and for digital mammography or MRI compared to film mammography.4

In the task force’s decision analysis efforts, it examined the net benefit of mammography screening for women under different strategies. The benefit of mammography screening came from the evidence review, but there were also harms to be considered: 1) radiation exposure and the risk of future breast cancer, 2) false positive test results (1 in every 10 mammograms for women age 40-49 is a false positive), work-up of false positive tests (repeat imaging, biopsies), and overtreatment of “silent” tumors.5 This analysis concluded most of the benefit of annual screening could be retained with bi-annual screening while avoiding substantial false positive exams.

In the end, the controversy resulted from a “C” recommendation against screening women from ages 40-49 since the additional benefit of starting screening at age 40 is small compared to age 50, and that there are harms from screening at any age. The task force suggested decision making for this group be left to “individualized, informed decision making,” or letting women know about the benefits and risks, assessing if there are factors that would influence either assessment, and letting the patients make a choice.

The task force also identified research gaps that require further study, although it has no resources to commission the clinical trials that would be required (and a quick look at women’s health on the Institute of Medicine priority list for comparative effectiveness research did not reveal any studies of breast cancer screening).

So what is the moral of this story? The data the group provided is very clear and transparent for anyone who takes the time to read the material. However, it’s time to include some direct assessment of patient perceptions in assessing the risks and benefits of medical decisions (rather than a paternalistic assessment of physicians). This should be done systematically as part of the review process, or can be done on a case-by-case basis as a less preferred option (as was recommended here). Second, in an era when so much medical care is not beneficial, is there any reason to recommend against beneficial therapy (even if the magnitude of benefit is small and the “net benefit” when subtracting the harms is uncertain)? With these two reservations, we should acknowledge this is exemplary practice of “evidence-based” medicine. We need to gauge whether the public reaction is to the process of evidence synthesis, or to the final recommendations themselves. This determination will be critical to our ability to move forward in making the practice of medicine more transparent.

1http://www.ahrq.gov/clinic/uspstfix.htm

2http://www.ahrq.gov/clinic/uspstf/grades.htm

3U.S. Preventive Services Task Force. Screening for Breast Cancer: U.S. Preventive Services Task Force Recommendation Statement. Ann Intern Med. November 17, 2009 151:716-726

4Heidi D. Nelson et. al., Screening for Breast Cancer: An Update for the U.S. Preventive Services Task Force Ann Intern Med November 17, 2009 151:727-737

5Mandelblatt JS et al for the Breast Cancer Working Group of the Cancer Intervention and Surveillance Modeling Network (CISNET) . Effects of Mammography Screening Under Different Screening Schedules: Model Estimates of Potential Benefits and Harms. Ann Intern Med November 17, 2009 151 : 738 – 747

Amazing the difference one day makes in the employment outlook. Yesterday, the market shot up because “only” 512,000 applied for initial claims — down from 532,000 the previous week. We saw banners: “Employment Situation Improvement,” “We Have Turned the Corner”, and “Jobs Fuel Market Rally”.

Today we learn that 190,000 jobs were lost in October. That’s about 40,000 worse than widely expected. The unemployment rate rose to a 26 year high, 10.2%.

Understanding the numbers

For those of you that subscribe to my twitter, you know that I was critical of the analysis of the Initial Claims release on November 5. The media noted two pieces of good news. First, the level of claims decreased by 20,000. It is true that is good news. Second, Continuing Claims decreased by 68,000. It is not clear that is good news.

The reason is simple. Many people drop off the regular program not because they get a job — but because the program expires for them. These job-seekers then have a chance to apply for extended benefits or emergency benefits. Hence, you need to look a little deeper.

While the reporting of Extended Benefits and the Emergency program (EUC) is delayed, the recent numbers show an increase of 25,000 in Extended Benefits and a surprising 90,000 in the EUC.

The bottom line is that people are not getting jobs.

Let me give you some perspective on how serious this is. We have lost 7.3 million jobs in this recession. The last really bad recession began in 1981. Many don’t remember this was a time of considerable turmoil with some short term interest rates going above 20%! On a population adjusted basis, the jobs lost in the recession that began in 1981 was 4.3 million. At the time, that was really bad.

In addition, it is not over.

Yes, it is true that the rate of job loss is slowing. That is good news. However, we really need to get at least +100,000 in non-farm payrolls to stop the rate of unemployment from rising. We need about +200,000 to start recovering jobs. That is hugely different from where we are today.

Now, you are used to me saying negative things. I did see three pieces of good news in the employment report. First, temporary employment rose by 33,000. That is often a leading indictor of employment bottoming out. Second, the amount of overtime slightly increased. Again, this is a leading indictor. Finally, the revisions of the previous two months were also good news.

My guess is that the temp employment and the overtime are completely overlooked by market observers.

Time to Revisit the Stress Test

Do you remember the famous stress test that was done after the government had bailed out the big banks?

There were two scenarios: “Baseline” and “Alternative More Adverse”.

The Adverse scenario had unemployment hitting 8.9% in 2009 and rising to 10.3% in 2010. These assumptions were announced in April 2009. I quickly referred to this exercise as a “sham”.

The Adverse scenario is supposed to be a real downside scenario. In contrast, I thought the Adverse scenario would be “the good outcome”. Think about it. The worst case was 8.9% unemployment in 2009 (note this was supposed to be the average for the year). We are already at 10.2% in October and the average over the past 10 months is 9.1%. We have blown through the worst case scenario.

If we hold the rate at 10.2% for the last two months of the year (which is very optimistic), the average rate for 2009 will be 9.3%. Again, this is far from the assumed 8.9% worst case.

We are a hair away from 10.3% which is the worst case for 2010.

There is another critical input to the stress test that needs to be revisited: the assumption on prime mortgage defaults.

There is a positive relation between unemployment and prime defaults. However, using historical information can be misleading. Defaults are much more sensitive to unemployment today because as many as half the houses with mortgages have the situation where the loan is worth more than the house.

I have said previously that another “sham” are the number of bank closures. 115 closures is no where close to the number that should be closed. We had over 700 institutions closed during the S&L crisis including 406 FDIC insured banks in 1988-89.

Is the delay because the FDIC has run out of funds?

It is better to resolve the uncertainly. The weak banks need to fail. Our current situation leads to a lack of confidence. People don’t know if the bank is weak or strong because the FDIC is allowing the zombies to operate.

The All-In Unemployment Rate

I like to look at U6. This is the rate that includes: total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons.

Let’s be clear on the definitions (from the Bureau of Labor Statistics):

• Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past.
• Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job.
• Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.

The U6 rate (sometimes referred to as the “all in” rate) is a staggering 17.5% in October — rising from 17% in September.

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