Bleak Job Assessment and Mean Reversion

While unemployment figures and an academic discussion of the 'mean' in mean reversion do not seem related on the surface, I think they can be tied together. Mohamed El-Erian of PIMCO recently noted in the Financial Times that the American job situation is worse than we think:

This possibility of a very high and persistent unemployment rate is not, as yet, part of the mainstream deliberations. Instead, the persistent domination of a “mean reversion” mindset leads to excessive optimism regarding how quickly the rate will max out, and how fast it converges back to the 5 per cent level for the Nairu (non-accelerating inflation rate of unemployment).

The US faces a material probability of both a higher Nairu (in the 7 per cent range) and, relative to recent history, a much slower convergence of the actual unemployment rate to this new level. This paradigm shift will complicate an already complex challenge facing policymakers. They will have to recalibrate fiscal and monetary stimulus to recognise the fact that “temporary and targeted” stimulus will be less potent than anticipated. But the inclination to increase the dose of stimulus will be tempered by the fact that, as the fiscal picture deteriorates rapidly, the economy is less able to rely on future growth to counter the risk of a debt trap.

I think the key point is that we collectively as a society have not begun an earnest discussion of what happens when or if unemployment does not drop as quickly as it has risen. We have become accustomed to an unemployment mean that is far less than the unemployment numbers we are currently seeing; thus, we, or perhaps more aptly our policiticians, expect (hope) that we will revert relatively quickly.

However, there is no law that this reversion must happen for reversions sake or that it must happen quickly.

This brings me to an article in the same publication by Rob Arnott (Reversion to the Mean, but What Mean?). Pre-global financial crisis, risk premiums were at historically low levels. As Arnott notes,

The main drivers of markets – emotion, changing expectations and mean reversion – remain unaltered. Part of the global crash is mean reversion towards more sensible risk premiums. At the dawn of the crisis, the capital markets required very little reward for risk-bearing.

Stock market valuation multiples were high by historical standards and most spread products were priced to reflect some of the skinniest quality spreads ever. Another result of the debacle of the past year is a global capital market system that is trying to figure out what the new world order means for fair value.

That process is by no means finished.

With the government seemingly changing the rules of the game on a weekly basis, capital markets are scrambling to assign appropriate risk premiums. As Arnott notes, this process is far from complete.

The same can be said for unemloyment - there is no law stating we can consistently sustain a 4-5% unemployment rate. Yesterday's mean may be tomorrow's outlier - the "new normal" could be for an unemployment rate that no politician is ready to concede.

Comments

[Moon Kil Woong:]

The author has a very good point. Europe has long accepted high unemployment and has obscured it partially by constantly lowering the working hours. There is nothing to say the US will not follow in their footsteps.

As for risk premiums, the world is getting riskier by the day. This is especially true since governments are messing with the functioning of the free market. Their attempts to artificially regulate risk are creating serious market distortions, disincitives towards doing the right and profitable things, preventing the reallocation of scare resources towards productive and promising businesses, and leading closer to an outcome that results in inflation an recession at the same time. No wonder many of us find ourselves sweating even if we have a nice nest egg to sit on.

Jul 07 06:02 AM

[Tony Petroski:]

Since we are all Eurosocialists now, I assume the "new normal" is the rate Europeans put up with, 10-12% on an ongoing basis, and 18-20% if we go the "green jobs" path of Spain. On the other hand, they've put up with these rates for a generation and they are still around, albeit as a spectator on the sidelines of history.

Jul 07 08:14 AM

[Jason Rines...:]

Good comments. Reverson point in humble opinion is pre-FIRE economy of 1999. $10T economy. Moon Kil has consistently great comments about fundamentals, especially about continued malinvestment and attempt to preseve the status quo. That is akin to the forest analogy of creative destruction, that the forest burns down and out of the ashes seedlings now get sunlight and again florish, although in our tale a big firetruck comes along and the water from the hose is taxpayer money and future productivity putting out the flames for the big, tall rotting oaks.

Jul 07 04:03 PM

[Asbytec:]

Anyone who thinks this thing is close to being over is fooling themselves, green shoots or not. The whole system will collapse, folks, it's inevitable and simply a matter of time.

Oh, we can put it off for a while with tax payer and Chinese money, but when the dollar goes watch out below. All fiat currencies dependent on US debt generated consumption will follow it down ending with China and India who think they've decoupled form the US. Forget market volatility, we've seen nothing, yet.

Anyway, it's due. We've gotten so far from free market principles and productive capacity (and our constitution), Adam Smith's big hand is gonna spank us all. Period. And this is not Obama's fault, he's the guy with his finger in the proverbial dam.

Jul 08 06:36 AM

[Asbytec:]

What is a post industrial economy anyway? It's a house of cards building upon the real wealth built from (our old, rusting) industrial economy. That's what, it's a fake economy.

It's a condition where real jobs and production bleed away and menial labor, such as flipping burgers and landscaping, are done by the poorly skilled folks who remain behind, but cannot afford an inflated mortgage.

Such a condition is not sustainable, and a poor jobs report shouldn't have surprised anyone.

Jul 08 07:00 AM

[Asbytec:]

Tread ye not upon the green shoots of the field. They're be thorns there.

Jul 08 07:02 AM