Unemployment and the Credit Crisis


By
Henry C.K. Liu


This article appeared in AToL on September 18, 2007
 

 

Strong employment had been a key benefit of the liquidity boom even though wages had not been rising enough to keep up with asset prices. News on slow growth of employment for July 2007 had been an ominous sign that the liquidity boom was ending. Economists know that employment data are a lagging indictor, showing only the effects of previous periods. Yet official unemployment for July was only 4.6%, or 7.1 million workers, still “uncomfortably” near the bottom of the structural range (4 to 6%) of what neo-classical economists call a non-accelerating inflation rate of unemployment (NAIRU). The low structural unemployment rate presented a lingering inflation threat. It will continue to do so until unemployment rises past the 6% NAIRU limit to stall the economy with deflation.

The Voodoo Theory of Structural Unemployment

Central banks operate on some voodoo theory that NAIRU is the cardinal rule to keep inflation in check, using current unemployment to fight future unemployment, keeping some people out of work now in hope of enabling more people working later. The rationale is that excessively low unemployment is undesirable because it pushes up wages to cause wage-pushed inflation which will require central banks to raise interest rate which will in turn slow the economy to increase unemployment down the road. This necessary unemployment is called structural or natural unemployment and up to 6% of it must be tolerated to maintain a non-accelerating inflation rate. In other word, there is no case for central bank intervention as long as unemployment stays below 6%.

The problem with the concept of NAIRU is that when wages have persistently failed to rise as fast as the astronomical rate of asset appreciation, any talk of wage-pushed inflation is perverse and does not need 6% unemployment to contain.  This is particularly true when outsourcing of jobs to low-wage countries has kept inflation abnormally low. In fact, full employment with rising wages is an effective way to close the wide gap between stagnant wage income and run-away asset prices buoyant by debt.

Not only is NAIRU a dubious theory, particularly in a debt bubble, it is also decidedly a pervert moral posture of neo-liberalism. NAIRU condones a policy of making a helpless minority pay heavily now for maximizing future marginal job opportunity that may benefit the majority, instead of foregoing future maximization to ensure that all can have jobs now to share the benefits of full employment equitably. The equity issue is exacerbated when structural unemployment consistently falls on the same segment of the labor force that is least able to fend for itself.

Credit Crisis Aggravated by Stagnant Wages

The credit crisis since August 2007 is obviously caused by years of systemic credit abuse, but it is aggravated by stagnant wages that have been out of step with run-away debt-pushed asset inflation for almost a decade. Throughout the nation, workers have been forced to live in homes priced at levels their wages cannot support because wages have persistently fallen behind home prices.

The resilience of US equity markets, buoyant by robust employment and strong corporate earnings fuel by cheap debt, has been frequently cited by irrational yet unyielding optimists as proof that the credit crisis in the money markets is merely a passing shower in otherwise fair economic weather. The reality is that the robust employment and strong corporate earnings have been the unsustainable result of systemic credit abuse. This illusion, formed by mistaking debt-pushed exuberance in the stock market as a sign of health in the economy, was shattered on Friday, September 7, by news of the first job contraction in four years which many market participants regard as the first signs of a financial perfect storm.

Having bought into the myth of a benign decoupling of the credit squeeze from the real economy, analysts had expected a gain of 110,000 new jobs for August. The unwarranted expectation caused market shock sparking sharply lower stock prices when the ugly reality showed a loss of 4,000 jobs. Normally, central banks, driven by an institutional bias bordering on phobia toward inflation threats, would consider unemployment rising up toward 6% positive news since it removes inflationary pressure. But the news of a reverse in employment in August spooked the jittery market, even though the overall unemployment rate stayed at a benign 4.6%.  The market surmises that when the credit market collapses even with low structural unemployment, the economy is heading for serious trouble.

Talks of recession immediately proliferated in the media as it finally dawned on even the most doggedly wishful-thinking analysts that August was the month that economic reality set in to dispel doctrinaire myths which assert that economic fundamentals can remain strong in finance capitalism even when financial markets seize up.  Waves of layoffs had been anticipated in all housing and financial services related sectors in recent months, but unemployment was still expected to stay below the 6% NAIRU level, posing no serious threat to the economy except inflation. This is the reason the Fed has been reluctant to lower the Fed Funds rate target.

Now, suddenly in August, like the subprime mortgage crisis spreading to the entire financial system, contagion is spreading unemployment to all sectors. The market fears that unemployment might shoot above 6% within a few short months because layoffs have been made easy and swift for corporate management by government policy in the last decade. Whether the Fed will lower the Fed Funds rate target in the next FOMC meeting on September 18 depends on whether the Fed sees 6% unemployment is on the horizon.

Poor Employment Data tilted Market Sentiment

Despite reports of massive bank exposure approaching $1 trillion to the system-wide credit squeeze from a 13.4% contraction of the commercial paper market in the past four weeks, the mood among equity investors had still been one of cautious optimism sustained by silly pep talks from giddy analysts. That unwarranted optimism evaporated with the jobs report for August.

Share prices fell and both corporate bonds and Treasuries rallied to push yields down sharply on the very day of the bad news on jobs, as traders fled to safety on the realization that many more homeowners will have difficulty meeting higher adjusted interest payments in their floating-rate mortgages later this year and the next when unemployment rises further. Recession risks are overshadowing rate cut hopes as market participants begin to understand that rates cuts can be neutralized by a liquidity trap in which banks cannot find enough credit-worthy borrowers at any rate.

The interest rate futures market was already pricing in a Fed Funds rate of 4.57% by the end of October, a 68 basis points drop from current Fed Funds target of 5.25%. Fear remains that rate cuts not only may not help alleviate the present credit squeeze in the non-bank financial system, it could also be a psychological trigger that would destroy the Fed’s already dwindling credibility. A market that catches on to the impotence of central bank intervention can go into a free fall.

Interest Rate Cut Stimulates More Risk Appetite

In fact, a program of sharp rate cuts will render risk-averse investment unattractive and revive insatiable risk appetite for abnormally high returns that has landed the economy in its current sorry state in the first place. A case can be made that what is needed under current conditions is not more cheap money from the Fed, but full employment with rising wages by government fiscal stimulants to boost consumer demand.  The government should make use of the money that the banks cannot find worthy borrowers to lend to, and the money cautious investors are seeking to lend to the government, creating jobs for infrastructure rehabilitation and upgrading education to get the economy moving again off the destructive track of privatized systemic financial manipulation.

Credit Market Seizure Causes More Unemployment

The scurry by banks to shore up their deteriorating balance sheets as the commercial paper market dries up as a source of funding for many of their highly-leveraged borrowers could slow down bank funding for consumer credit further to cause a downward spiral of more layoffs in the already anemic economy. Also, as recently completed private equity deals structured with cheap money turn distressed with a credit squeeze, massive layoffs in the target companies will follow, adding to further sharp rise in unemployment.

Rate Cuts Hurt Exchange Rate of the Dollar to Cause Inflation

More ominous, the wide anticipation for a rate cut by the Fed on its September 18 FOMC meeting has already pressured the exchange rate of the dollar, pushing up gold prices. By September 12, the GLD exchange-traded fund (ETF) for gold set a 52-week high of $70 with the gold prices rising above $700 per ounce from $610 in January. Oil has risen to over $79 per barrel. Food prices are rising. A further weakening of the dollar combined with faster growing economies in emerging markets means foreign investors would invest in non-dollar zones or in US companies that have non-dollar revenue, further weaken the US domestic market.

All 10 major sectors in the S&P fell lower on Friday, September 7, and for the week, the consumer discretionary sector fell 3.2% amid fears over lower consumer spending. Homebuilders lost 6.8% for the week, taking its fall for the year to 50%. Financials declined 2.6% for the week, while the S&P investment bank index fell 0.8% on the day of the discouraging jobs report, taking its loss for the year to 16.5%. Investors are still waiting nervously to see whether the market can clear a backlog of $300 billion in unsold debt paper and bonds associated with this year’s record private equity buy-out deals.

In the midst of all the negative news, it is sometime forgotten that the DJIA is still above 13,000, a level substantially higher than economic fundamentals would justify. Left alone, a truly free market would adjust downward by as much as 40% before all the liquidity fluff is removed. The pleasure of excess in the market is never restrained by the excess of pleasure which unfortunately must be paid for at some point by pain in the economy.

Structural Disparity in Job Opportunity

Still, structural disparity in job opportunity persists in the faltering economy. In August, white unemployment was at 4.2%, below the overall rate of 4.6%; African American at 8.0%; Hispanic at 5.9% and Asian at 3%. The last two categories did not include illegal immigrants which could alter data on underemployment substantially. Teenage unemployment (16-19) was at 15.2% while black teen unemployment was 26.5%. The pain of NAIRU has not been equitably shared even in the liquidity boom. The rising tide failed to lift all boats.

Hidden unemployment was 16.2 million or 10.3% of the labor force. They included 4.3 million who had part-time jobs because they could not find fully time employment and 4.8 million who wanted jobs but were not counted in official statistics because they were not looking, of which about 1.4 million searched for work during the prior 12 months and were available for work during the reference week.

In addition, millions more were working full-time, year-round, yet earned less than the official poverty level for a family of four. In 2005, the latest year data were available, that number was 17.0 million, 16.2% of full-time workers. In June, 2007, the latest month available, the number of job openings was only 4.3 million, nearly 4 job-seekers for each job opening, while corporate earnings continued to rise from job outsourcing and financial manipulation such as share buy-backs made possible by a liquidity boom.

Phantom Strong Economic Fundamentals

With the liquidity boom abruptly halted, residual robust employment and corporate earnings had been misidentified as the alleged remaining “strong” economic fundamentals to which high government officials and Wall Street cheer leaders misleadingly referred, in defiance of facts even weeks after the subprime mortgage crisis broke out.  Even honest fools would know that a collapse of credit markets would lead quickly to rising unemployment and falling corporate profits, and high government officials and high-paid analysts are surely not fools. The issue then must be one of honesty.

Non-farm payroll employment dropped by 4,000 in August to 138 million, and the unemployment rate remained at 4.6% or 7.1 million workers, more than the total population of any one US city except New York.  Still, 4.6% is uncomfortably on the low end of NAIRU (4 to 6%) and that means an interest rate cut now would risk inflation down the road in a faltering economy, i.e., stagflation, as in the Carter/Volcker years of 1977-81.  This is the dilemma faced by the Fed, a cut in short-term rates may do more harm than good by not helping to sustain a liquidity boom yet fueling accelerated inflation, not to mention leading to a loss of confidence of the market in the Fed’s ability to manage a monetary and financial crisis.

Socialize Risk to Deliver Privatized Profit

Like their flawed attitude toward risk, the authorities in charge of regulating financial markets and the economy apparently think that inflation-fighting structural unemployment spread over the whole economic system is not damaging to the economy as long as the resultant profit is privatized and concentrated on a preferred selection of financial institutions, even if the privatized profit is achieved by externalizing the cost of risk to the entire financial system through structured finance. Free-market capitalists obviously think that socializing risk or unemployment is not dreaded evil socialism, only socializing profit is.

Drop in Labor Force Participation

Over third quarter of 2007, total payroll employment changes have averaged 44,000 new jobs per month, well below the monthly average of 147,000 new jobs between January and May.  In August, employment in manufacturing, construction, and local government education declined, while job growth continued in health care and food services. The civilian labor force edged down to 152.9 million, and the labor force participation rate decreased to 65.8%.  The declines were largely due to a drop in labor force participation among teenagers; their participation rate fell to 39.7%.  Total employment in August was 145.8 million.

Part-time and Temporary Workers

The number of persons working part time for economic reasons, at 4.5 million in August, 2007, was 359,000 higher than a year earlier.  This category includes persons who indicated that they would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs.

Nearly 1.4 million persons (not seasonally adjusted) were only marginally attached to the labor force in August, down by 227,000 from a year earlier.  These individuals wanted and were available to work and had looked for a job sometime during the prior 12 months.  They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.  Among the marginally attached, there were 392,000 discouraged workers in August, little different from a year earlier.  Discouraged workers are those not currently looking for work specifically because they believe no jobs are available for them even if they try.  The nearly one million remaining persons marginally attached to the labor force in August had not searched for work in the 4 weeks preceding the survey for reasons such as school attendance and family responsibilities.

Drop in Employment in August

The overall drop in employment in August was preceded by negligible job growth in June (+69,000) and July (+68,000), as revised.  In August, employment continued to fall in manufacturing and construction; local government education also lost jobs.  Job gains continued in health care and in food services and drinking places.

Manufacturing employment declined by 46,000 in August, losing 215,000 jobs over the past year.  In August, declines were widespread among component industries: for durable goods, job losses in motor vehicles and parts were 11,000, machinery 7,000, wood products 7,000, furniture and related products 4,000, and semiconductors and electronic components 4,000.  For nondurable goods, manufacturing job loss continued with 4,000 in apparel and 2,000 in textile mills. Construction employment declined in August by 22,000, with most of the loss occurring among residential specialty trade contractors.  Since its most recent peak in September 2006, construction employment has fallen by 96,000. Employment in local government education fell by 32,000 in August, as seasonal hiring was less than usual.

Health care employment continued to grow in August (+35,000); the industry added 396,000 jobs over the year.  In August, the good news was that employment continued to grow in all the components of health care: ambulatory care services (+18,000), hospitals (+11,000), and nursing and residential care (+6,000).  The bad news was that this was the sector with the highest inflation rates.  Employment in social assistance rose by 14,000 and was 83,000 above its year-ago level, showing that the economic cancer of income disparity was growing faster than the economy as a whole.

Within leisure and hospitality, food services and drinking places, employment continued to expand in August (+24,000).  The industry has added 350,000 jobs over the year, showing that the rich were still enjoying the good life, albeit employment in the accommodations industry has trended down over the past 3 months due to a drop in business traveling and middle income family vacationing.

Employment in retail trade was little changed in August because of back-to-school shopping. A job gain in building material and garden supply stores was partially offset by a decline in general merchandise stores.  Wholesale trade employment changed little in August because unemployment in these sectors tends to have longer lag time.

Employment in financial activities was flat in August, following a large increase in July.  Within the industry, employment in credit intermediation edged down over the month and was 19,000 below its most recent peak in February 2007. The trend is expected to rise sharply in coming months to reflect turmoil in the credit market. One company, Countrywide, alone announce a job cut program of 12,000 in the next three months. The mortgage brokerage industry is expected to lose 100,000 jobs this year. A sharp shift in employment from deal making to distress restructuring is expected.

In professional and business services, management and technical consulting services added 7,000 jobs in August, and temporary help employment continued to trend down. Temporary help has lost 72,000 jobs thus far in 2007 as companies downsize by first shedding temporary workers with no severance cost and pension liabilities.

Average hourly earnings of production and non-supervisory workers on private non-farm payrolls increased by 5 cents, or 0.3%, in August to $17.50, seasonally adjusted.  Average weekly earnings grew by 0.3% over the month to $591.50.  The CPI (Consumer Price Index) in July was 2.4% higher than in July 2006. August 2007 CPI data are scheduled to be released on September 19, 2007, at 8:30 am EST, one day after the scheduled Fed Open Market Committee (FOMC) meeting that decides on Fed Funds rate targets. The Employment Situation for September 2007 is scheduled to be released on Friday, October 5, at 8:30 a.m. (EDT), three weeks before the scheduled two-day meeting of the FOMC on October 30-31.

The Honest Services Issue of Public Officials

On Friday, September 7, the disappointingly bad news on August employment was released to the public at 8:30 a.m. EST by the Bureau of Labor Statistics. Although the data had been embargoed until official release time, surely both the Fed and the Treasury had advanced knowledge of BLS data as they were collected. It is inexplicable why those in charge of maintaining the sustainability of a healthy economy and open and transparent markets would knowingly pronounce misleading prognosis on economic trends that they know to be false and that would be refuted by pending public release of official data in a matter of days. Do these officials not realize that by not coming clean before the sun rises on what they know to be false, they damage rather than promote market confidence in their ability to manage the economy?

By any measure, the employment data for August were discouraging. Yet on Thursday evening, September 6, 2007, some 12 hours before the public release of the dismal BLS August employment data, Treasury Secretary Henry Paulson said in an interview on Nightly Business Report on PBS that turmoil in credit markets will only exact a price on the US economy but would not stall its growth. “There will be a penalty to our economic growth and I'm quite comfortable that we're going to continue to grow, create jobs,” said Paulson. “We have a very strong economy against the backdrop of these stresses and strains in the capital markets,” the US Treasury chief added confidently.

The Treasury Secretary’s bravado was not echoed by market confidence the next day. Mortgage defaults continue to soar to seize up credit markets as lenders grow increasingly reluctant to lend and investors to invest in commercial paper amid uncertainty about the true conditions of portfolios with risky mortgages that have been packaged into synthetic tranches of securities, given investment-grade ratings by rating agencies and sold in credit markets to unidentified investors around the world, leaving the market scrambling to determine which institutions are left holding the unsold toxic commercial papers.

When asked how long he thought it would take to sort out the stress in capital/debt markets and determine how serious the contagion problems actually are in subprime mortgage loans, Paulson, having repeatedly declared that problem had been contained in previous weeks, now said: “It's certainly going to be into the weeks, maybe a matter of months. I have a difficult time making projections, but it will be a while.”

It is not clear if Paulson, the nation’s highest finance official, was making a political statement or deliberately false market analysis by someone in the position to know about the true state of finance in the economy. The US Treasury for over a decade under both Democrat and Republican administrations has been the branch of the government most responsible for pushing financial globalization to produce a strong US-dominated global economy at the expense of a weak US domestic economy held up by debt. The situation makes it very difficult for the Fed to use monetary ease, i.e., lowing dollar interest rates, to stimulate the US economy without pushing the exchange rate of dollar down, which will further weaken the US domestic economy. A collapse of the dollar will make a recession seem like tea dance by comparison.

Enron Executive not Guilty?

It should be recalled that Enron top executives who made similar, knowingly false statements about their company to calm markets were convicted of fraud and sent to prison for it. The conviction was based on the so-called “honest services” theory that the defendants had conspired to deprive the company of.

On September 11, Paulson finally came clean on the seriousness of the crisis of confidence in credit markets and admitted that it would take longer to work out than previous financial shocks of the past two decades, such as the 1982 Latin American debt crisis, the 1997 Asian financial crisis and the 1998 Russian bond default that sank LTCM, a big, highly-leveraged hedge fund. The uncertainty over the distribution of holdings and the complexity of valuing structured finance instruments based on subprime mortgages could last for up to two years, as many such loans reset to higher rates over time. Still, he assures the market that the US economy is fundamentally strong, a position that instead of calming markets only makes him seem disconnected to reality.

Paulson spoke in Washington as Jean-Claude Trichet, the European Central Bank president, warned that it was time for global financial authorities to tackle unregulated entities whose activities had contributed to the latest upheavals. Ratings agencies were called to a special meeting for questioning by regulators on the way they rated structured financial products based on mortgage collaterals.

As Treasury Secretary, Paulson of course enjoys legal immunity on misleading political statements that technically stay clear of perjury or other impeachable offenses. And no suggestion is made here that Paulson is not an honorable man. Yet moral immunity from robbing society of “honest services” by the Treasury Secretary of the world’s most powerful economy is a different matter in the court of public opinion and in the judgment of history.

Interestingly, the day after the Paulson interview on PBS, former Enron CEO Jeff Skilling filed an appeal before the Fifth Circuit Appeals Court in New Orleans more than 15 months after he was convicted and nearly nine months after he began serving a 24-year, four-month prison term in southern Minnesota.

Skilling’s top-rated legal team, led by Daniel M. Petrocelli, who also famously won a wrongful death civil suit against O.J. Simpson on behalf of Fred Goldman, surviving father of murdered victim Ron Goldman, argues that errors by prosecutors and US District Judge Sim Lake, who presided over Skilling’s first trial in Houston, require the appeals court to overturn all 19 of his convictions of conspiracy, securities fraud, insider-trading and lying to auditors. “They were in search of crimes knowing this wasn't a clear-cut case, and in particular, that Jeff Skilling hadn't done anything wrong,” said Petrocelli in an interview, whose firm, O’Melveny & Meyer, reportedly was owed $30 million in legal fees by Skilling from the first trial.

The appeal said the government sought to criminalize normal business activities in its zeal to ensure someone paid for Enron’s failure. “That someone was Jeff Skilling — the last man standing when the court meted out its punishment,” the appeal said. Former Enron Chairman Ken Lay, Skilling’s co-defendant in their fraud and conspiracy trial last year, died six weeks after the pair was convicted, vacating his criminal liability.

The major arguments presented by the appeal include:
a) Prosecutors used a flawed theory that Skilling robbed Enron of his “honest services” to prove the overarching count of conspiracy to commit securities and wire fraud. A Fifth Circuit panel rejected that prosecution theory in a share-holder class action suit against Enron two months after Skilling’s conviction.
b) Judge Lake gave flawed jury instructions, most notably allowing jurors to find Skilling guilty of deliberately ignoring fraud when his defense was that no fraud existed. Lake refused to move the trial from Houston, where the defense contends anger about those hurt by Enron’s collapse poisoned the jury pool. Skilling never asserted an “ostrich” defense, a usual prerequisite to issuing the “deliberate ignorance” instruction.
c) Skilling’s prison term is excessive and unconstitutional, being four times longer than any other convicted Enron executive, two to three times longer than comparable white-collar defendants and six years longer than the average federal sentence for murder, albeit slightly less than the record-breaking 25 years in prison being served by Bernie Ebbers, the former boss of bankrupt WorldCom.

Judge Patrick Higginbotham of the Fifth Circuit signaled last December that Skilling’s legal argument could be well received regarding 14 of the 19 counts. In a ruling denying Skilling’s request to remain free on bond during appeal, Higginbotham pointed to “serious frailties” in those counts, noting “difficulties brought by a decision of this court handed down after the jury's verdict.” Higginbotham did not sit on the panel that issued the honest services decision, but he also wrote that Skilling had not raised issues likely to lead to reversal of all his convictions.

Skilling’s appeal argues, however, that the prosecution’s “honest services” theory taints all the other counts and that Skilling should get a new trial. The theory took a judicial hit in August 2006 when the appeals panel threw out convictions of four former Merrill Lynch & Co. executives in the Enron case. The judges said prosecutors improperly argued that the defendants robbed Enron of their “honest services” when they helped push through a loan on Nigerian barges disguised as an asset sale in late 1999 to help the energy company meet its missed earnings targets.

The appeals panel ruled that the “honest services” theory did not apply because the Merrill Lynch defendants acted in Enron’s corporate interests and did not take money or property from the energy company, even though their firm profited financially from the arrangement. There was no criminality because the money came from society, an entity that apparently has no court-recognized legal rights or advocate of legal standing in the legal system of market capitalism.

Prosecutors in the Skilling case had argued that he “robbed” Enron of his “honest services” by breaching his duty to make sure financial statements correctly reflected the state of the company.

Skilling argues in his appeal that he did not steal anything. Yet he was unjustly convicted of one count of conspiracy, a dozen counts of securities fraud, one count of insider trading and five counts of making false statements to auditors, while he was acquitted of nine counts of insider trading. The “honest services” theory was presented by the prosecution only with the conspiracy count, but the appeal argues an instruction Judge Lake gave the jury links it to the other counts as well. Oral arguments in the appeals case are expected to be scheduled for 2008.

Conflict between Systemic Guilt and Individual Guilt

The issue raised by the Skilling appeal, beyond the legal technicalities, was a conflict between systemic failure and individual responsibility. The court found Skilling guilty personally to absolve the system from guilt. The Appeals Court has ruled in related cases that convicted defendants were acting within the laws and regulations then governing their behavior. The Court’s decision implies that criminality rests with the system, not the individuals involved. However, logic would suggest that Skilling, by participating in a guilty system, cannot escape personal criminality even though he did not violate any laws of the system. That logic has been firmly established by the historic Nuremburg trials for war criminals.

Over the years of the liquidity boom, some people have profited very handsomely securitizing and selling subprime mortgages. These people were not even required to pay their fair share of taxes. Now in the consequential liquidity bust, these same people are home free because they have passed the risk onto unsuspecting money market and pension funds that hold the savings of middle income citizens. The structured financiers are keeping their ill-earned profit while the massive loss will be borne by million of others who innocently thought they were investing in risk-averse instruments created by the same financiers. Even the former Chairman of the Federal Reserve had been on record for having said publicly that systemic risk is a good trade-off for unprecedented economic expansion. There is a high probability that individuals responsible for the credit melt-down that will hurt millions will be brought to justice before the end of the day. The uncertainty is who they would be.