Bears Overly Pessimistic About Unemployment

By James Kostohryz  SEP 04, 2009 3:20 PM

The outcome is uncertain, but some factors are irrelevant predictors of growth.


Many readers ask me how it’s possible for the economy to recover if unemployment is so high. Indeed, many are fond of pointing out that the “real” unemployment rate is higher than the 9.7% reported today.

The truth of the matter is that when projecting growth, it really matters very little what the absolute rate of unemployment is -- whether it be 9.7% or the 16.8% U-6 alternative figure provided by the BLS, or the even higher figures publicized by Shadowstats.

What matters is the change at the margin. Growth is all about change.

Let’s assume that the unemployment rate is 10% and that it remains at that level for a full year -- i.e. the unemployment rate remains unchanged. Let’s assume that the average number of hours worked doesn’t change. Let’s also assume that there’s no net change in the number of long-term unemployed. What would one project for the growth rate of private consumption over the next 12 months?

One would expect nominal consumption growth of at least 4.0%. Why?

First, 1.0% growth is generated simply from the 1.0% growth labor force, which means that in order to keep the unemployment rate constant, there needs to be employment growth of 1%. All things equal, employment growth of 1% will mean nominal gross national income growth of 1.0%.

Second, even in the midst of the current brutal recession, average hourly earnings have grown by 2.6% per annum. All things being equal, income growth of 2.6% will imply consumption growth of the same magnitude.

Third, productivity is growing at a 6.0%-plus clip, which implies earnings growth for companies. Even the most bearish Wall Street analysts are forecasting very dramatic earnings growth in 2010. Companies will either spend or invest most of that money, providing a substantial boost to net private expenditures.

Fourth, a stable employment situation will cause households to reduce precautionary savings somewhat as the fear of job losses subside. This will necessarily boost consumption.

Thus, in a scenario of a stable labor market -- i.e. employment conditions are neither improving nor worsening -- it’s difficult to see how consumption will increase by much less than 4.0%. A lower projection would require one to assume that consumers are going to become even more stingy and frugal than they are right now. That doesn’t seem likely. To the contrary, it seems more likely that on the aggregate, consumers will relax a bit on some of their more draconian savings measures.

Today’s Employment Report

So what does today’s employment report portend for future consumption growth?

Across the board, either on a month-over-month (MoM) or on a three-month rolling basis, whether you look at the overall non-farm payrolls numbers, the part-time work numbers, the discouraged-workers numbers, and all of the rest of it, it’s clear that the rate at which the employment situation is worsening has continued to slow. And it must be recognized that the situation is currently considerably better than most bears were expecting at the beginning of this year when forecasts of 500,000 job losses through the end of 2009 were common And just in case you’re wondering, taking into effect the adjustments through the much-speculated-about birth/death model would make no difference to the analysis. Most of the criticisms of BLS figures based on the birth/death model are bogus from a technical point of view. But regardless of this fact, what matters is the rate of change. And analyzing Birth/Death Model doesn’t do a thing to alter the view that the unemployment situation is leveling out.

If one looks at what’s happening in manufacturing industries and the incipient inventory correction, it seems likely to me that the economy will probably stop shedding net jobs by late this year. And if the inventory correction has legs, the net jobs should probably be growing at fast enough clip to begin to make a small dent in the unemployment rate by the second quarter of next year. (See: What Does Employment Mean For the Market?)

So, if this is the case, by April or May of 2010 the economy could be in the situation described above where the labor market is stable. This would allow overall consumption to grow by about 4.0%.


Many bears make the mistake of assuming that just because the unemployment rate is high -- or remains high -- the economy cannot grow. This is false. As long as the labor market simply stabilizes and unemployment doesn’t rise any higher, the economy can grow.

Now, there are other factors that impinge on consumption other than employment. Too many people make the mistake of equating unemployment with consumption. This is a mistake because the vast majority of the workforce has a job. Thus, less focus needs to be placed on those that don’t have jobs and more focus needs to be placed on this vast majority that do. We need to be asking what employed folks will be doing, going forward. In my mind, this is where there’s the greatest uncertainty.

As I pointed out in my article from yesterday, Two Warnings for the Bears, consumers on aggregate do have the financial wherewithal to be able to increase consumption -- even above and beyond the growth of their income. The question is whether and to what extent they will. This is as much a psychological matter as anything else.

One view is that Americans are undergoing a radical psychological shift and that they’re going to become frugal all of the sudden – indeed, that they’ll be even more frugal in the next 12 months than they were in the last 12.

Another view is that Americans will at least partially revert back to prior consumption patterns. As I pointed out in yesterday’s article, the vast majority of American households aren’t overly constrained by debt. It’s likely that these households will probably go back to living very much as they did previously -- i.e. consuming a roughly equivalent proportion of their income. This implies decreased precautionary savings, increased consumption, and renewed use of credit. At the very least -- in the case of those that won’t go entirely back to their prior consumption patterns -- they won’t be as frugal as they were in the past 12 months as the fear of doomsday isn’t nearly as great.

Assuming a scenario of a stable labor market, the only way consumption won’t grow nominally by at least 4% is if Americans change their consumptions habits radically and become even more frugal than they’ve been for the past 12 months. Let us take note of such a possibility.

But there’s another possibility with very important implications: Americans could revert to prior patterns, at least partially. If that happens, nominal consumption growth could rocket into the 6%-plus range. For example, 1% labor force growth + 2.6% wage growth + 1.4% incremental growth from profits driven spending + a 2% reduction in the savings rate = 7.0% consumption growth.

I haven’t made up my mind about which scenario will in fact play out. What I’m quite certain of is that bears are far too pessimistic, and that this pessimism is the product of a lack of understanding.
No positions in stocks mentioned.

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