Wednesday, June 29, 2011

We're #50, we're #50, we're #50!!!

Congratulations to Rhode Island on its recent ranking of #50, worst in the entire country, for "America's Top States for Business 2011" by CNBC (here is a link to an interview with CNBC's Scott Cohn about this). This designation is richly deserved. Our state's leaders should be very happy, as they have worked tirelessly over the last few decades laying the groundwork that would allow us to attain this prestigious designation. Think of all the publicity Rhode Island will now receive from this, something a substantially tourism-driven economy like ours thrives on!

Rhode Island actually "improved" its ranking this year, in the sense that we do things here, moving from "only" #49 last year to the number 50 this year. This shows that Rhode Island can lead the nation, just as it did a few years ago when it had the nation's highest unemployment rate, beating even Michigan. As I am writing this, Rhode Island's jobless rate is ranked third highest in the US, so there is clearly more work to be done. Let's get moving Rhode Island state leaders!

Forgive my sarcasm. It has a very substantial basis and long history based on my continual disappointment with the way things are done (or not done) here.

Looking at this survey, it is clearly the case that any such survey comparing all fifty states embodies elements of "apples and oranges." Yes there are arbitrary values and weights that are part of a survey that arrives at a single value or score to characterize the entirety of a state's economic performance. For Rhode Island, though, it is not that we scored among the lowest in all of the categories covered. We failed to score very well in any of the categories, something that I recall discussing going as far back as the 1990s. In fact, I even formulated a rule to anticipate Rhode Island rankings:

In any fifty-state economic comparison, Rhode Island will tend toward its alphabetical ranking of 39th.

Our state's best category score was 24th, a tie between Quality of Life and Education. As CNBC states for the Quality of Life category: "We scored the states on several factors, including local attractions, the crime rate, health care, as well as air and water quality." For education: "We looked at traditional measures of K-12 education including test scores, class size and spending. We also considered the number of higher education institutions in each state." Rhode Island ranked its worst in Infrastructure & Transportation (#49). 

What do the categories Education and Infrastructure & Transportation have in common? They both pertain to infrastructure. Infrastructure & Transportation pertains to our physical infrastructure, while education deals with our human capital infrastructure (training and skills of our population). Both remain seriously deficient. We have horrible roads and a labor force with grossly inadequate skills. It is important for us to own up to the fact that this information is hardly a secret to anyone, except perhaps any Rhode Island leader who chooses to live in a state of denial about Rhode Island's present economic realities. And, it shouldn't take very long for anyone to realize that Quality of Life, Education, and Infrastructure & Transportation are all interrelated, especially in an information based economy like that of Rhode Island. So, whenever we take actions to improve one of these categories, we indirectly move toward making improvements to all three. Does anyone want to argue that the above categories are independent of the cost of doing business here?

I'll let readers look at the survey results in greater detail, viewing all of the categories and the ranking for each state. But it shouldn't come as a surprise to anyone that Rhode Island ranked very badly on: Business Friendliness (#48); Cost of Doing Business (#46); and Cost of Living (#43). 

Let me finish by stating that the recent budget proposed by the Rhode Island legislature should not be viewed in the context of being "not as bad as the originally proposed budget," but in terms of whether or how it helps our state's national ranking problems and its business climate overall. As I have stated all too many times over the years, how we balance our state's budget is every bit as important, if not more so, than balancing it in general. Rhode Island did make some cuts to spending, but based on my strong suspicion that projected revenue growth has been overstated for FY2012, not enough spending cuts have been made. This will almost certainly result in yet another "January Surprise," as more budget changes will be required in January to ultimately balance the FY2012 budget. Let's hope our state's leaders prepare for this ahead of time, although that is exceedingly unlikely given their history. How can Rhode Island  be a "leading" state when the standard operating procedure of its leadership is entirely reactionary, not proactive. The answer has been that we do lead -- in things we never wanted to lead in, such as our state's worst business climate ranking.

Thursday, June 23, 2011

Energy Prices and Feedback Loops

As I am writing this (6/23/2011), energy prices are falling dramatically. This has been coming for some time now. There were a number of signs that this day would come. But you would never have known this based on the way the recent run-up in commodity prices has been covered in the media.

Let's start by considering an obvious relationship between energy prices and economic growth illustrated in the chart below (click to enlarge).

Everyone knows this. We witnessed this first hand in early 2008 and again this year. Higher energy prices affect both supply and demand. As for demand, higher energy prices reduce the purchasing power of consumers in terms of their real (inflation adjusted) income, diminishing their ability to purchase goods and services. This cuts into discretionary spending, spending we don't really have to do, but like to do. Industries that thrive on discretionary income are then hurt (ex: restaurants). On the supply side, higher energy costs increase input costs to businesses, raising their overall costs, potentially hurting their profits. How much will business costs rise? That depends on how much a particular business or industry uses the now-more-expensive energy inputs.

As this was occurring, media pundits did something they almost always do, attempted to predict the future entirely in terms of what was happening at that time. The basis for their forecasts were therefore predicated on the use of rulers, not economic theory or underlying economic signals. The result was forecasts like the one below (click to enlarge):

So, for those naive enough to rely on the media, panic naturally ensued. Would energy prices ever fall? How would we deal with the onslaught of permanently higher energy prices?

Of course all of this overlooked a very important saying about energy prices that has more than passed the test of time: "The best cure for higher energy prices is higher energy prices." In other words, you must take into account not only the entire set of shorter-term effects associated with rising energy prices outlined above but the longer-term impacts as well.

There are several effects of weakening demand. First and foremost, less demand hurts business activity overall, making it more difficult for firms to hire workers, possibly causing some layoffs. In other words, firms will tend to purchase fewer inputs overall than if activity were stronger. And as they cut back on purchases, their suppliers are also dragged into the weakness as this process continues (economists refer to this as the multiplier). Second, with diminished demand, even though costs are higher (as shown above) the ability of firms to pass along these higher costs is reduced, intensifying the overall weakness as profits weaken. These are important macroeconomic effects. Over the longer-term, the production of energy tends to rise, further helping to limit energy price increases.

Combining all of these factors, what occurs is a "feedback loop," where slower (and slowing) economic growth hurts the demand for energy, moderating or reversing earlier energy price increases. This is illustrated below (click to enlarge):

This is what we are beginning to witness now. The Federal Reserve and a host of other forecasters have been adjusting their growth projections for 2011 lower, largely the result of their presumption of continued higher energy prices. So, contrary to being able to forecast energy prices using a ruler, it is necessary to consider all of the effects I have outlined above. What will energy prices look like in the future when we correctly allow for this feedback loop? The chart below shows this (click to enlarge):

What all of this shows is that energy prices and the level of economic activity are simultaneously determined. There is not a one-way-only causation. I wish it were, that would make economic forecasting much easier!

From this, it should now be fairly easy to grasp the fact that lower energy prices are not necessarily an unmixed blessing. It is necessary to first consider why energy prices are falling. Since the emergence of OPEC in the early 1970s, energy prices often end up declining as a result of economic weakness they cause to occur. This does not mean that economic activity is about to explode. It will improve, but only after imploding for a bit longer (multipliers taking things lower for a while). Reiterating that last point, while higher energy prices don't instantly lower economic activity (it takes time for the effects of everyone paying the extra money to be felt), lower energy prices won't instantly restore the losses in economic activity. All of this takes time. That's why lags are so important in forecasting and economic analysis.

EPILOGUE: I created all the graphics for this blog post during my office hours in April, when I predicted to my classes on numerous occasions that we were near a short-run top in energy prices and nearing some sort of stock market correction. What was my basis for these predictions?

I used intermarket analysis, which is based on the fact that key asset markets (stocks, bonds, currencies, and commodities) are all linked together in today's global economy (actually I have created a course in this that I was teaching this spring).  I showed my classes that commodity prices were indeed rising (we all knew that). But, as commodity prices were rising, the inflation "alarm bell," interest rates, were actually declining not rising as higher expected inflation would suggest. Along with this, one commodity that is particularly sensitive to economic growth, copper, was also declining. Finally, the defensive sectors of the stock market (consumer staples, health care, and utilities) were outperforming the overall stock market. So, if future commodity prices were best depicted by a "ruler-based forecast" this intermarket pattern would either not have emerged, or it would have been temporary at best. The rest, as they say, is history.

I didn't make this post in April because, quite honestly, everyone would have thought that I was crazy. Gee that would be something new!

Monday, June 20, 2011

Media Appearances -- June 2011

Over  the last week, I have been on the radio discussing Rhode Island's pension crisis and the recently released budget for FY2012.  My discussion on the pension crisis was on WPRO with Buddy Cianci last Thursday (June 16). During that interview, we discussed my article in The Providence Journal dealing with my assessment of our state's pension crisis and my frustration at the lack of action by our state's leaders. On Monday (June 20), I was interviewed by Helen Glover on WHJJ about the newly proposed state budget. As I stated to Helen, I have a strange feeling that the projected deficit that the legislature is working with is too low and that the budget proposed at the end of last week will lead to yet another "January Surprise." Only time will tell if I am correct on this.

May 2011 Labor Market Data

The labor market data for May of 2011 have now been released. As always, Rhode Islanders and their media focused on the unchanged unemployment rate from April, 10.9%. And, in numerous stories, employment was described as "adding 1,300 jobs compared to April." If one goes behind the numbers, as I always do, there's a lot more going on, and as always, the jobs added figure that was reported was incorrect.

Perspective: I highly recommend that persons consider not just looking at data like this by focusing on the change from one month to the next (called month-to-month, or M/M). Very often it gets revised, so what we think happened this month ends up being changed, for better or worse, the next month. While it is useful (albeit fleeting) to look at month-to-month change, it is preferable to consider both what happened compared to a year ago (called year-over-year, or Y/Y) and the one-month change.

Unemployment Rate: Looking at Rhode Island's unchanged (M/M) unemployment rate in May, 10.9%, this was well below its level last May's value of 11.7%. However, our state's labor force fell over this period, by a number roughly equivalent to the decline in the number of unemployed. Conclusion: the "improvement" in our state's jobless rate from a year ago was largely due to unemployed Rhode Islanders dropping out of the labor force which statistically lead to their no longer being counted when the rate was calculated.

Another point I need to make concerns an extreme rarity that occurred with the May data. Unemployment data along with the number of working Rhode Island residents comes from the Household Survey. Forgive me as I provide the basic labor market identity:

LF = E + U

or Rhode Island's labor force (LF) for any period is the sum of the number employed of employed Rhode Islanders (E), referred to as resident employment, plus the number unemployed (U) Rhode Islanders. Here's the rare occurrence we witnessed with the monthly data (change from April to May of 2011):

Change in LF = -1,400
Change in E = -1,400
Change in U = -100

Obviously, there is rounding error here which should be overlooked. Here's the oddity: while our state's unemployment rate remained unchanged at 10.9%, there were 1,400 fewer Rhode Island residents employed (we'll overlook the change in U here). How and why would employed Rhode Islanders drop out of the labor force? It would be very easy to explain why unemployed persons would drop out -- lack of job opportunities. But employed??? The best explanation I can come up with is that a number of self-employed Rhode Islanders weren't doing so well and packed things in (literally). I guess they then went to a status where they opted not to look for work, leading to roughly similar declines in resident employment and the labor force. Will this oddity be present when the June data are released in a month? I wouldn't at all be surprised if it disappears!

Employment: As if all of this weren't confusing enough, there are actually two separate measures of employment. The first, presented above, from the household survey, is resident employment, the number of Rhode Islanders working, whether in Rhode Island or somewhere else. There is a second survey, the establishment survey, that counts the number of jobs in Rhode Island, or payroll employment. Unlike resident employment, this measure does not count self-employment. And, in order to compare adjacent months, the data must take seasonality into account, using seasonal adjustment.

Comparing month-to-month changes in employment, for resident employment, there was a decline of 1,400 (see above). For payroll employment, the gain that was reported was 1,300. The fact that there were different changes in both measures is not uncommon. What must be taken into account, however, is that the payroll employment figure for jobs added is almost always reported incorrectly.

To give a sense for why this is so, let me change to year-over-year payroll employment change, the measure I pay most attention to since monthly changes are often modified the next month. The chart below (click to enlarge) gives the number of jobs added and jobs lost over the last year.

Let's focus on May of 2011. For that month, Rhode Island had job gains of 9,500 versus job losses of 5,300. The net change in employment (year-over-year) was therefore 4,200. The local media, however, always reports this as 4,200 jobs added, which is clearly incorrect. Since February of this year, job gains in Rhode Island have clearly accelerated. Sadly, job loss has remained stubbornly high, leading to overall employment growth (i.e., change) of less that one percent (0.9% for May). 

So, this look into the labor market data released each month should illustrate that there's a lot more going on than any simple explanation can accurately conclude. Keep in mind that there are two labor market surveys, not one, and these often reflect different forces at work and thus come to different conclusions. And, for someone who has been following all of this in depth for as long as I have, sometimes I don't even understand all of what's going on. I guess that's why God invented data revisions!

Tuesday, June 14, 2011

Media Coverage of the April 2011 Current Conditions Index

The April 2011 Current Conditions Index (the full report is given on my website) received a fair amount of coverage in the local media. Here is my regular monthly discussion of the index on Channel 10's Business Talk with Barbara Morse Silva. The Providence Business News, as always, gave very nice coverage, as did GoLocalProv. Finally, I was also on the radio with Buddy Cianci on June 2 where we discussed pension issues and the Moody's downgrade for Rhode Island.

Thursday, June 9, 2011

2010 State GDP Numbers Released

The US Bureau of Economic Analysis recently released data for 2010 on Real Gross Domestic Product by state (the total value of final goods and services produced in each state during 2010). The 2010 rate of growth for Rhode Island looks fairly good: 2.8 percent, which gave Rhode Island a rank of 18th nationally. But, if you place this number in the context of economic performance since 2007, in other words, take where we've been into account, things aren't quite as bright.

If you've been reading my blog posts and writings over the years, you know that this is my preferred approach, one very different from what we often get from local media. All too often, they tend to view a single number such as the 2010 growth rate absent any meaningful historical context, basing their reports largely on that one number and the value that precedes it. This often paints a misleading picture, either overly optimistic or pessimistic, but reinforcing a perspective consistent with the most recent trend(s). So, let's take several views, but overall, use all of the information from the GDP release.

For 2010, the growth rate of real GDP for New England was 3.4% (relative to 2009). That was higher than the US rate, 2.6%, and every other region except for what the BEA refers to as the Mideast (the mid-Atlantic states). Within New England, Massachusetts had the highest 2010 growth, 4.2%, followed by Vermont with 3.2%, Connecticut at 3.1%, Rhode Island, 2.8%, Maine with 2.1% growth, and New Hampshire, 1.3%. So for 2010, Rhode Island ranked fourth in New England for real GDP growth.

If we were to merely focus on the results for 2010, the conclusion would be that Rhode Island turned in a very good performance, consistent with its very respectable national ranking. Let's now switch to a framework that looks at all of the data just released, which goes back to 2007.

The table below (click to enlarge) gives annual real GDP levels from 2007 through 2010 for our region overall and for each New England state as a percentage of respective 2007 values.

The first thing to note is that Rhode Island's real GDP fell by 2% 2008, a larger decline than either the region as a whole (actually the region increased that year), or any of the other states in our region. The entire region saw declines in real GDP in 2009. But since Rhode Island began a deep recession in mid-2007 (our real GDP fell 1% for that year), its relative position was even further diminished in 2009. For 2010, our region and each of its states improved from the levels in 2009, although three of the six New England states remained below their 2007 values. A quick examination of the table shows that as of 2010, Rhode Island remained farther below its 2007 real GDP than either the region as a whole or any other New England state. In fact, Rhode Island's ranking relative to its 2007 real GDP was the worst for the entire region.

So, while Rhode Island's 2010 growth rate of 2.8% was very good taken by itself, judging our state's current status by that single statistic is misleading. We're not back, especially compared to our neighboring states. But we have begun our move back -- according to my Current Conditions Index, our current recovery began in February of 2010. So,the 2.8% rate of growth for 2010 is that for the first year of our state's recovery, our version of a "V-shaped recovery" I guess.

Let me conclude with a table (click to enlarge) that shows the major sectors that contributed to Rhode Island's 2010 growth rate and one comment.

The sectors contributing the most to 2010 growth were: Finance and Insurance, adding 0.78 percentage points to our growth rate of 2.8 percent; Trade, both wholesale and retail, were also major contributors, their total was 0.69 percentage points; and the pleasant surprise was Durable Goods Manufacturing, with 0.40 percentage points. Based on how beaten down manufacturing here became, and aided by US dollar depreciation, Rhode Island's manufacturing sector has been one of the "stars" of this recovery. The contribution above attests to this.

Let me conclude with my comment. While I have detailed the most recent real GDP report for Rhode Island and the New England states here, I have believed for a very long time that state-level real GDP is one of the least reliable and most "noisy" statistics for statewide economic activity. Consider that while the first table above shows that Rhode Island was only 1.1 percent below its 2007 real GDP level at the end of 2010, according to labor market data (a separate source from this), employment remained almost 8 percent below its level at the last cyclical peak (in December of 2006). I find it very hard to reconcile these two statistics. Yes, productivity growth has been extraordinary throughout this recovery. But that large a disparity seems a bit extreme to me. If history is any guide, next year's labor market revisions will show lower levels of employment than those currently published. I don't expect those revisions to be all that large, so substantial disparities will still remain in the "stories" told by the real GDP and employment data. I'm just not willing to buy it! 

Friday, June 3, 2011

Have Rising Energy Prices Hurt Retail Sales in Rhode Island?

By now, just about everyone is aware of how burdensome the ongoing increases in food and energy can be. Sadly, our pay doesn't keep pace with these rising costs, so on an inflation-adjusted basis, income is actually falling (economists refer to this as real income). The result of declining real income is that one particular area of spending, discretionary spending, is hit very hard. Why? Because discretionary spending, spending that one really doesn't have to do, but would like to do, is generally predicated on either having extra purchasing power (i.e., higher real income) or using credit. Home equity is largely gone as a basis for credit, and many people are either unable or unwilling to add to their credit card debt. So, spending patterns adjust and the extra boost that discretionary spending gives to the economy begins to dissipate.

A scary factoid I recently read about concerning this is particularly disturbing: according to Walmart, spending by their customers at the end of each month has been dropping very sharply of late. Apparently, many of their customers simply run out of money by month's end! I honestly don't recall seeing anything that drastic in a very long time, if ever. This is clearly a sign of the magnitude of the problems the US is facing.

What about Rhode Island? Is there any empirical evidence that retail sales here have been hurt by higher energy prices? Sadly, the answer is yes. To explore this, I converted retail sales into their inflation-adjusted (i.e., real) values. I then contrasted the rates of growth in real retail sales for Rhode Island with growth rates in gasoline prices. To make this less volatile and to make it easier to visualize the underlying relationship involved, all growth rates compare values in a given month to the same month one year ago (called year -over-year, denoted Y/Y). The chart below (click to enlarge) shows the results.

To put this into context, the economic impact of rising energy prices depends on both the levels to which they rise and how rapidly they increase. The more rapid is the rate of increase, the less able are persons to adjust to the changes they are confronted with. The rate of increase in gasoline prices is shown in the chart as a rising red line as of June 2010.

First, and foremost, the negative effects of rising gasoline prices are not instantaneous. Thank God! It takes time for rising gasoline prices to significantly erode real income and hence the ability of persons to purchase goods. Also, it must be kept in mind that gasoline prices are not the only factor affecting real retail sales. Other factors also matter (employment, hours, etc.) so there will not be anything resembling a perfect correlation in a chart like this.

The chart shows that after gasoline price growth fell to very low levels by mid-2010, they began a sustained period of accelerating growth through March of 2011. Economic activity in Rhode Island improved during the second and third quarters of 2010 (based on my Current Conditions Index), which helped to offset some of the building negative effects of the more-rapidly rising gasoline prices. Note that there was a jump in real retail sales growth during the 2010 holiday season, in spite of the fact that gasoline prices had been rising at more rapid rates for a while by that time. But once the 2010 holiday season ended, I think of this as the "last hurrah" for retailing here, things changed. While real retails sales were still rising, their growth began to slow as we entered 2011. Eventually, real retail sales declined (their growth became negative) driven in no small part by the period of accelerating increases in gasoline prices. Retail weakness, should it persist, does not bode well for future economic growth here, and it won't help us to sustain recent pleasant surprises in retail sales tax revenue.

Where do we go from here? Recall that both levels and rates of growth in gasoline prices matter. So, while the rates of increase in gasoline price have recently slowed, the result of moderating global growth and some firming of the US dollar, the level of gasoline price is still relatively high, close to $4 per gallon. Absent major declines in gasoline price this summer, this stubbornly high cost of gasoline will continue to take its toll on economic activity here.

Timing can be everything. As Rhode Island's economy has been growing more slowly of late (based on my Current Conditions Index), repairing the damage from high and rapidly rising gasoline prices will take time, so don't expect any snap back of the rate of growth here. That would be true even if we didn't have the negative effects of budget deficits and the pension crises to deal with.