Is it always a lagging indicator?

There are some themes or ideas that are just accepted as common wisdom, and, as such, ordained as truisms.

For a time, one of those ideas was that the U.S. consumer was resilient; for a long-time this remained true ---- until it wasn't. Another such theme was that of global decoupling; for a while, it too looked like it might turn out true --- until it didn't. A third was that subprime would be contained --- which, likewise, wasn't based on facts or evidence or even well thought-out analysis, but was just an optimistic assumption, or, better yet, presumption, that ultimately got disproved.

The problem with ideas such as these is that the reason for the platitude is hardly ever examined; its truism-ity is usually just assumed on a prospective basis, often because it has been generally true retrospectively.

I worry that the notion that labour is a lagging indicator is just such a notion.

Undoubtedly, in most recessions, labour has been a lagging indicator. But most recessions that we are familiar with have been inventory-cycle recessions, or have been recessions caused by the Fed hiking rates until something breaks, after which time they drop rates again and re-start the economic cycle, principally by way of the credit cycle.

In an inventory-led recession, such as the dot-com bust, companies project the good times too far out into the future, they build to over-capacity, find out they have too much inventory, cut back on hiring, do some firing, work down their inventories, and its only after a while of those inventories being worked off, whether or not sales have picked up, that they need to resume the labour cycle, once their inventories are lean again. Therefore, labour indicators lag in such a cycle.

In other Fed-hiking-induced recessions, the Fed fears the inflationary effects of an overheating economy, so it hikes til the economy breaks/brakes; then once it has decided that it has slowed the economy enough that inflation will remain contained, it reduces interest rates, which spurs lending, as both consumers can incur new debt more cheaply to finance their spending (mostly through housing) and businesses can likewise finance more projects because their cost of financing has fallen, which makes more projects profitable. As such, the economy gets going again, and as consumers spend and as businesses ramp up, more labour is required, and hiring picks up, but in lagged fashion.

These are the typical types of recessions we are familiar with; and these are the types of economic cycles from which we evolved the common wisdom that labour is a lagging indicator.

But is that equally true today? Needless to say, I have my (serious) doubts.

Back on April 9 I published a post called U.S. Employment Data, at the conclusion of which I noted:
"Labour data is considered a lagging indicator. While that surely remains true (i.e. the economy will show other signs of rebounding before labour does), labour trends impart their own impact on the economy, particularly in a recession that is being consumer-led, unlike some past inventory-cycle recessions. In this case, the consumer retrenchment can't help but be re-inforced by the employment trends, as overly-indebted consumers are now also increasingly income-constrained consumers."

Normally, when the Fed tries to rescue the economy by cutting interest rates, that works its magic by restarting the credit cycle --- borrowing escalates, which finances economic activity, which spurs labour creation. Today, the Fed has dropped rates to as low as they can go, but its magic has lost its magic. Banks are not expanding the credit on offer. And even if they were inclined to, consumers are in no shape (or mood) to incrementally add to their monstrous debt burdens.

Furthermore, the primary channel through which Fed-engineered interest rate changes has historically had its impact is through housing: low Fed rates tend to lead to lower mortgage rates tends to lead to more housing activity, including all the various multiplier effects therefrom. But in this cycle, because of the still large overhang of excess homes, that's simply not happening. Sure, homeowners will refi as much as they can to take advantage of lower interest payments on outstanding mortgage burdens, and this will help ease their pain and suffering, and, at the margin, will mean they have more money in their pockets to spend on gas and groceries, and it will also allow their debt repayments to work more on reducing the principal rather than just paying mostly interest, but it does NOT mean they will take on more debt.

Households are deleveraging. They have taken a huge hit to their wealth, there is no more MEW available, they are closer to retirement than they were a decade ago, during which time they've had very little savings (relying instead on asset price appreciation that has quickly since dissolved), and, even for those who had pension plans, those too have taken a serious hit, so they now realize they need to save. They need to repay their outstanding debts, and also to re-build their nest eggs (can't just retire off the proceeds of a future house sale), which means that consumption must be constrained to something less than their incomes. Which, in the meantime, is falling (not just from lost jobs, but from lost hours for those still working, and from neglible wage gains).

Similarly, businesses haven't much motivation to leverage off of low interest rates to increase their activity. They have huge levels of unutilized capacity, so, as low as (government-backed) interest rates are, they have little incentive to take that money to invest in new productive capacity or in the creation of new widgets. And, not all businesses have access to government-guaranteed debt, so funding costs for the broader business community, due to still-wide spreads, are not that incentivizing in any case.

Therefore, if the Fed can't re-start the credit cycle, then it can't restart the economic business cycle, and thus it can't do much to promote job growth.

Banks don't want to expand lending (they have enough NPLs and bad debts to worry about already, and why extend more credit into an already debt-heavy economy that is in recession and to debt-burdened consumers who have poor job prospects and declining collateral values). Consumers don't want to take on more lending (for all the same reasons the banks don't want to extend it --- both groups are properly motivated to see debt levels in aggregate fall). And businesses might be in a position to borrow money, but the question for them is what to do with it (Microsoft, for instance, did a very opportunistic (first ever, I believe?) debt issue to lock in some nice borrowing rates (just 100 back of Treasuries), but it was already sitting on a ton of cash, and its not as if issuing a bunch of bonds has any implication for its order book.)

So, without labour growth, where will expanding economic activity come from? For now, there is some that is coming from the government purse, and that increase in federal expenditures (above and beyond the decrease in state and local outlays) will likely be sufficient to impact growth in the near-term, but does little to address the structural problems in the economy (i.e. excessive debt) that do not bode well for the mid- to long-term.

At the end of the day, what promotes economic growth is spending growth, and what promotes spending growth is income growth, and what promotes income growth is job growth. And we ain't got none of that right now.

As long as deleveraging persists (and it will for quite some time given that total economy-wide debt loads have continued to increase relative to the size of the economy or personal disposable income, which have fallen faster than debt has been paid off, and given that the mirage that it was sustainable on the back of housing values has been discredited, and given that housing prices still remain stretched relative to historical norms), it is my belief that job growth will be a leading, not lagging, indicator of demand, and, therefore, of economic activity.

And, most unfortunately, we are stuck in a vicious circle. Businesses' profit margins have been crushed, so pressure remains on them to cut costs (i.e. cut labour). As labour conditions continue to deteriorate, aggregate demand will continue to be stifled. And so it goes and so it goes.

At some point, conditions will have reached a point that sustainable growth will become inevitable. But a decade-long debt-drinking binge will not be cured with a 10-month hangover --- not until all that bad booze has been purged from the system and the drunks are over the memory of how bad that hangover felt.