Free exchange

DALLAS Fed President Richard Fisher is an entertaining guy to listen to. He likes to tell jokes, as he did to open his latest speech on current economic conditions. This one is borrowed from Ronald Reagan:

Paddy McCoy, an elderly Irish farmer, received a letter from the Department for Works and Pensions stating that he was suspected of not paying his employees the statutory minimum wages and that an inspector would be sent to the farm.

On the appointed day, the inspector turned up. “Tell me about your staff,” he asked of Paddy.

“Well,” said Paddy, “there is the farmhand. I pay him 240 a week and he has use of a free cottage.”

“That’s good,” said the inspector.

“Then there’s the housekeeper. She gets 190 a week, along with free board and lodging.”

“That sounds fine,” said the inspector.

Paddy went on. “There’s also the half-wit. He works a 16-hour day, does 90 percent of the work, nets about 25 pounds a week when all is said and done, but takes down a bottle of whiskey and, as a special treat, occasionally gets to sleep with my wife.”

“That’s disgraceful, Paddy,” said the inspector. “I need to interview the half-wit.”

“Well,” said Paddy, “you’re looking at him.”

It's an amusing bit, which Mr Fisher uses as a segue into a discussion about how important it is to have "Outside the Beltway" people—that is, those not living in Washington and its inner suburbs, or non-insiders—weighing in on important policy issues. As a regional Fed president, Mr Fisher sees himself as needing to bring a "Main Street" perspective to FOMC meetings, in contrast to the views of appointees like Ben Bernanke.

I think it's perfectly fine to get lots of different perspectives on policy questions. Given the power residing in the Fed, I hope its leaders are challenged to defend their views. What bothers me is Mr Fisher's insinuation that there is a greater authenticity to Main Street views—that the economists in Washington are focused on big picture variables and miss the simple truths known to a humble, non-economist Fed president in Dallas.

But the Fed is a technocracy. Within a technocracy, the only thing that matters is the defensibility of one's arguments, not the backstory of the person making them, or how good they are at telling jokes. And unfortunately, Mr Fisher's views aren't particularly defensible. They're actually quite sloppy. For instance, he says:

A look within the United States makes clear the overriding influence of fiscal and regulatory policy. Monetary policy is uniform across the 50 states; the base rate of interest paid on a business or consumer loan or a mortgage in Michigan, California, Ohio or New York is the same as that paid in Texas. Yet there is a reason that Michigan and California each lost more than 600,000 jobs over the past decade while Texas added more than 700,000 over the same period. There is a reason that the population of Ohio grew by only 183,000 residents over the past 10 years, while Texas grows by that number every five and a half months. There is a reason that with each passing census, the state of New York has been losing congressional seats and Texas has been adding them; a reason that, in the recent census, California failed to gain any while Texas gained four. There is a reason that, as documented in the Jan. 12 issue of the Wall Street Journal, college graduates—the best and brightest of the successor generation—are leaving New York and Cleveland and Detroit and moving to Austin, Texas...There is a reason no state in the union houses more Fortune 500 headquarters than Texas. There is a reason for the disparate employment growth that has taken place in the 12 Federal Reserve districts over the past two decades, data that are documented in the graph at your place setting.

That reason has nothing to do with monetary policy. It has everything to do with the taxation and fiscal and regulatory policies of the states. The cost of capital does not explain the different economic performances of the states; the cost of doing business has everything to do with those differences. However well-meaning tax and regulatory initiatives in the laggard states may have been when they were conceived and levied, they have had unintended consequences that have led to economic underperformance and job destruction.

There's quite a bit wrong with these paragraphs. Why has population grown so rapidly in Texas and slowly elsewhere? Here's economist Ed Glaeser:

The Sun Belt pattern of low prices and abundant construction can mean only one thing: an abundant and elastic supply of housing. Demand for new housing, due to either sunshine or economic success, isn’t driving Sun Belt growth – low prices belie that explanation.

Rather, in the growing regions, even modest demand creates far more new construction, and population growth, because supply responds so enthusiastically.

In Texas, the lack of regulation that matters is control over construction of new housing. Elastic housing supply turns a small increase in demand for Texas life into a large population rise. That rise, in turn, supports some job growth. But as Mr Glaeser notes, productivity is higher in places like New York, as is the median family income. It's bizarre to lump together the economies of New York and Detroit (the former's population is at its highest level ever and wage growth there tops the nation; the latter has been declining for decades), but Census data indicate that the share of adults with bachelor's degrees is basically identical in New York and Dallas.

Perhaps more troubling is that Mr Fisher seems unaware of just what his job entails. Whatever one thinks of regulatory policy, it should be clear that the central bank's primary focus is macroeconomic management, and particularly the minimisation of big swings in key variables away from trend. All this chest-thumping about Texas' performance over the past decade is a total non sequitur so far as monetary policy is concerned, which wouldn't be a big deal except that Mr Fisher is speaking as a representative of the country's monetary policymaking body.

Right now, the Fed is interested in the extent of the economic slack in the country, and whether or not Texas topped the league tables in the production of rainbows over the past ten years it has an unemployment rate that's 8.3% and rising and half a million more unemployed people than it did before the downturn. The state's economy will also need to overcome efforts to close a $27 billion state budget gap over the next two years. The necessary cuts will be contractionary and disinflationary.

I don't want to knock Texas, which is full of wonderful people and which has gotten some important things right over the past decade. Neither do I wish to denigrate those who feel that leaders in Washington are out of touch with their views. What I find problematic is the behaviour of public officials in critical roles who seem unwilling to subject their views to rigorous scrutiny, in order to see whether there's substance beyond the jokes. Because unemployment, in Texas or anywhere else, is not funny.

IN 2007 and 2008, before the world was swept by financial panic, the biggest global economic threat appeared to be a sharp and sustained rise in commodity prices. Soaring oil costs rattled rich world consumers while a spike in food prices battered the world's poor. Prices tumbled during the crisis but have crept up again in recovery. A new crisis may loom. Overheating emerging markets are boosting global demand at a time when supply is tight. Extreme weather events have led to poor harvests around the world. Some credit rising prices with a wave of political unrest, which has itself placed upward pressure on commodities, especially oil.

This week, The Economist argues that some inflation concerns are overblown. Accelerating inflation is unlikely in weak developed economies, and emerging markets have plenty of tools available to fight rising prices. But the frequency with which commodity price spikes now seem to occur is worrying. And so this week, we asked members of the Economics by invitation network to discuss commodity inflation and talk about how central banks should respond.

Their responses indicate that there are no easy choices. Eswar Prasad writes that in the short term central banks should ignore volatile food price moves and in the long term structural supply increases are necessary, but:

This clear-cut answer is clearly not politically tenable in emerging market economies. Moreover, it turns out that the traditional analytical answer is overturned when one accounts for key features of emerging markets. A substantial fraction of households in emerging markets do not have access to formal finance, and they spend a major share of their household expenditures on food (and fuel). Hence, changes in food and fuel prices have substantial effects on the consumption decisions of these households. Since expenditure on food in total household expenditure is high, and demand for food is relatively inelastic, households in these economies factor in food price inflation while bargaining over wages. Through this channel, food price inflation may feed into inflation expectations. Thus, in emerging markets even inflation expectation-targeting central banks have to be concerned about food price inflation. As my recent research with Rahul Anand shows, central banks can stabilise the business cycle and improve average levels of economic welfare by targeting headline CPI inflation rather than core CPI inflation...

Jahangir Aziz agrees:

It is nearly impossible, especially in emerging markets, to ascertain when food inflation has crept into inflationary expectations and into generalised inflation before it is too late. Unless one is certain that the supply shock is truly temporary, it is better to be preemptive with policy tightening. True, this won’t relieve food inflation, but unfortunately curbing demand for other goods that are interest sensitive is the only real option. To safeguard medium-term growth, inflationary expectations need to be kept under control, and that means sacrificing near-term growth. The only choice is whether to sacrifice a little now or a lot later.

Meanwhile, Richard Koo suggests that authorities should keep an eye on financial impacts on prices, and John Makin says it's difficult to imagine that inflation is less destabilising than currency appreciation (in countries where appreciations are being delayed).

As always, I encourage you to read the responses in full. There are obviously some idiosyncratic factors supporting current price increases, but the broader trends are clear. Emerging market growth is likely to continue putting pressure on commodity supplies, and those supplies will increasingly be subject to disruption thanks to extreme weather events (and, relatedly, to political unrest and policy reactions). Central banks must begin thinking about how to negotiate these crises in a manner than minimises economic and human costs.

TODAY'S recommended economics writing:

• Which parts of stimulus worked best? (Real Time Economics)

• Pension funds: Catching up (Daily data point)

• Two competing views on America's economic future (Econbrowser)

• Made in the USA (Boston Globe)

REAL TIME ECONOMICS, the Wall Street Journal's economics blog, has a post up this morning that many monetary policy watchers will find amusing. "Fed Forecasts Pretty Accurate for 2010" reads the headline of the post, which goes on to note that the Fed's forecasts for economic variables in 2010 were pretty accurate. Of course, this is a bit like saying that the driver of an automobile is pretty good at telling passengers where the car is going. Expectations for central banks seem to have fallen a bit since Paul Krugman wrote that:

...if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.

The Fed should be pretty good at forecasting economic activity since the Fed has a great deal of control over it. And indeed, we were able to watch this control in action in 2010. For months leading up to April of last year, the Fed projected an unemployment rate in 2011 of between 8.2% and 8.6% (or so). Over the summer, projections for this rate seemed to increase, and by the November FOMC meeting, the Fed was projecting an unemployment rate in 2011 of about 9%. At the same meeting, the Fed announced its intention to begin a new round of quantitative easing. When the economy slows below the path it finds acceptable, it steps on the gas.

The Fed doesn't always do such a good job at meeting its forecasts, of course. In June of 2008, Fed economists were forecasting a 2009 employment rate between 5.3% and 5.8%; in fact, the unemployment rate was above 9% for most of the year. Most people, and perhaps most economists, would not call this divergence between predicted and actual unemployment a Fed failure, given the massive financial crisis that occured in September and October of 2008. Real interest rate behaviour suggests the Fed deserves at least some blame for the miss.

But to move toward the point, the latest employment report has some economists wondering whether the Fed will keep to its planned QE2 purchases. The message of that report was far from clear, but the changes in the household survey, including the near 600,000 job rise in employment and the drop in the unemployment rate to 9.0%, seem meaningful. This has Macroeconomic Advisers increasing its inflation forecasts and reiterating its warning that Fed tightening may come sooner rather than later. And Tim Duy has the Fed shifting its bias from more easing to tightening. Are they right?

I wish they weren't, but I suspect that they are. If we go back to January of last year, when economic figures were improving, and the Fed was mostly talking about its exit strategy preparations, we see a Fed forecast for 2011 unemployment of between 8.2% and 8.5%—almost identical to the forecast in November of 2009. I think we have to conclude that the Fed was basically happy with the trajectory of falling unemployment that it saw at that time. I think it was wrong of the Fed to be happy with this level of unemployment, but that's beside the point.

It's my feeling that the Fed will quickly grow concerned about inflation if the unemployment rate drops to 8.5% during the first half of the year. Ben Bernanke isn't going to draw any conclusions about policy from the mixed January report, but I agree with Mr Duy that his biases may have shifted, and February and March data will quickly indicate whether the January trend is real. Again, I think the Fed should still be biased toward expansion, and that it should tolerate a period of catch-up inflation, but that's beside the point.

There's one other point on this issue worth mentioning. A year ago, the Fed was forecasting long-run unemployment of 5.0-5.2%. In June of last year, it was forecasting long-run unemployment of 5.0-5.3%. In November, however, the forecast changed to 5.0-6.0%. This tells me that within the Fed there is some growing concern that the natural rate of unemployment has risen—that structural factors have raised the level to which the Fed can lower unemployment without generating an accelerating rate of inflation. And this is potentially important. The combination of a faster than foreseen drop in unemployment and a rise in the estimate of NAIRU represents—to Fed officials—that labour market slack is shrinking fast.

It's a little hard to square this with inflation data, or payroll employment figures, or jobless claims, or anecdotal evidence from labour markets. On the other hand, other economic variables are showing fast and accelerating growth. It's a little hard to believe given where the conversation was a few months ago, but if February jobs data come in strong, there could be a big change in message at the March FOMC meeting.

TODAY'S recommended economics writing:

• Soaring food prices (Paul Krugman)

• Failure to pay US soldiers is not default (Modeled Behavior)

• How much is a planet worth? (Marginal Revolution)

• Why did economists not spot the crisis? (Ragu Rajan)

• The inequality wildcard (Project Syndicate)

DESPITE the good efforts of my colleague, there’s still a lot of misinterpretation of the drop in the unemployment rate from 9.4% in December to 9.0% in January. Some on Wall Street say it’s a bad sign, attributing it to a decline in the labour force as people gave up looking for work. But that decline in the labour force is a statistical illusion. When you remove that illusion, the entire drop in the unemployment rate can be attributed to the unemployed finding jobs.

I’ll dig a bit more deeply into the disparity. The low payroll employment number seems to be due to bad weather. Normally you can look to the separate tally of employment from the survey of households for a different perspective but that figure was distorted by the estimation procedure that always happens between December and January.

Each month the Census Bureau on behalf of the Bureau of Labour Statistics surveys 60,000 households, then extrapolates the results to the entire American population. The resulting estimates of the labour force and employment thus depend heavily on what Census thinks the entire population is. Each January, it revises that estimate and it now thinks the population is 347,000 smaller than it previously estimated, primarily due to the presence of fewer Hispanics than expected. Perhaps the tougher economy has cut down on immigration while increased enforcement has reduced the inflow of illegal immigrants.

The BLS helpfully provides “smoothed” data that adjusts for the change in the estimation procedure. By this tally, employment jumped 589,000 between December and January, not by the meagre 117,000 using the unadjusted numbers. The labour force grew by 2,000 instead of shrinking by 504,000. So the unemployment rate fell because more of the unemployed became employed.

Here’s a summary of the data:

There still remains, however, the puzzling disparity between the household employment number and the payroll number. Household employment is defined slightly differently from payroll employment; it includes farm workers and the self-employed, for example. On an apples-to-apples basis, household employment, defined to be similar to payroll, rose a robust 540,000, compared to the mere 32,000 recorded in the payroll survey.

I have two possible explanations: some people who answered the household survey thought they were still working even though they stayed home because of weather. The second is that this is the usual statistical noise you get from trying to measure a huge number like the number of employed Americans through two different methods. The payroll number is usually the more reliable, so go with that. But the drop in the unemployment rate looks to be for real—although why the labour force has grown so slowly given that a recovering economy would normally suck more people in to work remains a mystery.

LOOK almost anywhere in the recent economic data and the signs point to an accelerating recovery. A solid fourth quarter GDP report contained a truly blockbuster increase in real final sales. Manufacturing activity is soaring. Consumer spending is up and the trade deficit is down. Markets are trading at their highest level in over two years. And so economists anxiously awaited the first employment figures for 2011, hoping that in January firms would finally react to better conditions by taking on lots of new help.

Instead, the Bureau of Labour Statistics has dropped a puzzler of an employment report in our laps—one which points in many directions but not, decidedly, toward strong job growth. In the month of January, total nonfarm employment grew by a very disappointing 39,000 jobs. This was not at all what forecasters were expecting. Earlier this week, an ADP report indicated that private sector employment rose by 187,000 in January; the BLS pegged the figure at just 50,000. There were some compensating shifts. December's employment gain was revised upward from 103,000 to 121,000. November's employment rise, which was originally reported at 39,000, has been revised to a total gain of 93,000.

But there is bad news, as well. The BLS included its annual revision of the previous year's data in this report, and while job growth over the year looks stronger than before, the level of employment looks worse. In March of last year, 411,000 fewer Americans were working than originally reported. And thanks to a weaker employment performance in April through October, 483,000 fewer Americans were on the job in December than was originally believed to be the case. For now, the economy remains 7.7m jobs short of its previous employment peak.

The labour market picture becomes foggier still when one turns to the household survey data. America's unemployment rate fell 0.4 percentage points in January for a second consecutive month, dropping the rate to 9.0%. Why? According to the household data, employment grew by 117,000 over the month while the number of unemployed Americans fell by 622,000. A word of caution is in order: new population estimates are used each year to compute the household figures, which means that the January household survey numbers are not directly comparable to the December figures. It would seem from this report that the decline in the unemployment rate is mostly driven by departures from the labour force (which fell substantially), but the employment-population ratio actually rose for the month, thanks to a reported decline in the population of working adults. But according to the BLS, practically the entire drop in the labour force total is due to the population adjustment. If one were going to compare December numbers to January numbers by stripping out the annual adjustment (and this is a dicey proposition) the household survey would show a slight rise in the labour force and a substantial gain in employment (of 589,000) nearly equal to the drop in unemployment (of 590,000).

But the sample size of the household survey is quite small, which means that it would be unwise to read too much into any one aspect of the report. Meanwhile, economists are pointing to the annual adjustments and to bad weather as major factors clouding the picture. But we can say a few things with some certainty. The 39,000 payroll increase will almost certainly be revised upward in coming months. Apart from construction, private sector employment continues to grow, and in manufacturing it is growing strongly. But for another month, the economy has not added the number of jobs we would expect to correspond to the level of observed economic activity. And far too much of the drop in unemployment appears to be due to the exit from the labour force of long-term unemployed workers and early retirees.

So for another month, Americans will wait, frustrated and uncertain, to see when growth will once again mean new employment opportunities.

FEDERAL RESERVE Chairman Ben Bernanke (most influential economist of the past decade?) gave a speech today discussing the economic outlook and the Fed's role in supporting economic activity. The Federal Open Market Committee's policy stance, he argued, is having a positive effect on current economic conditions:

A wide range of market indicators supports the view that the Federal Reserve's securities purchases have been effective at easing financial conditions. For example, since August, when we announced our policy of reinvesting maturing securities and signaled we were considering more purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen from low to more normal levels. Yields on 5- to 10-year Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases.

All of these developments are what one would expect to see when monetary policy becomes more accommodative, whether through conventional or less conventional means. Interestingly, these developments are also remarkably similar to those that occurred during the earlier episode of policy easing, notably in the months following our March 2009 announcement of a significant expansion in securities purchases. The fact that financial markets responded in very similar ways to each of these policy actions lends credence to the view that these actions had the expected effects on markets and are thereby providing significant support to job creation and the economy.

Right? Monetary easing is raising growth expectations which is raising real yields. Monetary easing is raising growth expectations, which is raising equity prices. And monetary easing is raising growth expectations, which will reduce unemployment:

An analysis shows that the Federal Reserve's large-scale asset purchases have been effective at reducing the economic costs of the zero lower bound on interest rates. Model simulations indicate that, by 2012, the past and projected expansion of the Fed's securities holdings since late 2008 will lower the unemployment rate by 1½ percentage points relative to what it would have been absent the purchases. The asset purchases also have probably prevented the U.S. economy from falling into deflation.

But Mark Thoma worries:

That gets us down to 8% in 2012. We can argue about what "working" means, but if it means reducing unemployment to acceptable levels, to repeat a point I've made again and again, this alone is not nearly enough.

Hm. Mr Thoma seems to be suggesting that absent QE2, the unemployment rate in 2012 would be 9.5%, which is unlikely. The Fed's forecast range for the unemployment rate in 2012 is 7.7% to 8.2%, and the Congressional Budget Office forecasts an unemployment rate of 8.4% (this forecast dates to after the announcement of QE2, but isn't meaningfully different from its forecasts from the summer of 2010). This would suggest that with QE2 in place, American unemployment is likely to be between 6% and 7% in 2012. That's not full employment, but it's pretty close. You can argue that more needs to be done (indeed, I think the Fed itself could do more). But it is worth noting that the Fed has put the American economy on a substantially better recovery path than it faced before (Scott Sumner would say it has returned the economy to the path off which it previously led it).

A big risk is that the Fed will back away from its policy too quickly, thinking all is going well and worrying premptively about inflation. As Karl Smith says, today's speech is somewhat reassuring on that front. On the other hand, you have non-economists like Dick Fisher who've managed to get themselves on the country's monetary policy-making body saying that—despite 9.4% unemployment and continued decline in the Fed's preferred inflation gauge—"given the way the economy is going now, and this is me speaking just for myself, I would not be supportive of any further quantitative easing". My sense is that neither Mr Fisher's view nor vote will matter much if Mr Bernanke is convinced that more is necessary. Still, this reflects a substantial threat that faces much of the rich world: that governments will worry too much about deficits or inflation while their economies remain weak.

Raphael A. Auer is the deputy head of the International Trade and Capital Flows Unit at the Swiss National Bank and a research associate at the Lichtenstein Institute of Princeton University.

AT FIRST thought, the recent rise of inflation in China seems to be reassuring news for American policymakers concerned with the trade deficit: price increases in China make US firms more competitive and high inflation may also induce China to let the yuan appreciate at an accelerated pace to lower the cost of imported goods. Considerations along these lines have lead treasury secretary Timothy Geithner to note that current economic developments “will bring about the necessary adjustment in exchange rates” without any need for further intervention by policymakers.

What has not entered this policy discussion, however, is that the trade deficit with China arose for a reason, namely that Chinese goods are dirt cheap. In fact, the increasing importance of cheap imports was a major contributing factor to the low-inflation environment of the last decade (this recent post on Free Exchange frames the magnitude nicely).

If the American trade deficit is reduced via either Chinese inflation or a nominal appreciation of the yuan, the disinflationary effect of cheap Chinese imports will be reversed. Given that nearly a sixth of all US consumption of manufactured goods is actually made in China, any real appreciation would have a substantial direct impact on inflation due to the weight of Chinese goods in America's inflation indexes. In a recent study*, I document that such an appreciation might also substantially alter the competitive environment on many US markets and consequently lead to widespread inflationary dynamics.

The study examines the 2005 to 2008 period when the Chinese government let the yuan appreciate by a combined 17% vis-à-vis the dollar. Matching this appreciation with sectoral US price data, it documents how a higher yuan translates into higher import prices and, in turn, how this affects the prices that domestic firms charge. Overall, the results suggest that in the covered sectors, a 1% appreciation of the yuan causes American producer prices to increase by a little over half a percentage point.

The figure above uses these findings to simulate the effect of a yuan appreciation on producer price inflation. In both scenarios the yuan appreciates by 25%, with the appreciation being spread over either 10 or 25 months. For example, these simulations suggests that a 25% appreciation spread over 10 months is equivalent to a temporary 5 percentage points (!) shock on American producer prices.

Inflation in China will have enormous consequences for the course of US inflation. The key question is, of course, what can one do about it? Many argue not much: a real appreciation in China will sooner or later feed into American inflation, in one of two ways. First, it can be achieved via a controlled nominal appreciation of the yuan. Second, in the absence of such an appreciation it will come via inflation in China, since—as Paul Krugman bluntly puts it—inflation is merely “the market’s way of undoing currency manipulation”.

However, this does not imply that there are no policy options. While the spillover of Chinese inflation into US prices is unavoidable, its timing can be controlled via the timing of the yuan appreciation. American Inflation is still low at the current juncture; the core CPI gained a muted 0.8% during 2010 and the ample excess capacity (recently estimated to equal 4-5% of GDP by Morgan Stanley) suggests that there is no imminent danger of high inflation during 2011.

The inflationary outlook might be very different a year or two down the road. Energy commodities rose by 7.5% in December 2010 alone and across the globe, investors are preparing for a long-lasting commodity rally. These commodity price hikes are likely to affect producer prices and consumer inflation within a couple of years. Although a full fledged recovery of the housing market is not foreseeable, it is still highly likely that prices for shelter will increase at a much higher rate in 2013 than the 0.4% increase observed during 2010. What if we add to this upside inflation risk a marked real appreciation of the yuan, for example taking place during mid 2012?

Given that inflation is still low, but surely on the rise, isn’t now the optimal time for the yuan to appreciate? A swift appreciation of China's currency on the order of magnitude of 5-10% followed by a return to the current slow appreciation policy might just be what is needed to contain inflation on both sides of the Pacific Rim: such a policy would increase short-term inflationary pressure in the US, but not beyond acceptable levels. Since this policy would ease inflationary pressure at home, without disrupting the Chinese export sector, the Chinese government, as well, should be more willing than ever to support such a revaluation.

* Raphael A. Auer, “Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/08 Revaluation of the Renminbi”, Working Paper No. 68, Globalization of Monetary Policy Institute, Federal Reserve Bank of Dallas, January 2011.

ECONOMISTS have been reading Detroit its last rites for years now. In 2007, economists Ed Glaeser and Giacomo Ponzetto explained how changes in technology destroyed the city's business model, based on the returns to industrial agglomeration. In remarks made while in Stockholm accepting his Nobel prize for work on (among other things) economic geography, Paul Krugman declared that the carmaker bail-out was at best a temporary salve, and that Detroit's car industry was doomed.

Ah, but weren't they mistaken! Carmaker output was up over 6% last year, as vehicle sales rose over 13%. In January, vehicle sales returned to pre-Lehman crash levels, and GM sales were up an astounding 22% year-on-year. In Detroit, manufacturing employment has stabilised, and nearly 10,000 manufacturing jobs have been added since the sector hit bottom in mid-2009. And get a load of this:

The 10 largest over-the-year jobless rate decreases in December were reported in Michigan areas: Muskegon-Norton Shores (-4.8 percentage points), Monroe (-4.4 points), Jackson (-4.3 points), Flint (-4.2 points), Holland-Grand Haven (-3.9 points), Detroit-Warren-Livonia (-3.8 points), Saginaw-Saginaw Township North (-3.5 points), and Grand Rapids-Wyoming, Lansing-East Lansing, and Niles-Benton Harbor (-3.4 points each).

How wrong could the economists be? There's just one, little problem. Here's total employment for the Detroit metro area over the past decade:

The long decline continues. Well, then why has Detroit's unemployment rate fallen so much? Part of the reason is that the household survey, used to compute the unemployment rate, shows a better employment performance for Detroit over the past year. But the other part of the story is a steady, dramatic decline in the labour force. Since 2007, about 100,000 workers have left the Detroit labour force. And despite the real improvement in the economic outlook over the past few months, the bleeding goes on.

What points should we take away from this performance? Well, it may or may not have been a good idea to step in and rescue the carmakers, but the critics who pointed out that it would not save Detroit were right. This should have been obvious at the time, given that it was widely agreed that putting carmakers on a firmer footing would involve drastic cuts to their labour forces and rationalisation of production facilities.

A second point follows from this: however strongly America's manufacturing sector rebounds from the crisis and benefits from global rebalancing, it's unreasonable to think that rising manufacturing employment can do much to absorb labour market slack. Manufacturing has only grown less labour-intensive over time, and the truly labour-intensive industrial jobs will seek out markets abroad where labour costs are far cheaper than in America. Just as economists pointed out before and during the crisis.

It would be too early to write off the Detroit area entirely. As you can see, nearly 1.7m people continue to work in the area. But if Detroit is to thrive again, it will have to discover new and growing industries that depend for their success on the kinds of benefits firms now derive from urban proximity.

SURELY, we'll all remember when we first heard this news:

In a country with more sheep than people, a group of New Zealand farmers plan to create a cartel to reverse falling profits and boost prices for wool used to make yarn for carpets.

The Wool Partners Co-Operative is offering farmers shares in return for their “strong wool” fleeces in an effort to corner 16% of global supply and wield power to control prices. The group hopes to replicate the success of Fonterra Co-Operative Group Ltd. a milk cartel created a decade ago in New Zealand that has grown into the world’s biggest processor of dairy products.

I'm not quite sure how this is supposed to work, however:

Shadbolt hopes the cartel will help hard pressed farmers cope with the decline in the global wool trade as the development of cheaper synthetic materials has challenged wool as the main source of yarn for rugs globally.

Given the availability of cheap alternatives, is a cartel designed to boost wool prices really the best idea?