The great wall of unemployed


Joblessness in China is rising, prompting fears of social unrest. But how high is the true unemployment rate?

THE employment outlook is “grim” according to Yin Weimin, China’s minister of human resources and social security. So grim, in fact, that on November 26th the People’s Bank of China slashed rates by more than a percentage point—the most in 11 years—to boost growth. The slowing economy has led factories to cut jobs, and there are mounting fears that the swelling ranks of the unemployed might one day take to the streets and disrupt China’s economic miracle. To assess such risks one must consider how high unemployment might rise.

The snag is that both the level and trend of China’s official jobless figures are meaningless. Until the 1990s, the government more or less guaranteed full employment by providing every worker with an “iron rice bowl”—a job for life. But when soaring losses at state-owned firms forced the government to lay off about one-third of all state employees between 1996 and 2002, the official unemployment rate rose only slightly. Today it is 4% in urban areas, up from 3% in the mid-1990s.

But the official rate excludes workers laid off by state-owned firms. Thus at the start of this decade, when lay-offs peaked, it hugely understated true unemployment. Over time, as laid-off workers have found jobs or left the labour force, the distortion will have shrunk. Another flaw is that the official unemployment statistics cover only people who are registered as urban dwellers. An estimated 130m migrant workers have moved from the country to the cities, but there is no formal record that they live there, so they are ignored by the statisticians. After adjusting the official figures for these two factors, several studies earlier this decade concluded that the true unemployment rate was above 10%—and might be even as high as 20%.

If unemployment is already so high, it would not take much of an economic slowdown to push it to crisis levels. However, a more recent study suggests that the jobless rate has fallen a lot since the start of this decade. Albert Park, of the University of Oxford, and Cai Fang and Du Yang, of the Chinese Academy of Social Sciences, have analysed China’s 2000 census and 2005 mini-census (covering 1% of the population), which include migrant workers. The raw census data suggest that the total urban jobless rate fell from 8.1% in 2000 to 5.2% in 2005. But when the jobless figures are adjusted to an internationally comparable definition, the rate in 2005 was less than 4%.

As a crosscheck, the economists also used the 2005 Urban Labour Survey of five big cities. This confirmed that the urban unemployment rate, including migrant workers, had indeed fallen—from 7.3% in 2002 to 4.4% in 2005 (see chart). But the rate for migrant workers is lower than for permanent residents because they return home if they cannot find work. As the chart also shows, excluding migrants, the urban unemployment rate fell from 11.1% to 6.7%. And since 2005, unemployment has undoubtedly fallen further. Earlier this year, factory bosses complained that they could not find enough workers; and faster real-wage growth also suggested that demand for labour was outpacing supply. Thus before China’s economy started to sputter this summer, its jobless rate was probably only 3-4%. One important qualification to these numbers is that China’s labour-force participation rate—ie, those in work or seeking it—fell to 65% in 2005 from 69% in 2000. If discouraged workers have left the labour force because they could not find a job, then the unemployment rate may understate the hardship they face.

But the finding that unemployment has fallen sharply in China over the past five years makes sense. The right-hand chart, from the World Bank’s latest China Quarterly Update, shows GDP growth relative to its estimated potential growth rate if the economy operated at full capacity. From 2003 to 2007, actual growth ran ahead of potential, so unemployment should indeed have dropped. However, the bank expects China’s growth to fall below trend in 2008 and 2009, implying that unemployment will climb. The bank forecasts growth of only 7.5% next year, its slowest for almost 20 years and well below its estimated potential growth rate of around 9.5%. Jobs are already disappearing—especially in southern China, where thousands of small exporting firms have closed this year.

Chinese commentators are currently fixated upon whether the economy can continue to grow by at least 8% a year. That was the old rule of thumb for the growth needed to absorb new entrants into the labour market. But that 8% figure has little scientific basis. Over the past decade, the trend growth rate has increased as a result of heavy investment and faster improvements in productivity. Maybe that is why the World Bank reckons that China’s potential growth rate (ie, the rate needed to keep unemployment steady) is now about 9.5%.

For employment, the type of growth matters as much as its pace. China is creating fewer new jobs than it used to. In the 1980s, each 1% increase in GDP led to a 0.3% rise in employment. Over the past decade, 1% GDP growth has yielded, on average, only a 0.1% gain in jobs. Growth has become less job-intensive, so the economy needs to grow faster to hold down unemployment.

One reason for this is that the government has favoured capital-intensive industries, such as steel and machinery, rather than services which create more jobs. Louis Kuijs, the main author of the World Bank’s report, argues that China needs to shift the mix of its growth from industry, investment and exports to services and consumption. To adjust the structure of production requires a further strengthening of the yuan, raising the price of energy, scrapping distortions in the tax system which favour manufacturing, and removing various shackles on the services sector.

More labour-intensive growth would also boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus. But most important, by allowing more workers to enjoy the rewards of rapid growth, it could help to prevent future social unrest.

Clearly, however, central bankers and we economists were unprepared for the magnitude of the present financial crisis, and even less for its large effects on the real economy through the drying up of credit for mortgages and business investments. This recession is still ongoing, but it appears as if it will be the most severe recession since 1982, when American unemployment peaked in some months at about 10.5 percent. One year into the recession according to the NBER dating, unemployment has reached 6.7 percent, and it is still rising at a fast pace.

Central banks, especially the Fed, did respond rather rapidly to the unfolding of the financial crisis, even before it had a large impact on the economy. The Fed employed all the weapons in its traditional arsenal, such as lowering interest rates and easing access to the discount window. It also innovated beyond traditional approaches by allowing investment banks access to its credit, and by helping to arrange for the takeover or elimination of weak investment banks, such as Bears Stern and Lehman brothers.

In contrast to the Fed, the US Treasury took a series of actions with dubious merit, including bailouts and a fiscal stimulus, that had few consistent principles. The latest as reported in the NY Times and Wall Street Journal is to use Fannie Mae and Freddie Mac to encourage banks to drop mortgages to 4.5 percent in order to raise housing prices and encourage home building. Yet Freddie and Fannie and their government guarantees contributed to the housing mess by encouraging excessive building of residential dwellings. Any effect of this proposed price ceiling on housing prices on mortgage rates would be small, but the damage to adjustments in the housing market would be major. The goal of policy should be to reduce, not increase, the power and distortions caused by these two institutions.

In any case, the Fed and Treasury's actions combined obviously were not sufficient to greatly contain the damage to the real sector. The retreat from risk has been so large that treasury bills and bonds are selling at very low interest rates, other measures of risk are way up, and lenders are reluctant to lend, even when expected rates of return on their investments are high. Not surprisingly, the confidence of central bankers and economists that we have learned how to moderate greatly the real business cycle has been shattered. It is revealing how many leading macroeconomists have been silent during the unfolding of this crisis. Perhaps the prudent approach is to go back to the drawing board before offering an interpretation of what happened, and how to combat it.

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Harvard University's endowment suffered investment losses of at least 22% in the first four months of the school's fiscal year, the latest evidence of the financial woes facing higher education.

The Harvard endowment, the biggest of any university, stood at $36.9 billion as of June 30, meaning the loss amounts to about $8 billion. That's more than the entire endowments of all but six colleges, according to the latest official tally.

Harvard said the actual loss could be even higher, once it factors in declines in hard-to-value assets such as real estate and private equity — investments that have become increasingly popular among colleges. The university is planning for a 30% decline for the fiscal year ending in June 2009.

Other university endowments also are suffering, and many states are cutting public funding of higher education. Colleges are instituting hiring freezes, planning enrollment cuts and discussing steep tuition increases, intensifying worries about the impact of the recession and financial crisis on college access.

The federal government already has taken emergency steps to boost lending to students, and several well-off colleges have said they will maintain or boost financial aid to help families hurt by job losses, investments setbacks and borrowing problems. But not all colleges have the financial heft to withstand the many forces bearing down on them.

Joni Finney, a professor at the University of Pennsylvania who studies college economics, says she worries that public universities and less-wealthy, smaller private colleges may not be able to keep their doors open to all students. "If you go down the food chain of higher education, it's harder and harder to deal with these kinds of cuts," she says.

Private-college budgets are sensitive to investment declines because they typically tap their endowments each year to help cover operating expenses.

The University of Virginia Investment Management Co. said it lost nearly $1 billion, or 18%, of its endowment over the four-month period, reducing it to $4.2 billion. In Vermont, Middlebury College says its endowment fell 14.4%, to $724 million. In Iowa, Grinnell College's endowment dropped 25%, to $1.2 billion. In Massachusetts, Amherst College says its endowment, $1.7 billion as of June 30, also fell by 25%.

In a letter to Harvard's deans, university President Drew Gilpin Faust and another official blamed "severe turmoil in the world's financial markets" for the endowment loss. She said it would lead to budget cuts, and that the school would sell bonds to increase its financial flexibility.

The Harvard letter said the 22% loss, from July 1 through Oct. 31, understates the actual decline because it doesn't reflect assets such as real estate whose values couldn't yet be estimated. Currently, endowment income funds 35% of Harvard's $3.5 billion budget.

The 30% fiscal-year loss Harvard is planning for would eclipse the loss of 12.2% in 1974, its worst over the last 40 years.

Harvard's loss marks a sharp reversal from the endowment's formerly chart-topping performance. Harvard and Yale University — which hasn't disclosed its endowment's recent performance — pioneered an investment approach that de-emphasized U.S. stocks and bonds and placed large sums in more exotic and illiquid investments, including timberland, real estate and private-equity funds. That strategy, which was widely copied, helped the schools avoid significant losses after the technology boom ended in 2000.

But the current market has been far less favorable, partly because both Harvard and Yale have relatively small holdings of bonds, such as U.S. Treasurys, one of the few assets that have performed well. Harvard began its fiscal year with a target of having 33% invested in publicly traded shares, split among U.S. stocks, which have dropped 24% in the four months through October, and international stocks, which have fared worse.

Other investments, such as commodities, which were a boon to Harvard in past years, have turned negative in recent weeks. Harvard has sought to sell off about $1.5 billion in investments with private-equity firms, which typically use their assets to fund corporate takeovers, according to people familiar with the situation. That would be one of the largest sales ever of a private-equity stake. But its private-equity partnerships received bids of only around 50 cents on the dollar, say other people familiar with the matter.

Daniel Jick, chief executive officer at Boston-based HighVista Strategies, which handles money for some endowments, says that in some prior years, investments such as real estate and private equity have helped buffer endowments against losses on stocks.

In her letter, Harvard's Dr. Faust said the endowment loss has "major implications for our budgets and planning, especially since our other principal revenue streams also stand to be challenged by the economic crisis." Along with federal research funding, universities rely heavily on tuition and donations. Strained family finances could make it difficult for more families to afford tuition, while stock-market declines typically curb gifts.

To maintain its programs and commitments, the letter said, Harvard is expecting to spend a higher percentage of its endowment than it had recently. It said it was taking a "hard look at hiring, staffing levels and compensation," and was "reconsidering the scale and pace of planned capital projects."

This year will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered.

Practically every day the government launches a massively expensive new initiative to solve the problems that the last day's initiative did not. It is hard to discern any principles behind these actions. The lack of a coherent strategy has increased uncertainty and undermined the public's perception of the government's competence and trustworthiness.

The Obama administration, with its highly able team of economists, has a golden opportunity to put the country on a better path. We believe that the way forward is for the government to adopt two key principles. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers.

How do these principles apply to the present crisis? First, the market economy provides mechanisms for dealing with difficult times. Take bankruptcy. It is often viewed as a kind of death, but this is misleading. Bankruptcy is an opportunity for a company (or individual) to make a fresh start. A company in financial distress faces the danger that creditors will try to seize its assets. Bankruptcy gives it some respite. It also provides an opportunity for claimants to figure out whether the company's financial trouble was the result of bad luck or bad management, and to decide what should be done. Short-cutting this process through a government bailout is dangerous. Does the government really know whether a company should be saved?

As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well.

From this perspective, one must ask what would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy? One argument often made is that these institutions had huge numbers of complicated claims, and that the bankruptcy of any one of them would have led to contagion and systemic failure, causing scores of further bankruptcies. AIG had to be saved, the argument goes, because it had trillions of dollars of credit default swaps with J.P. Morgan. These credit default swaps acted as hedges for trillions of dollars of credit default swaps that J.P. Morgan had with other parties. If AIG had gone bankrupt, J.P. Morgan would have found itself unhedged, putting its stability and that of others at risk.

This argument has some validity, but it suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG's viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard. AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior.

Similar principles apply to the housing market. It appears that many people thought that house prices would never fall nationally, and made financial decisions based on this premise. The adjustment to the new reality is painful. But past mistakes do not constitute a market failure. Thus it makes no sense for the government to support house prices, as some economists have suggested.

Where there is arguably a market failure is in mortgage renegotiations. Many mortgages are securitized, and the lenders are dispersed and cannot easily alter the terms of the mortgage. It is unlikely that the present situation was anticipated when the loan contracts were written. Government initiatives at facilitating renegotiation therefore make a lot of sense.

Our desire for a principled approach to this crisis does not arise from an academic need for intellectual coherence. Without principles, policy makers inevitably make mistakes and succumb to lobbying pressure. This is what happened with the Bush administration. The Obama administration can do better.

Mr. Hart is a professor of economics at Harvard. Mr. Zingales is a professor of finance at the Chicago Booth School of Business.