The Economics of Unemployment

A lot has been said and will likely continue to be said about the fact that as the recession ended unemployment has remained high. As employment starts to pick up it would serve well to try to understand the economics of unemployment.

In 2009 we had a stimulus bill – The American Recovery and Reinvestment Act – which was intended to increase GDP and lower unemployment. The results were mixed at best. The only certainty is the increase in the national debt. At the end of 2010 we had an extension of the “Bush era tax cuts” which was touted as more stimulus.

Why is there so much unemployment at present?

In general this is due to the recession which resulted from the liquidity crisis of 2007. As GDP fell companies needed fewer workers because there was less demand. Current workers were laid off and new workers were not hired. Okun’s Law states that for every 2% drop in GDP, unemployment increases by 1%. This (like just about everything in economics) is not really a law but a rough approximation or rule of thumb. Keynesians see increased government spending as a solution. The notion is that if the government makes up the output gap by spending then the rest of the economy will start growing and the seeds planted by deficit spending will grow into mighty oaks which will mean increased GDP, spending, jobs and tax revenue. Of course this is not what happened.

Unlike the bursting of the dot-com bubble the housing bubble was a borrowed money bubble. It destroyed the wealth of individuals and banks.

What really causes unemployment and how is it remedied?

Economists generally break unemployment into three categories: cyclical, structural, and frictional.

Cyclical unemployment is a consequence of business cycles: opportunity knocks, companies create jobs because they believe they can turn opportunity into jobs and profits, and eventually supply exceeds demand. Once there is not enough economic demand to create a job for everyone seeking employment, layoffs occur.

Frictional unemployment or equilibrium unemployment occurs voluntarily when people move from job to job or into and out of the labor force. Some of this is “take this job and shove it” unemployment where folks are seeking a better job. This can also result when people graduate from college and enter the labor market. The fact that they are looking for a job adds them to the employment force. A woman who has a child may take unpaid time off from the labor force. Frictional unemployment arises from the length of time required for the employer and the employee to connect. (This same sort of “search friction” occurs in the housing market.) When there are positive signs for hiring, more people may reenter the work force and actually increase the unemployment rate. The “work force” includes those working and those looking for work.

Structural unemployment is a bit more sinister. This has to do with the changing nature of the labor market and the potential mismatch between those seeking jobs and the skills which go with the available jobs. With the collapse of the housing bubble the demand for jobs associated with home construction fell dramatically. From its peak in August 2006 more than 2 million construction jobs were lost. There are substantial job openings in health care and education but carpenters and plumbers may not be prepared for those jobs. This is structural unemployment.

This can be seen in the monthly Bureau of Labor Statistics report on job openings.

Structural unemployment would also include people left behind because they cannot sell their underwater home and move to a place where there may be job openings for someone with their skills. This is more complicated in the present day when most families have need two paychecks and two job openings in order to relocate even if their home had equity.

Keynesian economics and the suggested deficits which go with it address only cyclical unemployment. Perhaps cyclical unemployment eventually takes care of itself even without added deficits and the only economic advantage is that deficit spending may clear recessions sooner. In reality, Keynesian notions may have stopped working in the early 1970’s. This is a topic which is so polarized politically that a rational discussion is almost impossible.

There are other issues beyond these textbook descriptions regarding unemployment. One is the extension of unemployment benefits (which used to go to 26 weeks) to 99 weeks. The work (on frictional unemployment) of the winners of the 2010 Nobel Prize in Economic Sciences conclude that more generous unemployment benefits give rise to a higher unemployment rate and longer search times. In a job market with substantial structural unemployment the seeming social benefit of extended unemployment insurance may turn into a kiss of death as the gap between the skills of those unemployed and the skills required for job openings widens. This is not about carpenters becoming teachers but about service sector job-seekers keeping up with rapidly changing software systems.

Sticky Wages

There is an important difference between the labor market and other markets. Unlike the prices of commodities, wages tend to be sticky. They do not in any sense quickly adjust downward when there is sharp unemployment. While no one really knows why wages are sticky it seems to be the case that when recessions occur wages do not really fall but simply grow more slowly. Economists may suffer from having too little experience with managing. The best explanation for sticky wages may simply be that if I am an employer with 100 employees and because of reduced demand need to cut my labor costs by 10% I have two simple choices: 1) cut everyone’s pay 10% and keep all 100 employees or 2) lay off 10 employees and keep wages flat for the remaining 90. If I choose #2 the laid off people are gone and not around to complain and those remaining may feel lucky and average morale may be high. If I cut everyone’s wages all I may have is 100 unhappy employees and declining morale and productivity.

What Should the Government Do About Unemployment?

My belief is that there is little positive that the government can do about unemployment. Businesses and workers come together and create jobs. The weight of government regulation is so large that the net effect that the government has on creating jobs is negative. The goal of government should be to minimize the damage that it does to the job market.

At present there is a gigantic mountain of cash in commercial banks and investment banks waiting to be invested or loaned. The unemployment rate will fall only after that gigantic mountain of cash is deployed to start new companies. One of the issues may be that capital deployment has recently tended to look only for “hot” sectors. We had bioscience and then the dot-com boom/bust. There may be an underlying problem with the way we deploy capital but that is a discussion for some other time.