The Economics of Unemployment

When the Great Recession ended it took a relatively long time for the Unemployment Rate to fall. One important issue was that 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 was 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 we have a low unemployment rate (under 5%) but the unemployment rate is simply not the best metric for the health of the jobs market. We have lost too many relatively high-paying manufacturing jobs and replaced them with low-paying waitresses and bartenders. An alternative may be the Labor Market Conditions Index which is produced by the Fed and takes into account: 19 labor market indicators: unemployment rate, labor force participation rate, part time for economic reasons, private payroll employment, government payroll employment, temporary help employment, average weekly hours (production), average weekly hours of persons at work, average hourly earnings (production), composite help-wanted index (Conference Board), hiring rate, transition rate from unemployment to employment, insured unemployment rate, job losers unemployed less than five weeks, quit rate, job leavers unemployed less than 5 weeks, jobs plentiful vs. hard to get (Conference Board), hiring plans (NFIB) and jobs hard to fill (NFIB).

This issue is by no means simply academic. The Fed justified its December rate hike and may justify further rate hikes by pointing to the low unemployment rate. It that is not the best metric of the state of the labor market they should broaden their horizon.