The nature of Unemployment

I want to expand on a point I made in a recent post about the nature of our elevated unemployment today. I asserted that we face elevated unemployment today for cyclical (or demand-based) reasons, rather than structural (supply-based) reasons. This is actually a very important distinction to make, because the policy implications for each cause of unemployment are very different. Luckily, there is a nice story that goes along with each side (structural and cyclical unemployment), which makes telling the difference fairly easy! (fair warning; this is a long piece, but fairly easy to follow and very important in understanding the economic policy over the last 5 years):

Structural Unemployment:

We had a massive housing and financial bubble that burst. During the boom, the economy overinvested in construction and finance-related jobs. Now, our economy has to deal with retraining those individuals, which takes time—the reason that unemployment is elevated, is because old workers from those industries in which there were tons of job losses don’t have the skill-set to find employment yet in growing industries. Here is an interview with Charles Plosser, a Federal Reserve President that believes the structural unemployment story:

This mess was caused by over-investment in housing, and bringing down unemployment will be a gradual process. “You can’t change the carpenter into a nurse easily, and you can’t change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they’ll find jobs in other industries. But monetary policy can’t retrain people.

This opinion of unemployment is common among the punditry and political elite—here’s Bill Clinton with basically the same story:

But there are already more than 3 million jobs open and unfilled in America, mostly because the people who apply for them don’t yet have the required skills to do them.

Cyclical Unemployment:

This view is a bit more nuanced. Basically, there is always some degree of structural unemployment in an economy as large and dynamic as ours. There is constant labor-market churn with firms being created and firms dying—whenever someone loses a job, it always takes a little bit of time to find a new job and it might require some retraining. This is not a new story, and it explains why unemployment remains between 4 and 5.5% when the economy is at “full employment.” [Because any further reduction in the unemployment rate would cause inflation to rise and the economy to overheat.]

However, our unemployment today remains elevated above the levels of unemployment considered to be acceptable for an economy at ‘full employment.’ Believers in the story of cyclical unemployment argue that this elevated unemployment is caused by a lack of aggregate demand—a housing and financial bubble sparked a financial crisis which led to a recession. In the recession, households lowered consumption as they sought to pay off excess debt run-up during the boom (caused by either over-extending themselves or by a tanking housing market leaving the borrower underwater). The Federal Reserve attempted to stimulate spending by lowering real interest rates, but could lower rates no further once the overnight lending rate hit the zero-lower-bound (you can’t charge negative interest rates because banks and people will just hold cash instead). The decline in private consumption lowered demand for consumer products, so businesses lowered investment levels (initially) as well.

Normally in this situation the government would spend more money to offset the decline in private-sector spending, and the currency would depreciate, making American goods relatively more attractive on the world market. However, the GOP has prevented the government from adequately offsetting private-sector spending with more spending (and no, deficits don’t mean we have been spending more, because tax revenue falls in a recession too. The appropriate measure to look at is total government spending.) Additionally, the 2008 global Financial Crisis drove investors to ‘safe-haven’ markets, and, as the world’s reserve currency, that meant demand for US Treasury bills soared (preventing a depreciation of the currency). So, in this story, unemployment remains cyclically elevated today as a result of job losses suffered during the 08 recession, and the labor market hasn’t recovered because the normal mechanisms to revive a labor market (monetary policy, fiscal policy, net exports) have all run into obstacles.

So, both stories sound convincing. How do we prove one vs. the other is correct? Luckily, the analytical framework for each story lends itself to a series of predictions about policy events that have taken place over the last several years.


If there were structural unemployment, we could predict rising unemployment in the fields impacted by the ‘bubble’ (housing, finance, government, etc) and falling unemployment in growing fields (like tech) as those that previously worked in the inflated job sectors retrained and went to work in ‘new economy’ fields. On the contrary, cyclical unemployment would predict rising unemployment across all job sectors as broad-based demand in the economy fell. What actually happened?

From Krugman and Mike Konczal:



The other major implication of structural unemployment is that wages are mismatched—there is a shortage of ‘skilled’ workers possessing the right tools for high-wage jobs (so their wages should be rising) but there is a large set of workers lacking the proper skill-set for today’s economy (the unemployed) who are demanding wages in excess of business-demand for their skills. As such, there is a limited supply of goods in this economy (businesses would produce more to meet consumer demand if only they could get appropriately priced labor)—in this economy, government deficits would lead to rising real interest rates as government debt competed with private sector resources, and a large increase in the labor supply would lead to inflation (as consumers competed over scarce products).

On the contrary, if the economy is suffering from a shortfall in demand, then government deficits will not drive up interest rates (as it is putting idle resources to work), an increase in the money supply will not lead to inflation (as people will just hold cash), and wages for those workers that are employed would be rising rapidly. Again, this is a very simple predictive difference to test—what happened?

FRED Graph

FRED Graph

So, if you actually look at economic developments over the past 5 years, we are clearly seeing signs that our unemployment is cyclical and demand-based, rather than structural and supply-based. What does this mean moving forward?

1) Stop cutting government spending; deficits aren’t a threat to interest rates until the economy has no more cyclical unemployment, and government spending can help offset private sector cutbacks in consumption. It would help a lot if the government stopped actively making things worse.

2) Don’t worry about inflation. It won’t be a problem until the economy is back at full employment. (And, based on current government policy, that will be awhile).



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