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Political Illusions

Mark Thoma: How Long Until We Reach Full Employment?

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MT:

Economist's View: How Long Until We Reach Full Employment?: I took the month to month difference in the unemployment rate (from 1948:2 to 2011:2), then took two averages, one when the difference is positive (unemployment is increasing) and one when the difference in negative (unemployment is falling):

Average monthly increase in unemployment:   0.2143
Average monthly decrease in unemployment: -0.1143

Notice that, as is evident in the graph, increases in the unemployment rate are, on average, larger than decreases. Thus, unemployment generally rises faster than it falls. Next, I used the second number, -0.1143, to forecast the monthly changes in the unemployment rate (the red line in the graph). Since the precise value of the natural rate of unemployment is unknown, here are a few benchmarks:

7% unemployment in July of 2012
6% unemployment in March of 2013
5% unemployment in December of 2013....

If anything, relative to the last two recoveries, this forecast is optimistic. Even so, it will still take two years to get to 6% unemployment.... Things may be looking up, but we have a long way to go and it's too soon to turn our backs on the unemployed.

Let me second what Mark says in that last paragraph. We seem to have two types of recoveries: (i) recovery from Federal Reserve-inflicted liquidity squeeze recessions, and (ii) recovery from financial-market generated bubble-collapse recessions.

The history seems to be telling us that the recovery from (i) is rapid: once the liquidity squeeze ends, all economic activities that were profitable and productive before in the last boom are profitable and productive again, and so you simply reproduce your pre-recession pattern of economic activity, and voila!

The history also seems to be telling us that the recovery from (ii) is slow: the problem was that certain financial assets were grossly overvalued, and once they come back to reality there is an overall shortage of financial assets as savings vehicles or of safe financial assets that induces a shortfall of aggregate demand. A return to full employment requires that something happen to boost the economy's supply of financial assets as savings vehicles or of safe financial assets--whichever was the cause of the downturn in the first place. Only then will households and businesses be comfortable spending at a full-employment pace.

The problem is that you cannot boost the economy's supply of financial assets as savings vehicles--the thing that the economy was short of in 2002--by simply returning to the 2000 pattern of economic activity, for the problem is that the 2000 pattern of economic activity produced a lot of things--venture-capital investments in dot-coms--that people thought were savings vehicles but that were not so. The problem is that you cannot boost the economy's supply of safe financial assets--the thing that the economy is short of today--by simply returning to the 2006 pattern of economic activity, for the problem is that the 2006 pattern of economic activity produced a lot of things--mortgage CDOs on newly-built houses--that people thought were safe financial assets but that were not so.

This is not to say that we are doomed: there is no reason that the structural adjustment needed to build another and a different pattern of economic activity has to be accompanied by prolonged high unemployment. Indeed, prolonged high unemployment is an obstacle to structural adjustment: you cannot make private investments to serve as backing for financial savings vehicles when demand is so slack that those private investments do not generate any profits; you cannot find pieces of the real economy to back safe financial assets when demand is so slack that real economic activities that are perfectly safe in normal times are now accompanied by substantial amounts of risk.

But the process of structural adjustment does not happen quickly by itself: you cannot simply replace everybody on their pre-recession horse on the merry-go-round and start the music again. You need to do something big on a large scale if you want a rapid recovery: move risk onto the government's books (if you can do so without transforming government debt into a risky asset) in order to transform privately-issued risky assets into safe ones on the one hand or have the government invest and thus create safe savings vehicles on the other, banking policy or fiscal policy--those are your choices, because the conventional monetary policy of trading cash for short-term Treasuries works only if the economy's problem is a genuine liquidity squeeze.

And we are, right now, not undertaking either the expansionary banking policy or expansionary fiscal policy on a sufficient scale to generate a rapid recovery.

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