Stalking the Cause of Unemployment

The Fed’s researchers favor a cyclical cause as the explanation

Is the U.S. jobs crisis structural or cyclical? To the man or woman who’s lost a job, the pain is the same no matter the cause. To economists, though, finding the right answer to that question could help the Federal Reserve and even legislators shape policy.

Fed researchers have been scouring data and examining models to determine why the jobless rate has remained stuck around 9 percent or more since April 2009. If the rate is stuck because the economy is in a deep cyclical downturn, Fed Chairman Ben Bernanke and his colleagues should be able to bring down unemployment by keeping interest rates near zero, eventually stimulating demand and encouraging businesses to start hiring again, says Sung Won Sohn, former chief economist at Wells Fargo and now an economics professor at California State University-Channel Islands. In this scenario, the Fed’s loose monetary policy will get the U.S. back to what’s called the natural rate of unemployment—the rate that an economy can sustain without triggering inflation.

Should joblessness stem mostly from structural changes, that would mean a permanent reallocation or loss of jobs in certain fields; the vagaries of the normal economic cycle would have little to do with it. In this case, the Fed’s loose money policy is dangerous, since it’s designed to manage the cycle, not a massive transformation. The Fed, says Sung, “will have simply created more future inflation because of a flood of liquidity” it has released.

Researchers at the Fed are reaching the conclusion that they are dealing with a mostly cyclical bout of unemployment. Fed forecasters say U.S. unemployment will return to its pre-crisis level of 5 percent to 6 percent by 2016 or 2017.

Several pieces of evidence support the researchers. Mary Daly, who heads the Federal Reserve Bank of San Francisco’s applied microeconomic research department, points to two charts with 33 bars that all point down. They show eight industries getting hit equally hard after the 18-month recession that ended in June 2009, suggesting that much of the past two years’ unemployment is broad-based and should dissipate as the economy improves. “If we were mismeasuring the natural rate of unemployment, I would expect to see rapid wage growth in some sectors offset by wage declines in others,” says Daly. “I don’t see that. I see pretty uniform patterns across all sectors.”

Another telling indicator is joblessness among college graduates aged 20 to 24, according to Daniel Aaronson, director of microeconomic research for the Federal Reserve Bank of Chicago. The rate climbed to 14.5 percent in June from 8 percent four years ago, while the national rate rose to 9.2 percent from 4.6 percent. The similarity between these movements points to cyclical causes for unemployment. If the economy were creating job opportunities, then these mobile young workers would be among the first to profit from them. They are not.

One major change in workers’ lives is the fall in housing prices. Researchers Raven Molloy and Christopher Smith of the Fed board in Washington and economist Abigail Wozniak at the University of Notre Dame found no evidence, though, that homeowners in states with the biggest declines in housing values had a harder time relocating to new jobs than renters. Their work indicates that the inability to move from properties with negative equity isn’t contributing to a rise in structural unemployment.

Nobel laureates Edmund Phelps and A. Michael Spence, along with Wall Street economists Drew Matus and Troy Davig, disagree with the Fed researchers. They argue that the Fed is not paying enough attention to changes in the labor force that monetary policy can’t fix. Matus, a senior U.S. economist at UBS Securities in Stamford, Conn., notes that 44.4 percent of the people who were unemployed in June have been out of work for 27 weeks or more; in 2001 the share was as low as 10 percent. “There’s some risk that they don’t get it right,” says Phelps, referring to the Fed researchers. “But there’s some risk they don’t get it at all. For one thing, the Fed underestimates the strength of structural forces pulling the economy back to a new normal,” he says.

One area of disagreement focuses on the natural rate of unemployment. The higher the natural rate, the less policymakers can do to stimulate the economy without stoking higher prices, and the more crucial it is for the U.S. to take other steps, such as retraining workers. Phelps, who teaches at Columbia University and who helped pioneer the concept of the natural rate, estimates it has climbed to about 7 percent from 5.5 percent since the mid-1990s.

Shigeru Fujita, a senior economist at the Federal Reserve Bank of Philadelphia, also sees significant structural forces at work, pointing to labor’s declining share of the economy since the early 1980s, when measured by workers’ compensation as a percentage of gross domestic product. “There are many things that traditional economic models can’t explain,” says Fujita, “one of which is jobless recoveries.”


    The bottom line: The Fed’s conclusion that cyclical forces are causing unemployment may lead it to keep interest rates low for too long.

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