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Why Employment Might Not Fully Recover Until 2013

The most recent employment report shows the unemployment rate at 10.2 percent, and the broader unemployment rate that accounts for part-time work and discouraged workers at 17.5 percent. With numbers like these, can we expect good news on the employment front anytime soon?

Historically, a good rule of thumb has been that the peak in unemployment lags the trough in economic output by a quarter. Thus, if output begins recovering in the second quarter of the year, unemployment would not begin to decline until the third quarter.

But as shown in these graphs of the unemployment rate and NBER-dated recessions, this changed with the 1990-91 and 2001 recessions. The graph below shows the change in the relationship over time:

Unemployment and Recessions

This second graph highlights that in the most recent recessions, the peak in the unemployment rate came a year or more after the trough in GDP, and that the current unemployment rate is still moving upward:

Unemployment and Recessions since 1990

Employment lags changes in output because firms usually wait to see if a recovery is permanent rather than a temporary uptick before committing to the costly task of hiring new people. But the reason for the change in the relationship between output and unemployment after 1990 is not fully understood, making it harder to know how to battle the problem using government policies designed to stimulate employment.

How long till employment recovers?

An important question is whether this new relationship between unemployment and output observed in the last two recessions will also be present in this recession. All indications are that it will. The most recent employment report shows the unemployment rate rising past 10 percent even though it appears output may have already turned the corner, while new claims for unemployment insurance are still over 500,000, a number that indicates the economy is still losing jobs overall. In fact, I am worried that the peak in unemployment could lag even further behind the recovery than it did in the last two recessions.

It's not just the lag between the turning points in output and employment that leads to a pessimistic outlook for labor numbers. Once unemployment does peak, output still needs to return to its normal growth level before we see a return to full employment. The San Francisco Fed doesn't expect a return to normal growth until the middle of 2012, and this means that unemployment likely won't fully recover until somewhere in 2013.

The reason for the slow recovery is partly due to the depth of the recession -- the deeper the hole, the longer it takes to crawl out of it -- but it's also because of the large amount of structural change that the economy must go through before it can recover. Prior to the recession we had too many resources in the housing, finance, and auto industries, and it will take time to move the people and resources who used to work in these industries into areas of the economy where they can be employed productively. And as new productive activities outside these areas arise, firms will install the best technology available. This technology will, in general, be more capital-intensive than before, and so we will need to surpass the pre-recession level of output before the demand for labor will return to its previous level. In addition, firms typically reorganize their job assignments after layoffs and discover that the same work can be performed with fewer workers and this, too, can slow the recovery period for employment relative to output.

The bottom line is that there's still a long road ahead, particularly for labor, and for that reason I am very much in favor of additional government policy targeted directly at the employment problem. In addition, given the record levels of long-term unemployment we are experiencing (those unemployed 27 weeks or more now constitute 35.6 percent of the unemployed; see here for a graphical representation of the situation), the recent vote to extend unemployment benefits was overdue and very welcome.

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