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Will There Be a 'New Normal' For Unemployment?

In my last post, I wrote about the longer than usual time period I think it will take for unemployment to return to its normal, or full employment level, but I didn't define what normal unemployment is. An important question for policymakers is whether there will be "a new normal" for unemployment once the recession is over, and if so, what that level of unemployment will be.

The types of unemployment
Economists define three types of unemployment: frictional, structural, and cyclical. Frictional unemployment is defined as the unemployment that occurs because of people moving or changing occupations. Demographic change can also play a role in this type of unemployment since young or first-time workers tend to have higher-than-normal turnover rates as they settle into a long-term occupation. An important distinguishing feature of this type of unemployment, unlike the two that follow it, is that it is voluntary on the part of the worker.

Structural unemployment is defined as unemployment arising from technical change such as automation, or from changes in the composition of output due to variations in the types of products people demand. For example, a decline in the demand for typewriters would lead to structurally unemployed workers in the typewriter industry.

Cyclical unemployment is defined as workers losing their jobs due to business cycle fluctuations in output, i.e. the normal up and down movements in the economy as it cycles through booms and recessions over time.

What is normal unemployment?
Cyclical unemployment is the main worry of policymakers such as the Fed, and they attempt to minimize this type of unemployment through policy changes such as lowering interest rates in recessions. We are currently seeing this in action. Frictional and structural unemployment are considered normal and necessary. When these are the only two types of unemployment that exist, i.e. when cyclical unemployment has been eliminated, the economy is considered to be at full employment.

Why are frictional and structural unemployment considered normal and necessary? Frictional unemployment promotes efficient matching of workers and jobs. It allows workers to leave jobs they don't like or aren't good at and then find new jobs to which they are better suited. If there were never any vacancies, finding a better matching job would be much more difficult if not impossible. It would require trading jobs with someone who has the job you want and wants the job you have (and both employers would have to agree to make the hires). This means that some degree of frictional unemployment is desirable.

Structural unemployment allows the economy to implement new technology such as robots on assembly lines, and to respond to changes in demand for various products. If we didn't allow this type of technological change, we'd be using outdated production methods and always be consuming exactly the same mix of goods at every point in time.

A new normal?
Prior to the current recession, the target rate of unemployment -- the sum of the frictional and structural components -- was somewhere near 4 percent. Will it be the same after the recession ends? That depends upon what happens to the frictional and structural components of overall unemployment.

Frictional unemployment falls during recessions. People are afraid to leave their jobs, even jobs they dislike quite a bit, because the prospects for finding new employment aren't very good. And searching for a new job while still employed is less likely to be successful than during boom times. But as the economy recovers and confidence in job prospects recovers along with it, the level of frictional unemployment should go back close to where it was. Thus, I don't expect this component to change very much.

The change in the structural component could, however, be significant. I expect structural unemployment to be higher than it was, particularly in the next few years. We had too many resources in housing, finance, and automobile production, and it will take time for the economy to make the necessary structural adjustments. When this is combined with continuing globalization, as well as the higher savings rate and correspondingly lower consumption expected from households in the future, both of which cause structural change within the economy, the expectation is that the new target rate of unemployment will rise above the 4 percent level it was at before the recession.

Exactly how much it will rise and for how long is hard to say. A 5 or 6 percent rate, or even somewhat higher is certainly imaginable, but getting it right is important. If policymakers target an unemployment rate that is too low, they risk causing inflation (one reason for the high rate of inflation in the 1970s is that the Fed targeted a 4 percent unemployment rate when the actual rate of normal unemployment was much higher due to structural and demographic change). If they target a rate that is too high, then they risk having people be unnecessarily unemployed in the economy.

However, this does not mean we are completely powerless. There are ways to help with structural unemployment, though the tools for doing so aren't as powerful as we'd like. In essence, structural unemployment arises from a mismatch between the supply of jobs in various industries and geographical locations, and the workers available to meet those needs. Thus, job training that promotes a better match of worker skills with available jobs, programs that help workers move to places where jobs exist, and programs to induce firms to locate where there is an oversupply of workers, e.g. Detroit, can mitigate some of the impact. Extended unemployment compensation can also cushion the blow for workers during the adjustment period. But the history of these programs indicates that we shouldn't expect miracles for workers, and some degree of higher unemployment will need to be tolerated while the economy undergoes the necessary structural adjustments.

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