Tuesday 31 January 2012

The largest and longest unemployment gap since WWII

Our chart on the historical experience of recessions and recoveries has got a lot of attention. But it's largely descriptive.  For the current UK economic policy debate, I think this one is far more important (click to enlarge): 

It shows the difference between the UK’s actual unemployment rate, and  estimates of the “structural” unemployment rate, also known as the “NAIRU” (the non-accelerating inflation rate of unemployment), from 1970 to the end of the Office of Budget Responsibility's forecast period.   This difference is sometimes described as cyclical unemployment, or the “unemployment gap.”  Here’s another chart showing all three variables: actual unemployment, the NAIRU, and the gap (see note at end on  sources for the NAIRU). 

Why does the unemployment gap matter?  Well, as the name implies, the NAIRU is an estimate of the level of unemployment that you would expect if the economy were stable, with inflation neither rising nor falling.  If the economy were roughly on trend, with inflation stable near the 2% target, unemployment should be about at the NAIRU.

Put another way, the NAIRU is a measure of the level of unemployment resulting from the supply side of the economy  - workers’ skills, how the labour market works, how competitive firms are, etc; things that change only relatively slowly over time.  The unemployment gap measures how much extra (or less) unemployment there is as a result of macroeconomic conditions – i.e. cyclical unemployment resulting from labour demand, or lack of it.  In other words, if macroeconomic policy is broadly on track, the unemployment gap should be small; it is a measure of the number of people who are not working because macro policy isn’t either.

So what does the chart tells us?  It says that the unemployment gap in the aftermath of the 2008 recession will be larger and longer than any recession since 1970 (which certainly means any recession since the war) including the early 1980s, although there is probably some uncertainty about the 1980s estimates.  It says that - on the official view and the official forecast - the unemployment gap is a million now, rising, and will be higher in 2013 than now; and that even by 2015, fully seven years after the recession began, it will be over 2 percent of the labour force, about 650,000 people. 

Why should this be the case?  It is something of a puzzle.  It is quite easy to understand why the gap rose in the 1980s and early 1990s. In order to bring downward pressure on inflation - to correct previous macroeconomic policy errors - it was “necessary” for unemployment to be above the NAIRU for a period.  As Norman Lamont put it, unemployment is "the price we have to pay" to reduce inflation.  This was infelicitous politically, but expressed the consensus economic doctrine (I was his speechwriter at the time, incidentally..).

It is far less obvious why this should be the case now.  We don’t have an inflation problem going forward; both NIESR and the Bank think it will fall below target.  So the conventional view of macroeconomic policy management, which the Treasury and the Bank still broadly subscribe to (see my previous post) suggests that this just shouldn’t happen; and if it does, something has gone badly wrong.  Sensible demand management should in principle ensure that, with stable inflation, the unemployment rate should fall back to the NAIRU reasonably quickly.  But that’s just not happening.

What do I conclude from this?  Quite a lot; I think this is a remarkably revealing chart.

First, it shows how the fall in the NAIRU – due to successful labour market reforms, under governments of both parties, over the past three decades – has obscured just how bad the post 2008 period is set to be for the UK labour market.  The absolute level of unemployment does not look very high by the standards of the 1980s.   But the amount that is down, not to structural problems, but to macroeconomic developments and policy is unprecedented in the post war period.

Second, it clarifies what is sometimes a rather esoteric debate about the “output gap”.   NIESR is in broad terms somewhat more optimistic than the OBR on this (i.e., we think the output gap is somewhat larger, so there is somewhat more spare capacity and policy can be somewhat looser).  But it's complicated; there's room for debate, and everybody uses a different methodology. What this chart shows is that what everyone can agree on is that there are lots of people who are unemployed, not for structural reasons but cyclical ones, and that this will continue to be the case for the foreseeable future. If that doesn’t represent “spare capacity”, what does?

A third point is related to this one. It illustrates the extent to which economists who say that there is little we can do through macroeconomic policy at the moment, and must therefore turn to “supply side” reforms, are simply missing the point.  A good example is the normally sensible Matt Oakley here.   I’m all in favour of (evidence-based – many proposals are not) supply side reforms. But the supply side of the UK labour market already works pretty well; that's what the low NAIRU is telling us. It’s the demand side that is the main problem for the foreseeable future.

Fourth, it puts to rest the issue of whether, in practical terms, demand management can be achieved by monetary policy alone. There is an argument, put most vigorously by Scott Sumner, that if demand is the problem, monetary policy is always the answer.   It has implicitly been endorsed by the government here; for example David Cameron recently said “we are fiscal conservatives but monetary radicals.”  The theory is complicated, but I actually find this argument very convincing intuitively; surely a central bank that can print money can always ensure that households and firms spend enough?  But yet here we are –  "fiscal conservatism and monetary radicalism" promises persistently elevated levels of cyclical unemployment for the foreseeable future.  This is not what we should be looking for from the policy mix.  I would not argue by any means that this is all the fault of UK policymakers (the Government and the Bank of England); wider macroeconomic factors clearly play a role.  But I think it is reasonable to conclude that, regardless of the theory, in practice monetary policy is not enough.  

Fifth, there is a risk that the forecast turns out wrong - but not in a good way. In other words, that the unemployment gap turns out to be lower than forecast, because the NAIRU turns out higher. We know that unemployment (especially youth unemployment) has "scarring" effects; i.e. that an individual experiencing a spell of unemployment has lower employment probabilities later in life, presumably because they become disconnected from the labour market, or their skills atrophy.  But this is structural, not cyclical, unemployment; it adds to the NAIRU. In other words, if we accept a persistently high level of cyclical unemployment now, we will condemn ourselves to a persistently high level of structural unemployment in the  future.

Finally, this last argument illuminates a point I’ve been trying to make about the balance of risks attached to the current stance of fiscal policy.   The most sensible argument against short-term fiscal stimulus comes from those (like Chris Giles in the FT, for example) who argue that the risks to credibility of fiscal easing are large, while the potential gains are small.   In my view the risks are hugely exaggerated (see here and here).   But my point here is about the other side – the downside of inaction.  If we do not do something to boost labour demand now, we are not just taking a risk.  We are accepting the likelihood of continuing high levels of unemployment that will damage both many individuals and society as a whole.  [Those of a mathematical bent should read Brad Delong for a brilliant analysis of this point.]

In 1925 Winston Churchill expressed his dismay that policymakers seemed to be “perfectly happy with at the spectacle of Britain possessing the finest credit in the world simultaneously with a million and a quarter unemployed.”  We are making the same mistake.  Ultimately, that is what this chart is telling us.

Note on construction of the NAIRU seriesI have taken estimates of the NAIRU from the OECD (up to 2002) and HM Treasury/Office of Budget Responsibility (from 2003 on), when the series are in fact quite close.  This isn't ideal; I wanted to use Treasury/OBR  numbers throughout because I'm focusing on the "official" forecast and its implications, but they don’t seem to publish a consistent series (if the Treasury give me their estimates of the NAIRU back to the early 1970s, I will amend the chart accordingly). The key point here is that the OBR has recently restated its view that the current and prospective NAIRU is 5.25%.  The unemployment forecast is also that of the OBR, so the chart gives the official forecast of the gap going forward, not NIESR’s, although assuming current policy the differences will probably not be huge.    The OECD's estimates for the NAIRU going forward are somewhat higher, so the gap would be somewhat smaller; but this in part just reflects my final point above.  

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