What Causes Recessions and Unemployment?

By Daniel Richards, Manzur Rashid, Peter Antonioni

Over the last 50 years, the U.S. economy has grown at an average annual rate of about 2.8 percent. Roughly 1.1 percent has come from population growth: the country typically adds more workers each year. But the majority of it comes from the fact that it gets more productive each year — to the tune of about 1.7 percent annually.

If this progress had been steady and even, macroeconomists could just focus on the long-run growth questions. But, like true love, the course of GDP seldom runs smoothly. The Great Recession of 2007–09 is just the latest reminder that the economy often wanders far from the long-run trend, with GDP falling and unemployment rising. The GDP that those unemployed workers could have produced — such as more or better healthcare, more or better transportation services, more or better education, or a lot of other stuff that society values — is lost.

To be sure, given how unemployment is measured, some people are unemployed even in the best of times. Basically, you’re considered to be unemployed if: a) you don’t have a job, and b) you’ve been looking for one in the last few weeks. Yet over any month or quarter, some people lose or quit their jobs and look for new ones. Others, either new young workers or older ones who had been happy taking time off, enter the labor force and search for employment as well.

Because it takes time to match each worker with a specific skill set to a firm looking for just those skills, these workers clearly meet the definition of being unemployed. Because such unemployment reflects the normal frictions in the job matching process, economists refer to it as frictional unemployment.

In addition, there are structural features of the labor market that also lead to positive unemployment even in overall good economic times, what economists call structural unemployment. Regulations, for example, that make it difficult to discharge workers once they are employed are also likely to make companies reluctant to hire workers in the first place.

State licensing policies and regulations can have a similar effect. It may surprise you to learn that virtually every state imposes a licensing requirement not only for professional occupations like doctors, dentists, and lawyers, but also for those such as manicurists, cosmetologists, HVAC contractors, and massage therapists. Some even impose requirements for being an upholsterer, a locksmith, or an interior designer.

Often there is little reciprocity between states. So, in moving from one state to another, a worker frequently must repeat many of the exams and training necessary to regain her license. This expense can be enough to wipe out any gain from moving to a different state. Even if there is a surplus of, say, medical technicians in New Mexico and a shortage in California, those in New Mexico may choose to stay unemployed rather than move to California and incur the cost of regaining a license. Recent estimates suggest that such licensure requirements cost up to nearly 3 million jobs per year.

Minimum wage laws can also cause structural unemployment. By mandating a wage higher than the market would, such laws can attract a lot of workers while at that same time making companies less willing to hire. The excess supply will again be considered unemployed — not because there are no jobs but because they cannot get employed by offering to work for a lower wage.

The law prevents that. To be sure, this view has been challenged in recent years as economists have found that such effects may be countered by the fact that a higher wage makes it easier to hire and keep workers, thereby paying for itself in lower turnover costs.

But part of the reason for this is that, within the U.S., the current federal minimum wage is so low. In inflation-adjusted terms, the current federal minimum wage of $7.25 per hour would have to be about $9 to reach the peak reached in the late 1960s. At such low levels, it is perhaps quite plausible that even significant increases to, say, $12 or $15 an hour might still not create any unemployment. However, at some point, the traditional argument surely holds. Mandating a minimum wage of $30 an hour, for example, would definitely price large numbers of workers out of their jobs.

In the case of both frictional and structural unemployment, any solutions lie mainly in policies to improve the functioning of the labor market, that is, in microeconomic policies. These might include improving the information that workers and firms have about each other and reforming licensure practices.

By contrast, cyclical unemployment reflects more purely macroeconomic forces. It is, as its name implies, a short-run phenomenon associated with the business cycle. It usually stems from low demand for goods and services that leads firms to cut production and lay off workers. Those workers want jobs and are willing to work — there just aren’t enough jobs available to employ them.

Cyclical unemployment is very costly because it means not using resources to produce goods that the economy would produce if it were operating normally. The U.S. Congressional Budget Office estimates that in 2009 the U.S. economy lost about $1 trillion (nearly 7 percent) of GDP due to the unemployment associated with the recession. That’s a whole lot of healthcare, automobiles, education services, or whatever we wanted to use those unemployed resources to make.

This is why understanding the reason that the economy periodically falls into recession is the second great macroeconomics question. The payoff to reducing the costs of cyclical unemployment is potentially very large.