Wednesday, December 21, 2011
Are we worried about the wrong unemployment number?
To understand the implications of these political recommendations, it is helpful to review the various types of unemployment. The commonly reported unemployment number measures the percentage of people who are actively looking for work but cannot obtain employment. While an important statistic, it is not a comprehensive measure of labor unemployment. Another measure of unemployment reports the percentage of working age adults who do not participate in the labor force; this is sometimes referred to as labor non-participation rate. This measure provides information on the economy’s aggregate demand for labor, while the first measure provides information on how hard it is to find jobs. In the United States the headline unemployment rate stands at 9% and the non-participation rate is around 30%. This means that 21% of working age adults are voluntarily unemployed and/or structurally unemployed.
In this discussion, we exclude voluntary unemployment associated with attaining higher education or engaging in full time homemaking and focus, instead on the structurally unemployed or displaced workers. Structural unemployment largely signifies a lack of aggregate demand for lower skill labor (note by lower skill, we do not mean to judge the social value of skill but merely the market price/excess demand for skill), which has been attributed to an increase in the substitution of technology and capital for labor in the modern production process. It is convenient to think of outsourcing overseas as a form of technology innovation; outsourcing to China and India can be viewed as technology (cheaper and faster transportation, telecommunication, supply chain monitoring, etc.) empowering management to manage international workforce. This substitution has made society more productive as a whole even while labor participation declines due to permanent displacement of the lower skilled labor force.
Governments have chosen to support the displaced low skill laborers through a variety of social and welfare programs to ensure some level of subsistence consumption for the displaced population. The combined effect of low demand and low natural wages with government welfare has meant an increase in voluntary unemployment. Quite simply, people without the skills to get jobs that merit wages above the subsistence income provided through welfare remain voluntarily unemployed to qualify for welfare. The growing non-participation rate observed in employment data is a natural consequence of human capabilities evolving slower than technological advances.
The following extreme example helps us understand structural unemployment. Imagine if scientists were to create the benevolent version of the Terminator. Outside of a few robotic scientists, the rest of us will never work again, as we would be completely uncompetitive against the machines. However society would be incredibly prosperous with abundant production of all goods and services that we demand as a civilization; the government will not worry about unemployment but be focused on building a welfare state to distribute the gains from this technological windfall. The structural unemployment rate would be near 100%, and all of us will be, in one form or another, on government welfare. It would be hard to argue, from a consumption perspective, that the society is worse off in this situation.
Involuntary unemployment is generally related to people who are currently unemployed, but have been active members of the labor market and possess skills which are relevant to the modern production and delivery of goods and services. High involuntary unemployment is usually correlated with a negative shock to the economy, which causes otherwise productive firms to fail and thereby creates a sequence of negative feedback effects, all of which further reduce wages and employment opportunities. Times of high involuntary unemployment are almost always times of low or negative GDP growth, of inadequate government tax revenue, which leads to inadequate provision of public services, of very negative stock market returns, of declining housing prices and of tight credit.
High levels of involuntary unemployment inflict significant damage on the economy and on the wealth and standard of living for all, in addition to the pain inflicted on families who have lost labor income. So, the headline unemployment rate, in this context, should really be viewed as another indicator for the slowing of an economy rather than as a narrow indicator on the scarcity of jobs.
Because the natures of structural and involuntary unemployment are so very different, the policy responses must be very different. Involuntary unemployment is actually the easier situation to deal with. The Keynesian approach of stimulating the economy temporarily during the downturn to buffer good businesses from failing and short-term unemployment insurance to buffer household consumption shocks are very sensible solutions for smoothing business cycle shocks.
Structural unemployment is usually the more controversial subject. While permanent welfare for the permanently displaced workers can make sense, it does also create incentive problems—potentially inducing many otherwise capable adults to seek welfare instead of work. [We abstain here from discussing corporate welfare; generally, there is little reason for permanent corporate welfare as there are no humanitarian reasons against letting uncompetitive firms fail.] Perhaps more problematic is the moral hazard problem created by the welfare policy tool. Providing more welfare benefit—that is providing some part of the population with unearned income and benefits—is always a popular election promise and a solid strategy for winning a populous election. This means that there is a real risk that the welfare provided by government results more often from political maneuvering rather than economics analysis, which suggests that the level of welfare is likely significantly above the optimal level. When sub-optimally high welfare is provided, it can induce sub-optimally high labor non-participation—that is, intellectually and physically capable individuals would rationally choose not to incur the cost of acquire economically valuable skill. This sub-optimally high welfare provision, on the one side of the equation, reduces employment related tax revenue, and, on the other side of the equation, creates greater government welfare expenditure, leading to increased fiscal imbalance and ultimately large national debt.
At the end of the day, the incentive problem associated with welfare does not sit with the laborers, as some people are fond to suspect, rather it sits with the cunning politicians, who understand all too well the method for legally buying votes.
by jason c hsu