The cost of sustained unemployment
I WAS going through some old open tabs in my browser this morning, and I came across this post by Brad DeLong, in which he walks through work on America's labour market that seems to be informing a forthcoming Brookings paper with Larry Summers. He takes us through an interesting exercise. Based on changes in America's labour-force participation rate and employment-population ratio over the past two years, Mr DeLong puts together an estimate of the impact of labour-market weakness on the long-run employment-population ratio. And based on that information, one can estimate the effect on potential output, which he suggests may have fallen by 0.5%:If so, then the experience of the past two years provides enough information to produce a one-episode estimate of the labor-side hysteresis parameter η needed for the simple analytical framework. Two years during which real GDP has stayed flat at 7% below our pre-2007 estimates of potential output have managed to push potential output down by 0.5%: that suggests a value for η of 0.5/(7 x 2) = 0.035...[A]nd with a value of 2.7%/year for the long-term growth rate g of the American economy, such a value for η looms very large in the social-welfare cost benefit analysis indeed. With a real social rate of time discount rd of 5%/year, η of 0.035 produces a present value of gross benefits from expansionary fiscal policy at the margin 2.5 times as large as simple multiplier calculations focused on current output. With a rate of time discount of 4%/year, it is not 2.5 but 3.7 times as large. And with a social rate of time discount of 3%/year, it is not 2.5 or 3.7 but rather 12.7 times as large.The social discount rate of 4%/year also allows us to do a calculation of the cost of each extra month’s delay in the coming of a recovery proper to the U.S. labor market. Inserting an extra month with the output and employment gap at its current level costs the American economy roughly $100 billion in foregone immediate output. And, at a social real discount rate of 4%, if the reduction in labor-force attachment is indeed permanent, it also costs the American economy $270 billion in the present value of reduced future potential output.That's a lot. And while there's a lot of uncertainty surrounding these estimates, the broader story—that sustained cyclical unemployment will raise the structural rate of unemployment, reducing labour supply and potential output—is both simple and compelling. Mr DeLong specifically mentions fiscal policy in the analysis above, but one can't help but think through these dynamics when looking at the Fed's economic projections, which note that—given what the FOMC considers to be an appropriate monetary policy—the unemployment rate is unlikely to be much below 7% a full 2 years from now.