Some Policy Implications of the Interdependence of Cyclical and Structural Unemployment

I have decided to forego discussion of the potentially heavy burdens faced by households with incomes in excess of $250,000 should the tax cuts not be extended for income in excess of $250K (see the poignant story here), and focus on the challenges of the unemployed, and what challenges persistent unemployment in turn poses for macroeconomic policy. (Side note: our assessment of the plight of the +$250K income households should be tempered to by the knowledge that even those households with income in excess of $250K will see a tax cut under the President's proposal, since household income below the $250K threshold would be taxed at the current lower marginal rate [0])
From the introduction to a paper presented at the joint ILO-IMF conference on Growth, Employment and Social Cohesion, entitled The Human Cost of Recessions: Assessing It, Reducing It, by Mai Dao and Prakash Loungani.

Recessions leave scars on the labour market; the Great Recession of 2007-09 has left gaping
wounds. Over 200 million people across the globe are estimated to be unemployed at present.
Among countries with unemployment data in the IMF's World Economic Outlook (WEO)
database, there has been an increase of over 20 million unemployed people since 2007. The
ILO estimates that globally the increase is over 30 million. As shown in the left panel of
Figure 1, three-fourths of this increase in the number of unemployed people has occurred in
the 'advanced' economies (the term used in the WEO to denote high per capita income
countries) and the remainder among emerging market economies. The unemployment rate
has increased by 3 percentage points in advanced countries since 2007 and by 0.25
percentage points in emerging markets...

The paper documents a wide variety of effects, but one striking implication is the impact on mortality, as shown in this graph:

Figure 5 from Dao and Loungani (2010). Notes: Marginal effect of displacement on odds of mortality, with 2 SE bands. Source: Sullivan and von Wachter (QJE, 2009).

In terms of implications for macroeconomic policy, I thought this graph was of relevant. It shows that the longer the duration of unemployment, the lower the probability of employment in the next period. Depending upon the interpretation of this correlation, there are important public policy implications. If the extended duration of unemployment implies depreciation of skills relevant to the labor market, then this implies short term (cyclical) and long term (structural) unemployment are related phenomenon.

Figure 5 from Dao and Loungani (2010).

The (unoriginal) idea that long term cyclically induced unemployment can result in highly persistent quasi-structural unemployment implies that there is no sharp distinction between cyclical and structural unemployment. Econometricians might like to think of this point in the context of the distinction between the Beveridge-Nelson and Unobserved Components approaches to separating trend and cycle (see here for e.g.). I'm not saying the correlation of shocks to the cyclical and permanent components is one, but the above implies it's bigger than zero.

The authors write:

...With hysteresis, government policies
that stimulate demand confer larger benefits than otherwise if they can counteract the
increase in the natural rate and bring output back to potential. . A cross-country study by Ball
(2009) presents evidence that long-lasting demand expansions in the past have indeed
permanently driven down the natural rate of unemployment. Under some illustrative
calculations, the increased tax revenues from the return to a higher potential can lower the
debt-to-GDP ratio over the medium-run.

There is a risk of hysteresis in some countries, particularly in the United States and Spain,
given the sharp increase in the duration of unemployment and the persistent nature of the
shocks (e.g. to the housing sector) that lie behind the cyclical weakness in the economy and
hence the increase in unemployment (see Benes et al., 2010 and Vitek, 2010). Hence to the
extent that countries have fiscal space, exploiting it when there is a risk of hysteresis may
create jobs in the short run without hurting the medium-run fiscal outlook.

What this, and other research, suggests to me is that one shouldn't just throw up ones hands, when confronted by the possibility of structural unemployment. First, one needs to assess the magnitude of structural unemployment (which in my view is at the moment not the majority of the 9.6% unemployment rate [1], but more like 1-1.75 percentage points). Second, one has to then consider whether some efforts to reduce cyclical unemployment might also reduce cyclical unemployment.

Stephanie Guichard, Elena Rusticelli at OECD have examined the links from unemployment to long term unemployment to structural unemployment. From this, they estimate the change in structural unemployment arising from the crisis and great recession:

Figure 7 from Guichard and Rusticelli (2010).

More on the structural/cyclical unemployment debate: [3], [4], [5], [Econbrowser/Hamilton], [DeLong], [Economist symposium].

I would note that the two statistical estimates of the increase in structural unemployment (IMF, OECD) based upon two different econometric approaches are substantially less than Minneapolis Fed President N. Kocherlakota's estimate of more than 2.5 percentage points [6] (which is the sum of a calibration using Shimer's matching model, and the SF Fed's estimate of UI-induced unemployment).