Market Logic

Distinguishing structural from cyclical unemplyoment

Posted in economics, macroeconomics by mktlogic on April 18, 2010

Christina Romer’s recent comments are somewhat troubling.

Romer writes,

” I find it distressing that some observers talk about unemployment remaining high for an extended period with resignation, rather than with a sense of urgency to find ways to address the problem. Behind this fatalism, there seems to be a view that perhaps the high unemployment reflects structural changes or other factors not easily amenable to correction. High unemployment in this view is simply “the new normal.” I disagree.

Deficient Aggregate Demand Is Key. The high unemployment that the United States is experiencing reflects a severe shortfall of aggregate demand. Despite three quarters of growth, real GDP is approximately 6 percent below its trend path.”

Romer goes on to argue, based on something like Okun’s law, that because the current unemployment rate and growth in GDP (measured as income) are consistent with a historical relationship between unemployment and GDP (measured as output), current unemployment is best attributed to cyclical factors.

Some problems with this line of reasoning: First, it’s an incomplete argument to estimate the relationship between unemployment and output growth and then cite current period values of these variables as evidence against structural employment. It may well be the case that the existing relationship was observed in periods were employment problems were structural. Romer seems to take it as given that the sample period used to determine the “normal” relationship between unemployment and GDP growth was characterized by purely cyclical employment effects.

Beyond that, Romer misses the relevant problems of observational equivalence here. Here’s a simple analogy: If consumers want apple pies but producers gear up to make cream pies instead, apple growers will soon be converting their orchards to grazing fields to fulfill the sudden increase in orders for dairy cream to be sent to bakers. Workers who might have gone into botany will go into veterinary medicine to satisfy the demand for large animal veterinarians. Once the cream pies hit the market, they will be received poorly by consumers and there will be a surplus of pies. Dairies will lay off workers to cope with falling revenues. To an aggregate demand theorist, this purely structural episode will looks like a case of declining aggregate demand. And there is a reason for that: To an aggregate demand believer, everything looks like a case of fluctuating aggregate demand.

This is the ultimate problem with aggregate demand theories of macroeconomic fluctuations. They provide no way of distinguishing between changes caused by declining aggregate demand and changes caused by supply side errors.

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