Demand or Supply?

CHICAGO – Economics is all about demand and supply. Typically, the two are equal, and, if not, powerful forces push them towards each other. But, with high and persistent levels of unemployment in the United States, there is a real question about the nature of the problem: is aggregate demand too low, or are there problems with supply? President Barack Obama’s administration seems to think that the problem is one of demand, and has passed stimulus measure after stimulus measure, reducing taxes and increasing transfers and government spending in order to boost consumption and investment. The Federal Reserve is of a similar mind, not only maintaining rock-bottom short-term interest rates, but also embarking on an adventurous policy targeting long-term rates. Some progressive economists want even more. Why have these policies not worked thus far in bringing down unemployment, even though the growth recovery is well under way? The progressive economist says that stimulus worked, staving off a much deeper recession – if not worse – but that the measures were too timid to generate a robust recovery. The conservative economist responds that it is precisely because the government has become so free with taxpayers’ money that households, fearful of future taxes, are hunkering down and increasing savings. Moreover, the increasingly activist government has left businesses uneasy about future regulatory and tax measures, and thus reluctant to invest. The truth probably lies somewhere in between. Government spending – especially on unemployment benefits, aid to states, and some construction projects – probably helped avert a more wrenching downturn, but continued red ink worries households, which are also trying to rebuild savings and reduce debt after a spending binge. The regulatory uncertainty created in areas such as health care makes it difficult not only for the health-care industry to make long-term investment decisions, but also for businesses to make long-term hires. Nevertheless, before rushing to judgment about current policy, we should recognize the trend in recent US recoveries of slow job growth. From 1960 until 1991, recoveries from recessions in the US were typically rapid. From the trough of the recession, the economy recovered the lost jobs in eight months on average. The recoveries from the recessions of 1991 and 2001 were very different. For instance, in 2001, it took just one quarter for output to recover, but 38 months for jobs to come back. Explanations abound. Some economists argue that, unlike past recessions, in which workers were temporarily laid off from an industry only to be rehired as the recovery picked up, job losses starting in 1991 were more permanent. Matters were exacerbated by firms’ postponement until a recession of hard choices about closing unviable plants and shedding workers. As a result, unemployed workers had to find jobs in new industries, which took more time and training. Others suggest that the Internet has made it easier for firms to hire quickly. So, rather than hire in a panic at the first sign of recovery, as they did in the past, for fear that they will be unable to do so later and lose sales, firms today would rather ensure that the recovery is well established before hiring. Hence also the growth in temporary hires today. Regardless of what the right explanation is, the history of recent recessions suggests that we should not be surprised that the job recovery is taking time. There is, however, an aspect of the problem that is different this time: layoffs in construction. Therein lies an additional explanation for tepid job growth, as well as a salutary lesson about policy. In the last boom, construction jobs expanded significantly, with investment in housing as a share of GDP increasing by 50% from 1997 to 2006. As my colleague Erik Hurst and his co-authors have shown, states that had the largest rise in construction as a share of GDP in 2000-2006 tended to have the greatest contraction in that industry in 2006-2009. These states also tended to have the largest rise in unemployment rates between 2006 and 2009. The unemployed comprise not only construction workers, but also ancillary workers, such as real-estate brokers and bankers, as well as all those who work on houses, such as plumbers and electricians. So the job losses extend far beyond those in the construction industry. It is hard to believe that any increase in aggregate demand will boost the housing market – which, remember, was buoyed by visions of steady price appreciation that few seem likely to hold today – sufficiently to re-employ all these workers. Hurst estimates that this “structural” unemployment may account for up to three percentage points of total unemployment. In other words, were it not for construction, the US unemployment rate would be 6.5% – a far healthier situation than today. Policymakers should remember that the housing boom was fueled by easy monetary policy, which sought to expand job growth as the US recovered from the last recession. Indeed, high-school graduation rates dropped in Las Vegas as people left school for readily available unskilled construction jobs. Now those uneducated unemployed are experiencing more than three times the unemployment rate of college graduates. It will be very hard for them to return to the workforce. The lesson for policymakers is clear: instead of constantly trying to boost spending and potentially creating problems for the future, a more sustainable way to improve job growth is to facilitate the “re-skilling” of the unemployed, especially those who were in construction-related jobs. Eventually, better labor-force supply will create healthier and more sustainable demand. Raghuram Rajan is Professor of finance at the Booth School of Business, University of Chicago, and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy. Copyright: Project Syndicate, 2011. www.project-syndicate.org For a podcast of this commentary in English, please use this link:

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Demand or Supply?