The Changing Meaning and Significance of Unemployment


The American economy seems to be showing signs of a split personality.  On the one hand, in terms of real or price level adjusted GDP, the economy is now in it seventh quarter of recovery and expansion after the very mild and short-lived recession of the first three quarters of 2001.  Of course the slowdown occurred in the middle of 2000 when we went from nearly 5% real growth to zero growth by the end of 2000. 


Despite the current expansion we are in, the unemployment rate is not only not falling; it is rising and now above 6%.  How can this be?  We must distinguish between the categories of unemployment and patterns of unemployment over a business cycle.  The categories of unemployment are frictional, seasonal, structural, and cyclical.  The most widely accepted and modern definition of full employment is that when no cyclical unemployment exists.  Even with an unemployment rate of 10%, in the presence of no cyclical unemployment, full employment still exists.  So, if the sum of frictional, seasonal, and structural unemployment equals 10% of the labor force, then, that is the full employment, unemployment rate.


Even if structural unemployment rises by 2 percent of the labor force, so that the sum of frictional, seasonal, and structural unemployment rises to 12%; as long as there is no cyclical unemployment, full employment exists and the full employment rate of unemployment is 12%. 


Frictional unemployment occurs when a worker quits in search of a job more in line with his or her talents.  For example, you complete your MBA and your firm fails to recognize it with a raise in pay.  You depart and begin looking for an employer more appreciative of you newly acquired credential.  Research seems to show that job search under this condition is more efficient if you quit rather than continue working while you are looking.


Seasonal unemployment occurs when golf course employees or farm hands are laid off when winter weather sets in.  The Canadian economy is saturated with this type of unemployment.


Structural unemployment occurs when a job is eliminated.  As restructuring occurs in the American economy, this type of unemployment dominates the statistics.  Many of the structurally unemployed are on the higher end of the compensation structure and had been earning six figures.  They will not be called back; the job is gone.  This is the major reason why in the current recovery and expansion, the unemployment rate is rising.


The last category of unemployment is cyclical.  As the economy weakens, workers are laid off.  When the recovery occurs, they are called back.  For the last several years in the auto industry, an increasing amount of layoffs is structural and not cyclical.


There is a typical pattern of unemployment over a business cycle.  As business cycles become shallower and shorter, some of these patters will become less discernable.  The first sign of recession setting in is a fall in labor productivity.  This occurs because, as production and sales fall, firms are reluctant to lay off workers until they are certain the slow down is going to continue; thus labor productivity falls.  A note of caution: one must be careful in this regard.  There are reasons other than recessions and recovery to explain falling and rising labor productivity. 


As recession persists, firms begin to layoff workers.  In a lengthy recession, some of the laid off workers become discouraged and no longer look for work.  When laid off workers stop looking, they are said to have become discouraged and are no longer in the labor force and hence are no longer unemployed.  The so-called discouraged worker effect mutes the severity of the recession by reducing the unemployment.


When the recovery starts, the first sign is a rise in labor productivity. Firms are reluctant to call back labor until they are sure the recovery is actually occurring and under way.  Again, this could be misleading because there are other causes for an increase in labor productivity aside from economic recovery. 


As the recovery continues, the discouraged workers become encouraged and begin to look for jobs.  This is called the encouraged worker effect.  It raises the unemployment and mutes the strength of the recovery.  The last report on unemployment indicating a jump in the rate was due partly to an encouraged worker effect, but also due to a continued rise in (new) structural unemployment.


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