The 'New Normal' of Unemployment

The American Economics Association
held its annual meeting in Denver last weekend. Most attendees appeared
to be in a very forgiving mood. While the economists in Denver recognized the severity of the economic slump hitting the United States
and much of the world, there were few who seemed to view this as a
serious failure of the economics profession.

The fact that the
overwhelming majority of economists in policy positions failed to see
the signs of this disaster coming, and supported the policies that
brought it on, did not seem to be a major concern for most of the
economists at the convention. Instead, they seemed more intent on
finding ways in which they could get ordinary workers to accept lower
pay and reduced public benefits in the years ahead. This would lead to
better outcomes in their models.

The conventional wisdom among
economists is that the economy will be forced to go through a long
adjustment process before it can get back to more normal rates of
unemployment. The optimists put the return to normal at 2015, while the
pessimists would put the year as 2018, and possibly, even later.

Furthermore,
many economists believe that the new normal will be worse than the old
normal. The unemployment rate bottomed out at 4.5% before the housing
bubble began to burst. If we go back to 2000, the United States had a
year-round average unemployment rate of just 4.0%. The optimists now
envision that normal would be 5.0% unemployment, while the pessimists
put the new normal at 6.0% unemployment and perhaps higher. As a point
of reference, every percentage point rise in the unemployment
corresponds to more than 2 million additional people without jobs.

The
willingness of economists to so quickly embrace this darker future is
striking. After all, one of the reasons that we have economists is,
ostensibly, so that we don't get such unpleasant news about a "new
normal". This is like a football team calmly accepting the sports
writers' prediction that they would have a winless season, and deciding
that their new goal was to minimize the margin of defeat.

The
prospect of an extended period of higher unemployment would be easier to
accept if there was a good argument as to why the economy cannot
achieve the same levels of employment as it had in the recent past.
Economists really don't have much basis for this lowering of
expectations of their own and the economy's performance.

The main argument seems to stem from the work of two economists, Carmen Reinhart and Ken Rogoff,
who have examined financial crises around the world. Their analysis
finds that, in most cases, it has taken countries roughly a decade to
recover from the effects of a financial crisis and return to a more
normal growth path.

There is an important limitation in the Reinhart and Rogoff analysis.
Most of the crises they examine were in the distant past, before the
development of modern economics and its bag of tools. If the thousands
of economists gathered in Denver know anything more about economics than
those not educated in the field, then it would be reasonable to expect
better outcomes than in prior centuries.

After all, through most
of human history a large portion of children died in their first years
of life. However, with modern medicine and good nutrition, infant
mortality is a rare event in wealthy countries. By the Reinhart and
Rogoff extrapolation, we would still expect most children to be dying
before the age of five, based on the historical experience.

The
methods for generating demand are not a mystery. It basically amounts to
the government spending more money until the private sector is again in
a position to fuel demand. The fears of deficits and debt that the
pessimists promote stem from a misunderstanding of basic economics.
Deficits can be a problem when they crowd out private economic activity.
In a severe slump like the current one, this crowding-out is not a
realistic fear; there are vast amounts of idle resources. Furthermore,
there is no reason that the debt needs to pose an interest burden on
taxpayers in the future. The Fed and other central banks can simply buy
and hold the debt, refunding the interest payments to the government.

If
economists did their job, they would be pushing policies to get the
economy quickly back to full employment. Instead, they just repeat lines
about how "we" will just have to accept some rough times.
Unfortunately, no one ever asks the economists who preach austerity how
much time they expect to spend in the unemployment lines.

If they don't know anything, then why should we listen to them?