Crushing America's Economic Potential

Updated August 2014

A paper with the rather lengthy title of "Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy" by Dave Reifschneider, William Wascher and David Wilcox, all of the Federal Reserve Board offers us a snapshot of where the American economy stands six years after the Great Recession began.  The paper provides us with an idea of the impact of the recession on the economy and how the United States' long-term economic potential has been reduced by the inability of monetary and political policy makers to put people back to work.

Let's look at four definitions first:

1.) Cyclical unemployment: this is the rate of unemployment that occurs when workers lose their jobs due to business cycle fluctuations (i.e. as the economy cycles through booms and recessions).  It is involuntary on the part of the worker.

2.) Frictional unemployment: this is the rate of unemployment that occurs because people move jobs or change occupations.  It is voluntary on the part of the worker. 

3.) Structural unemployment: this is the rate of unemployment that occurs because of changes in technology or changes in the demand for certain products.  It is involuntary on the part of the worker.

4.) Natural rate of unemployment: this is the rate of unemployment that an economy naturally gravitates towards over the long-term, a situation where labor and resource markets are in equilibrium.  The natural rate of unemployment is defined as the sum of structural and frictional unemployment and can be thought of as the full employment unemployment rate.   It is the average level of unemployment that is expected to prevail in an economy when there is an absence of cyclical unemployment (i.e. recessions).

Now, let's go back to the paper.  The authors begin by noting that the fallout from the collapsing housing market and financial crisis continue to impact the economy, pushing down aggregate demand which includes spending by consumers and all levels of government.  The drop in demand has also likely diminished the productive capacity of the economy.  They note that real GDP in 2013 was only modestly above its pre-Great Recession level and that various economists speculate that the financial crisis and resulting recession left a permanent negative impact on the productive capacity of the American economy.

Here is a graph showing what has happened to the natural and actual rates of unemployment since 1990:

As you can see, the actual rate of unemployment (in red) is still well in excess of the natural rate of unemployment five years after the Great Recession began and that the natural rate of unemployment was pushed up by one-half to a full percentage point after the Great Recession and that it is showing no sign of declining.  The authors suggest that the deepness of the rescission resulted in structural (i.e. permanent) damage to the labor market although it is unknown how persistent this damage will be at this point in time.

We can also see the damage to the labor market in this graph:

The labor force participation rate (in red) is far below the trend (in blue) and again, is showing no real signs of improving.  This suggests that many workers have simply given up and are no longer attached to the officially defined workforce.

The authors note that the drop in aggregate demand can (and probably has) had a long-lasting impact on the duration of unemployment which is quite apparent on this graph from FRED:

Right now, there are 3.155 million American workers that have been out of work for 27 weeks or longer.  This is nearly 270,000 more than were long-term out of work at the previous post-World War II record of 2.885 million in June 1983 and is by a wide margin, the most persistent long-term unemployed trend seen after any recession since 1948.

Now, let's look at the impact of the crisis on GDP as shown on this graph, noting the gap between the dashed green line that shows the trend of growth between 2000 and 2007 and the red line that shows the actual GDP growth:

Between 2000 and 2007, potential GDP growth was around 2.6 percent per year.  Between 2007 and 2012, potential GDP growth slowed to 1.3 percent per year on average, a slowdown that is even more pronounced during the past three years with the average annual change estimated at less than 1 percent.  This means that the level of potential GDP in the first quarter of 2013 was 6 percent below the potential based on data from 2000 to 2007 and that the shortfall in GDP will widen to 6.75 percent by the end of 2014.

Basically, what the authors are telling us is that in the current situation where there is both weak aggregate demand and high unemployment, a cyclic downturn can become a structural downturn where the economy is permanently negatively affected and there is a disconnect between the supply and demand components of the economy, resulting in a no- or slow-growth scenario.

Let's close with a quote from the paper:

"Thus, in an uncertain world, a policymaker’s choice of policy will depend not only on the extent to which he or she believes a demand shock is likely to affect potential GDP and employment, but also on his or her view of the risks associated with actively trying to offset these adverse supply-side developments through accommodative monetary policy."

An uncertain world indeed.  When you hear this from a central banker, it's time to run for cover.