Unemployment: The Key to Our Future

This morning’s release of the monthly ADP Employment Report adds some fuel to the green shoots argument. The story is the same as that we’ve been following for a couple of months now: things are getting worse less slowly. I suppose that means things are getting better in a perverse kind of way.

According to ADP the economy is still shedding jobs at a prodigious rate: we lost another 473,000 in June. The good news in this is that the monthly losses are significantly smaller than those we saw at the end of last year and the beginning of this. The average monthly loss during the second quarter was 492,000 compared with an average of 691,000 during the first quarter.

So that’s the good news: we lost under half a million jobs! Whoopee.

“Unemployment will be the key to our return to economic health, and the prospects are mediocre at best.”

I have tried to emphasize all along that the real issue is not the recession itself, we have the policies to halt the onset of depression, but the recovery. Unemployment will be the key to our return to economic health, and the prospects are mediocre at best.

We will learn later this week what the unemployment figure has grown to. Many analysts are thinking it will hit 9.6% or even slightly higher. Given that we are still losing jobs at a steady rate, and that there seems to be no re-hiring en masse on the horizon, the unemployment rate is almost certainly going to peak at about 10.5% by late this year or early next. Remember: unemployment lags behind the economy as a whole. Employers fire workers after a recession has started and re-hire after a recovery is well under way. So the drag effect of those lost jobs tends to hang around even after there are plenty of other signs of recovery: business investment usually picks up as firms retool for an uptick in sales, but the try to retool with a shrunken workforce rather than take on the expense of hiring more workers.

When we delve into the consequences of this drag effect it becomes obvious why this particular recession and recovery represents a challenge.

The bulk of our economy’s purchasing power comes from salaries and wages. This is reported through the personal income data. Last month, as I discussed at the time, most of increase in personal incomes came from the arrival of the stimulus checks. Wages contributed a decline. This was because unemployment reduced the number of workers receiving wages, not because the average wage fell dramatically, although there are signs that average wages are now beginning to fall.

Economic theory argues that wages should fall in line with a decline in overall activity because workers should prefer to receive a lower wage rather than none at all. Obviously this doesn’t reflect the real world: unemployment insurance mitigates job loss, at least for a while, and so reduces the incentive workers have to accept lower wages; union restrictions on wage changes also slow the process down; and earlier on in a downturn workers seem more willing to gamble on getting a new job at the old wage rate rather than accept a pay cut. For all these reasons wages are notoriously ‘sticky’. This stickiness invalidates much of the analysis that flows from standard economic modeling.

Nonetheless, the flow of wages will ultimately determine the tone of the recovery.

This is not good news.

As workers contemplate their financial situations they will have to decide how much to spend and how much to save. That balance is always a critical factor in the economy. The less savings the more consumption, and thus growth is faster. One component in this equation is the level of indebtedness. If workers are secure in their prospective employment they tend to be willing to take on debt in order to supplement wages as a source of cash for consumption. Furthermore, as long as paper sources of wealth such as house and stock price inflation, are rising, people feel that they can absorb the cost of debt because they have a ‘backup’ way to liquidate the debt in emergencies. The destruction of paper wealth over the past two years has been catastrophic for most consumers. It has eliminated their sense of security and has pushed them into a shift towards higher savings. In other words the unwinding of the housing bubble is contributing to surge in thriftiness.

Couple this effect with a massive run up in unemployment which, as I mentioned above, sucks out incomes from the economy, and the outlook for a strong rebound in consumption is very dim.

This is why high unemployment levels become so critical. The associated loss of spending power cripples the economy’s chances of entering the much hoped for ‘V’ shaped recovery – a rapid decline followed by a rapid recovery.

But then we have to confront a self-fulfilling prophecy: lower consumption resulting from high unemployment will prolong the period of high unemployment. Because wages are sticky and do not fall to help the job market correct itself the way the textbooks argue, an economy can easily get stuck in a self reinforcing cycle of low growth associated with relatively high unemployment. The only way to break out of this rather depressing cycle is more government stimulus. The argument is already being joined. Unfortunately the administration seems not to have the necessary nerve to press for it. That’s too bad since it is are only ‘escape card’.

So the longer we shed jobs, even at the diminished rate that now seems to pervade, the more sure we can be that the recovery will be a longer and slower one.

We are already breaking through the ‘worst case’ levels of unemployment that many analysts foresaw at the onset of recession and are likely to keep on going. This can only be bad news.

Which is why today’s ADP report, while good in some ways, was nowhere near good enough.

Dig in. The road ahead is long and arduous.