Economic policy should focus on preventing recessions rather than trying to ameliorate their effects

Why Has the US Economy Recovered So Consistently from Every Recession in the Past 70 Years? Robert E. Hall & Marianna Kudlyak. NBER Working Paper 27234, May 2020. DOI 10.3386/w27234

Abstract: It is a remarkable fact about the historical US business cycle that, after unemployment reached its peak in a recession, and a recovery began, the annual reduction in the unemployment rate was stable at around 0.55 percentage points per year. The economy seems to have had an irresistible force toward restoring full employment. There was high variation in monetary and fiscal policy, and in productivity and labor-force growth, but little variation in the rate of decline of unemployment. We explore models of the labor market's self-recovery that imply gradual working off of unemployment following a recession shock. These models explain why the recovery of market-wide unemployment is so much slower than the rate at which individual unemployed workers find new jobs. The reasons include the fact that the path that individual job-losers follow back to stable employment often includes several brief interim jobs, sometimes separated by time out of the labor force. We show that the evolution of the labor market involves more than the direct effect of persistent unemployment of job-losers from the recession shock---unemployment during the recovery is elevated for people who did not lose jobs during the recession.

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[During a recovery, unemployment seems little responsive to demand disturbances. Economic policy should focus on preventing recessions rather than trying to ameliorate their effects.]

11 Concluding Remarks

Why has the US economy recovered so consistently from every recession in the past 70 years? Our answer is that the labor market operates according to the principles of Diamond, Mortensen, and Pissarides, with one major new element: unemployment itself inhibits the rebuilding process that follows a recession that has caused a spike in unemployment. Strong negative feedback results in slow removal of excess unemployment.

Our view of the recovery of the US economy from a recessionary shock differs from the standard view. In the standard view, unemployment is high following a recessionary shock because there is a shortfall of demand. As time passes, demand recovers and unemployment returns to normal. Under the standard view, the reliable persistence of unemployment during recoveries arises from persistence in demand.

In our view, unemployment remains high after a recession and declines only gradually, because of frictions in rebuilding employment. These frictions impede both the individuals who lost jobs from the recession and those who did not, but found it more difficult to navigate the labor market.

According to this view of the labor market, the average level of unemployment depends on the frequency and severity of recessionary shocks. The natural rate of unemployment is not immutable. Instability arising from monetary policy shocks prior to the 1990s and financial shocks since then tended to elevate average unemployment, while long stretches of stability in the 1990s and 2010s demonstrated that the economy could achieve unemployment around 3.5 percent.