I’m on to the macroeconomics section of my book in progress, Economics in Two Lessons. The key point of this section is that, whereas the academic economics profession has wasted most of the last thirty years on the project of founding macroeconomics on (some near approximation of) standard neoclassical microeconomics, the validity of the core results of neoclassical microeconomics depend on the assumption that the economy is operating at full employment[^1]. This observation isn’t original – it was why Keynes saw his theory as saving capitalism from itself. Even the title I used in this post on the macro foundations of microeconomics turns out to be a reinvention of the wheel.
Having noted the importance of the full employment assumption in the abstract, how relevant is it? If the economy is, with notably rare exceptions, at, or close enough to, full employment, then it seems safe enough for economists to continue, as the profession has for 40 years or so, to treat macroeconomics as a special subfield with little relevance to the rest of the discipline.
To put the question simply, are recessions abnormal?
Are recessions abnormal ?
Much economic discussion is based on the implicit assumption that the ‘normal’ state of the economic or business cycle is one of full employment, and that mass unemployment is a rare exception to this state. On this view of the world, recessions are temporary interruptions to a pattern of stable growth. The pattern of economic activity associated with a ‘typical’ recession is ‘V-shaped’, with two or three quarters of sharp contraction followed by an equally rapid expansion which restores the economy to something close to full employment. The widely-used informal definition of a recession as ‘two quarters of negative growth’ reflects this view.
There have, however, been lengthy periods when the economy has behaved quite differently. In deep depressions, however, such as those following the Wall Street Crash of 1929 and the Global Financial Crisis (GFC) of 2008, the contraction is sharper and the recovery, when it comes, is slow and fragile. Even after years of ‘recovery’ employment remains far below normal levels.
During the Great Depression the ratio of employment to population in the US fell from 55 per cent in 1929 to 42 per cent at the depths of the slump in 1933. Despite the expansionary effects of the New Deal, employment remained weak throughout the 1930s, with the ratio only reaching 47 per cent in 1940.
The same is true the ‘Lesser Depression’, which began with the Global Financial Crisis at the end of 2008 and has continued ever since. The ratio of employment to population in the US fell from 63 per cent to 58.5 per cent at the onset of the GFC. Despite years of ‘recovery’, the ratio has remained at or near that level ever since.
There have also been lengthy periods when recessions were consistently mild, so mild that many observers believed the business cycle to have ceased to operate. The longest such period began with the outbreak of World War II in 1939, and came to an end in the 1970s. This ‘long boom’ began when wartime economic planning mobilised all available economic resources. Most economists expected the economy to decline when the war ended, as had happened after World War I. However, under the influence of Keynesian economics, governments in the decades after World War II were committed to maintaining full employment and did so with substantial success.
The Keynesian system of economic policies ran into difficulties during the late 1960s. The 1970s was a chaotic period of high inflation and periodic high unemployment. In the mid-1980s, the economy began to recover, as the Federal Reserve developed new tools for economic management. Recessions continued to occur, as in 1990 and 2000, but they were relatively brief and mild. By the early 2000s, economists discerned a period of relative stability which was quickly christened ‘The Great Moderation’.
However, the Great Moderation turned out to be an illusion. Whereas the Keynesian long boom had lasted for decades, the Great Moderation was already over by the time it was ‘discovered’. The bursting of the Internet bubble in 2000 marked the end of strong employment growth in the US and much of the developed world. The GFC turned slow growth into sharp decline, followed by stagnation.
Taking these disparate periods into account, can we regard full employment as the normal state of the economy, subject to temporary interruptions associated with downturns in the business cycle? The evidence suggests that we can not.
Before looking at the business cycle, it’s important to observe that, even under the conditions normally described as representing full employment, around 5 per cent of the labour force is unemployed and actively looking for work at any given time. In addition, substantial numbers of workers would like to work longer hours while others would enter the labour force and seek work if they thought such a search would be successful.
In treating such a state as one of full employment, the underlying assumption is that, under these conditions, unemployment arises from difficulties in matching workers with jobs, rather than from a shortage of jobs in aggregate. (This will be addressed later on).
Turning to the cyclical data, the United States was the first country where systematic study of the business cycle was undertaken, and therefore yields a long series of data based on consistent criteria. The National Bureau of Economic Research was set up in the 1920s and has long been the source of official estimates of the start and end dates for recessions in the United States. According to NBER estimates, over the 100-year period since 1914, around 25 years have been spent in recession.
However, this classification is, in critical respects an underestimation. The NBER treats recessions as beginning when the economy starts contracting, and ending when economic growth resumes. This treatment works reasonably well for ‘typical’ ‘V-shaped’ recessions where the recovery phase restores full employment within a few quarters.
In deep Depressions, however, such as those following the Wall Street Crash of 1929 and the Global Financial Crisis (GFC) of 2008, economic weakness persists long after the end of the contraction phase. At least from the perspective of labor markets it would make more sense to treat the recession as continuing until the economy returns to its pre-crisis growth path. In particular, as long as the employment-population ratio is far below its pre-crisis level, implying the existence of large numbers of unemployed or discouraged workers, wages do not properly represent opportunity costs.
To see the implications of this, consider the NBER data separately for the periods before and after 1929. Before 1929, contractions and expansions were about equally long, so that the economy was in recession a little under half the time.
Now, in addition to the NBER data, treat the whole of the Great Depression 1929-39 and the years since the GFC as recessions. On that basis, the US economy has been in recession for about a third of the period since 1929, only a modest improvement on the period 1854-1929.
But even this is an underestimate. The post-1929 average is pulled up by World War II when the government actively worked to ensure that everyone capable of working towards the war effort did so, and by the period of Keynesian macroeconomic management from 1945 to 1970. If these periods are excluded, the proportion of time spent in recession is around 40 per cent.
To sum up, except when governments are actively working to maintain full employment, the economy is in recession almost as often as not. The idea of full employment as the natural state of a market economy is an illusion.
[^1]: Full employment doesn’t mean zero unemployment, since some people are always changing jobs, or are in the process of leaving the labor market. Roughly speaking, the employment is at full employment in the sense required here when any additional job creation in one sector of the economy is feasible only by attracting workers away from other sectors.