The 'New Normal' of Unemployment

by Dean Baker
Saturday, January 15, 2011 by the Guardian/UK

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?