The Incidence and Duration of Unemployment over the Business Cycle
The unemployment rate provides information on the number of people who are unemployed as a fraction of the labor force at any given point in time, but when it rises, it doesn’t tell us much about why. We can’t tell by looking at the rate whether people who are unemployed are staying unemployed longer or whether more workers have lost their jobs.
This distinction could be important because each of these causes could result in a different set of problems for the labor force. Long-term unemployment, for example, might lead to a deterioration in workers’ general or occupation-specific skills, which would reduce their productivity if they ever do find jobs. An economy in which 10 percent of the labor force was unemployed for three months and 90 percent was unemployed for one month would have the same unemployment rate as one in which 10 percent of the labor force was permanently unemployed all year round, but the implications for human capital would be quite different in each scenario.
To understand how much each of these factors contributes to a rise in the unemployment rate, we looked at inflows into unemployment (job separation rate) and outflows from the unemployment pool (job finding rate) for all postwar recessions. In general, we found that as the economy enters a downturn, separations start rising and unemployment durations start getting longer (job findings decrease). After some adjustment in terms of employment by firms, separations usually start to fall before the unemployment rate peaks. What accounts for most of the subsequent rise in the unemployment rate is the longer unemployment durations of those who are still unemployed. Once the economy finally starts recovering, durations get shorter as firms create new jobs and absorb some of the unemployed.
It seems though, especially since the 1990s, that longer spells of unemployment have become more important in explaining levels of unemployment than a rising incidence of separations. The “jobless” recovery of the early 2000s and the current downturn are two cases in point. In the past three recessions, the percentage decline in the outflow rate during the cycle has been well above the respective percentage rise in the inflow rate.
Alternatively, we can measure how much unemployment would have increased due to each factor separately. Since the beginning of the current recession, the unemployment rate has doubled, and almost 95 percent of this change is explained by the decline in outflows rather than the increase in inflows. Said differently, the sharp rise in unemployment that we have seen is not due primarily to a sharp rise in separations but rather to the fact that once unemployed, the chance of finding employment has fallen dramatically. This means that unemployment durations are getting longer.
One might argue that longer durations as a result of lower outflows may reflect a permanent mismatch of skills among the unemployed. Workers who are out of a job for a long time lose skills, and their human capital in general deteriorates. To the extent that this is true, we might expect to have an unemployment rate that stays relatively higher even after the recession. As a matter of fact, looking at every recessionary episode in the post-World War II era, we do see a positive relationship between the fraction of the unemployment increase that is due to a decline in outflows and the magnitude of the decline in unemployment during the recovery. Recessions where declines in labor outflows have been the dominant source of change in the unemployment rate exhibit somewhat more muted recoveries, though the relationship is imprecise. The correlation between these two measures is 0.31.
However, the exceptionally large declines in the outflow rate during the current downturn might just be due to the sheer magnitude and the duration of the contraction. By many different measures, the current downturn might end up being one of the most severe recessions we have experienced in the labor market. Similarly, it is likely to be become one of the longest contractions in employment, hence longer unemployment durations might just be due to the duration of the recession.