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Long-term scarring of hysteresis on employment

By Michael Konczal

Imagine having a fever so bad that it permanently raised your body temperature. Now think of the current unemployment crisis, with new numbers being announced today of a steady 9.6 percent unemployment rate, functioning at the same way.

Thinking in terms of "natural" is very, well, natural to us. Some think we are hard-wired for it.   And it is a useful concept in many ways. Our body has a natural body temperature. We get shocked by disease and sickness. This raises our body temperature, but eventually we'll heal and our temperature will go back to the "natural" rate.

This type of thinking piggybacks onto our thinking about unemployment. It is standard that economists now believe there is a "natural" rate of unemployment. Our economy takes a shock from a financial crisis, a shift in demand, etc., and the unemployment rate rises. But eventually we'll heal and our unemployment will go back to the "natural" rate.

But what if it doesn't? What if periods of high unemployment scar the economy in such a way that it raises the permanent unemployment rate? What if periods of high unemployment lead to reduced wages and higher unemployment years down the line? This is what is known as hysteresis. (Ezra has written about hysteresis here.)

The economy right now is performing an experiment in this very thing, and the results are not promising. Let's look at a few key charts on this from the Hamilton Project's "An Economic Strategy to Renew American Communities" (pdf).

It starts by reproducing this chart from "Long-Term Earnings Losses due to Mass Layoffs During the 1982 Recession," a 2009 paper by von Wachter, Till, Jae Song and Joyce Manchester.

And this summary of some of the ill effects of hysteresis and unemployment:

Figure 1 summarizes evidence from a study that compares the earnings trajectories of workers who lost their jobs in a sudden mass layoff in the early-1980s recessions to workers who maintained their jobs throughout those recessions (von Wachter, Song, and Manchester 2009). Prior to the recessions, the earnings of displaced and nondisplaced workers followed a similar pattern. After the recessions, however, displaced workers faced devastating long-run earnings losses. Even in 2000, almost twenty years after the 1980s recessions, a sizable earnings gap remained. According to the study, the net loss to a displaced worker with six years of job tenure is approximately $164,000, which exceeds 20 percent of the average lifetime earnings of these workers. These future earnings losses dwarf the losses associated from the period of unemployment itself.

Beyond its effect on workers’ earnings, job loss also has negative economic and noneconomic effects on workers health, their families and their communities. Men with high levels of seniority when they are displaced from their jobs experience mortality rates in the year after unemployment 50 to 100 percent higher than otherwise would be expected (Sullivan and von Wachter 2009). These elevated rates of mortality are still evident even twenty years after the job loss and may reduce these workers’ life expectancies by twelve to eighteen months for a worker who loses his job at age forty.

The children of these workers also appear to suffer. Children whose fathers were displaced have annual earnings about 9 percent lower than similar children whose fathers did not experience an employment shock (Oreopoulos, Page, and Stevens 2008).

Young people are penalized for entering the work force when their local labor market has high rates of unemployment. Students entering the labor market during times of economic distress earn considerably less than their peers elsewhere, even ten years after leaving school (Kahn 2010; Oreopoulos, von Wachter, and Heisz 2008).

Michael Greenstone and Adam Looney continue to look at other measures of the 1982 recession by location. What they find is that areas that are hard hit never come back.

They also provide the economic theory with what is supposed to happen to make these values converge, and how it breaks down:

Blanchard and Katz (1992) describe the adjustment process in technical terms: “Shocks to labor demand first lead to movements in relative wages and unemployment. These in turn trigger adjustments through both labor and firm mobility, until unemployment and wages have returned to normal.” But, in more personal terms, the story is that when good jobs disappear, local wages stagnate and fall behind wages elsewhere. Workers looking for better jobs search more broadly for work and relocate for work, taking their families with them. The population falls and ages: families leave, young workers graduating from school move to new communities to start work, and older workers and retirees stay put. As workers leave and put their homes on the market, land prices depreciate relative to elsewhere.

An optimistic view is that these changes -- declining wages and falling land prices -- will ultimately spark a renaissance by attracting new businesses and providing new residents with better homes at lower costs. Indeed, in cities like Buffalo it is economic factors like these that are attracting businesses and families, especially those looking for more-affordable homes and a lower cost of living. But this path of adjustment is clearly a costly one, and stabilization takes
many years. That a recession could temporarily cause these impacts is not surprising. The fact that its toll remained and by some measures was greater a quarter-century later, however, is sobering.

And the unemployment we are going to be seeing over the next few years could leave a generation of Americans permanently scarred, with what we grow to consider "natural" far below the potential for the economy.

Mike Konczal is a fellow at the Roosevelt Institute. He blogs about finance, economics and other topics at Rortybomb and New Deal 2.0, and you can follow him on Twitter.

By Michael Konczal  | November 5, 2010; 10:36 AM ET
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