The Economy and You

The current recession is the worst since the great depression, and what really makes this recession scary is not so much how far we have to fall, but what will happen as we start heading back up. Two recent Business Week articles touch on two of the biggest challenges to a successful recovery.

The first article discusses the inflation risk inherent in any recovery. This recession was caused by a financial crisis, which severely restricted credit and impaired the functioning of our financial system. In order to prevent another depression (and stave off deflation) the Fed and the Federal Government have pumped enormous sums of money into the economy. Washington has pumped money in through tax credit, tax cuts, and good old fashion fiscal stimulus on an unprecedented scale. The Fed has lowered its target rate to almost 0% while at the same time turning loose a tsunami of government backed credit. In an ordinary recession these two actions would have produced a huge expansion of the money supply and would have caused levels of inflation that could bring an economy to its knees. What was different this time?

The credit crisis cut off the normal flow of funds to businesses and households. This dulled the effects of the economic stimulus, particularly those from the Federal Reserve (in economic-speak the money multiplier was significantly lower than in previous decades). The unique nature of this recession has required such extraordinary steps to prevent a depression because of the reduced flow of credit. The danger now is that the financial system is literally awash in money and as the economy begins to recover the blockages in the system will clear and a flood of money and credit will hit the economy. If this happens the recovery will be swift, but will likely yield another bubble and extremely high inflation. The trick is for the Fed to slowly siphon off the excess money and raise interest rates to prevent the flood of credit from hitting the system like a shot of adrenaline without choking the life out of the recovery. This is a very daunting task that historically has not been performed with precision.

The second article discusses the other side of the recovery equation: unemployment. The article points out that amid the highest unemployment rates in decades there are over 3 million unfilled jobs in the US. How can this be? The answer - structural unemployment.

To economists, not all unemployment is equal; in fact, there are four kinds: seasonal, frictional, structural, and cyclical. Seasonal unemployment is straightforward enough: some industries have seasonal ups and downs. Frictional unemployment represents typical job and labor mobility cycles and is generally very short-term unemployment. Structural unemployment represents unemployment caused by changing economic realities such as the rise and fall of industries and sectors of employment. Seasonal, frictional, and structural unemployment are always a part of any economy and comprise in varied proportions the natural level of unemployment. Cyclical unemployment occurs during the course of business cycles and is caused by recessions. This type of unemployment can be very long lived. A lot of the 8.9% unemployment right now is cyclical.

Now back to the original point, 3 million jobs remain open when unemployment is at nearly 9% reflects the fact that the landscape of our economy is changing with this recession. Too many professionals existed in fields such as construction and finance and they are now unemployed and will remain so for some time. At the same time fields like education and health care are still growing and they cannot fill all the jobs. This occurs because these are professional fields that require years of training and the newly unemployed financiers and contractors simply don't have the skills to fill these positions. The process itself is actually healthy for the economy in the long-run. We are matching employment to economic reality. The effect of this will be to prolong the high unemployment rate as the displaced workers get retrained. It is very likely that the natural rate of unemployment (NAIRU for all you economics students out there) is going to be reset to a higher level for a least a while.

What do these two factors mean for you? First and foremost, expect unemployment to continue to climb even as the economy bottoms out and then to fall slowly as workers are retrained. (If you have a child in college suggest a degree in education, medicine, engineering, or chemistry over finance.) Second, expect the recovery itself to be extremely slow. The Fed is likely to start pulling credit out of the system sooner rather than later keeping the recovery slow to avert disaster. The pain is likely to stop getting worse soon, but it's going to ache for a while!