Falling Demand in 2008 May Have caused this Recession, Yet Demand Stimulation Might Not End it Now

Since the start of this recession and slow recovery, there has been an ongoing debate about if their depth and duration are due to lack of demand or some other factors.  I’ve read a number of interesting blog contributions on these questions of late and wanted to share them.  I think they suggest blunt stimulation of aggregate demand may not help the unemployed that much, because at least now lack of demand is not the main problem.

First in The Short Run is Short Eli Durado makes a point on these issue and why monetary stimulus as the fed is pursuing may not be very effective though lack of demand was the initial problem:  it isn’t now.  This would mean the fed’s new stimulus is much too late to be effective:

If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

The point being that even  if this recession started out as a response to lack of demand and remained so, prices and wages should have fallen by now to clear the market (PUT WORKERS BACK TO WORK).  Unemployment due to lack of demand is a short-run phenomenon.  Is the short-run over after 4 years?

Obviously, there is no signal that is fired to let everyone know that the short run is over, so reasonable people can disagree about how long the short run lasts. But I think there is good reason to think that the short run is over—it is short, after all…

Around 40 percent of the unemployed have been unemployed for six months or longer. And the mean duration of unemployment is even longer, around 40 weeks, which means that the distribution has a high-duration tail.

Now, do you mean to tell me that four years into the recession, for people who have been unemployed for six months, a year, or even longer, that their wage demands are sticky? This seems implausible…

So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment

The Short Run is Short
Tue, 18 Sep 2012 13:54:26 GMT

He goes on to suggest:  that a lack of demand may have been the initial pulse that kicked of the recession and maybe it could have been offset by aggressive monetary actions at that time, but now the adjustment to that impulse has concluded.  The duration of the recession may be due to follow-up effects of the recession that can’t be offset by monetary (or fiscal for that matter) stimulus now.

So what about the duration of this recession?  It is part of a trend that has been evident in the last 3 business cycle as discussed in Countercyclical Restructuring and Jobless Recoveries.  This graphic (found in the paper  here) was really interesting:


That top graph represent the ‘average’ behavior of Total Hours and Employment following the trough of business cycle prior to the 1991 recession.  The colored lines below that line represent the %change at the same number of months from the trough.  That the recovery of both hours worked and employment has so clearly been much slower following the bottom of recession in recent recessions.  This recession isn’t necessarily the most slow in its recovery.

So why the change?  It may be because firms are more able to respond to recovery and demand for their product without expanding their labor force.  This in turn is because the recession caused the layoff of the least productive works, and thus the firms ability to expand is not hindered by fewer workers for a long time.  Or in the authors word:

…firms grow “fat” during booms but then aggressively restructure their workforce during recessions. In the model, fi…rms employ unproductive workers because learning about match quality takes time and because adjustment is costly. In recessions, firms shed [these] unproductive workers…  Firms enter the recovery “lean and mean with a greater ability to meet expanding demand without hiring additional workers.

Why is this effect so important now?  Firms may well be better at distinguishing the productivity of workers the author suggests.

It would seem to me that the problem may also be that changing demands on the employee are simply rendering more workers not able to offer what employment demands any more.  The long recovery time may just be a sign, that workers being left behind in skills are let go during recession and it takes a long time for the economy to generate sufficient demand for labor to make a place for these folks.  This is an increasing problem and thus the long drawn out recoveries.

The large number of long-term unemployed workers is consistent with this idea.

In any case, both of these articles suggest that stimulation of ‘demand’ may not be an appropriate response to the slow recovery EVEN IF DEMAND WAS THE INITIAL PROBLEM.


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