Thursday, August 20, 2009

When does unemployment return to normal? 

The graph above shows unemployment projections through three different scenarios calculated by Edward Knotek and Stephen Terry in the newest issue of the Economic Review of the Federal Reserve Bank of Kansas City. While unemployment fell quickly after recessions in the post-WW2 period, it did not in the last two recoveries in 1991-94 and 2002-05. Just using those last two recessions as benchmarks projects unemployment extending above 8% to 2012.

But Knotek and Terry also consider the effect of a recession accompanied by a financial crisis. In this case because the US has had few banking panics (particularly in the 20th century where data would be more available and more reliable), the authors depend on using experiences from European and Japanese recessions cum banking panics. That gives you the top line.

The authors warn about the possibility that the current recession may include an increase in the natural rate of unemployment. The banking crisis has caused overinvestment in housing and overborrowing in households, they speculate. If so, using expansionary fiscal and monetary policy is inappropriate and the stance of the current U.S. budget is too loose.

I'm not so certain that the U.S. banking system is like those the authors use to draw the pessimistic line. If the system is allowed to recover and develop unimpeded by the likes of Barney Frank and Christopher Dodd, I would expect a faster recovery. But it's quite certain this recovery is going to be longer and slower. I tend to use the term U-shaped, but a colleague gave me a great metaphor: a bathtub, with a very long period of slack economic activity.