THE BLOG
07/07/2010 01:43 pm ET Updated May 25, 2011

The Self-Inflicted Insanity of American Unemployment

News that the unemployment rate has fallen to a "mere" 9.5% seems to suggest an improvement in our dire economic prospects. The reality, however, is far grimmer, as the latest US Bureau of Labor statistics indicate. On balance, it would seem that the apparent "ignition" to the economy achieved in March and April through expanding employment, income, spending and production has somehow "sputtered" in May and June. This is indeed disturbing, since such sustained "ignition" is now necessary since fiscal policy is about to go into reverse.

There are many costs associated with high unemployment, both economic and social. They include not only daily income losses, which are catastrophic for most Americans, but also increased crime rates, family breakdown, increased incidence of mental and physical health disorders, increased alcohol and substance abuse and a generalized misery (See Bill Mitchell).

Yet despite the obvious pathologies created by long-term unemployment, bad policy continues to drive the Obama administration to perpetuate these trends. Worse, with polls indicating rising discontent with Democrat incumbents in the House and Senate, the President's political advisors appear to be recommending that the President ignore the advice of his economic team and press forward with deficit reduction ahead of job creation spending.

When Larry Summers and Tim Geithner come across as the voices of rationality, Houston, we have a problem. We actually think the public has a much more nuanced view of government spending than that suggested by President Obama's main political advisor, David Axelrod. He seems curiously more concerned about the deficit reduction fetishism of the country's corporate elites, including many establishment Democrats, than the views of the majority of Americans (see Michael Lind's excellent analysis).

To the extent that the public mood is in any way anti-spending and anti-deficit, as Axelrod recently suggested in a New York Times article, we would argue that such revulsion has less to do with deficit spending and more to do with ongoing perceptions of corporate predation and greed. Obama's fiscal policy stimulus has largely taken the form of extending and further entrenching inefficiency, financial subsidies and malinvestment in a bloated financial sector. All of this has real cost, in badly allocated resources, lost opportunity, and a further corrosion of the polity. Even though financial markets have stabilized, they are still under heavy assistance by the government and we have not dealt with the solvency problems. Banks have been posting profit, but gains largely come from exceptional cash inflows and financial subsidies. Suspicions of accounting manipulation (if not fraud) are also surrounding the valuation of their assets.

Any discussion of bailouts is generally limited to the dry, anodyne question as to their "costs" measured as a percentage of GDP. Such analyses ignore the more corrosive and significant political costs of a so-called "change" President perpetuating the manifestly unjust policies of his predecessors. In many respects, Obama may even go further if he persists down the road of cutting entitlement spending in both Social Security and Medicare, the Democrats' signature legislative achievements of the 20th century. Not even Reagan or Bush dared to go so far. Why bother, when the Democrats seem perfectly happy to self-immolate?

To a huge degree, fiscal stimulus has been politically discredited because the policies undertaken by the Obama administration (and the Bush administration before him) persistently refused to address the underlying cause of the problem: borrowers have not been able to meet the required payments on their mortgages. This requires sustaining their income and employment and, if necessary, drastically modifying their debt service burden. The whole boom of the 2000s (and more broadly the growth process that emerged at the in the early 1980s) was based on household borrowing and the continuation of negative saving trends (that is, household deficit spending). A good place to start recovery efforts, therefore, would be to change this method of economic growth.

Why hasn't this happened? Largely because policy makers across the globe (and, apparently, the President and his political advisors) remain in thrall to an ideology which has no basis in economic fact or established theory. It is, as the UK's head of the Financial Services Authority, Lord Adair Turner, remarked, a "cult." One of the central slogans of this particular cult is that while monetary policy is omnipotent, fiscal policy is utterly impotent and therefore wasteful.

Why do these cultists believe in the capacity of either real or nominal interest rate variations to produce full employment in all situations? We just went through a global financial crisis where interest rates failed to deliver us to the promised land, and instead aggressive fiscal stimulus had to be used to place a floor on asset prices, and to get them to bounce off the floor.

We often discuss the difference between "good deficits," which constitute proactive spending to bring down unemployment (and help reduce deficits by re-establishing growth), and "bad deficits," which arise as a consequence of misguided government attempts at fiscal austerity. Cutting unemployment insurance benefits, for example, will NOT reduce the deficit (unless we simply let a large number of the unemployed die or be forcibly deported so as to bring labor supply in line with current aggregate demand). Leaving aside this Swiftian solution, the deficit in that instance will go up because spending power will be diminished, unemployment will increase further and the automatic stabilizers will kick in. Japan's repeated misguided attempts at stop-start fiscal policy do not prove the futility of fiscal expansion. Rather, they demonstrate the futility of treating government expenditure as an isolated flow in the economy, whose withdrawal will somehow cause the deficit to go down.

That our President, his political advisors, and the members of Congress who resist extending unemployment benefits refuse to recognize this is clear evidence that the cult is severely deluded...still. Which brings us back to our unemployment rate, reflecting a fall that is more apparent than real. According to the BLS, the peak labor force participation rate in the previous growth cycle was 66.4 percent (January 2007) and it now sits at 64.7 percent after rising in early 2010 as workers were attracted by the positive employment growth. In the last month, participation fell by 0.3 percent, which amounts to around 712,000 less workers in the labor force in June 2010 than there would have been if the May 2010 participation rate had held.

Those workers join the ranks of the discouraged or hidden unemployed and should reasonably be added back into the calculation to assess the true unemployment rate. The decline in the unemployment rate merely reflects a decline in participation rates. It's less a bellwether of economic strength and more a cri de coeur of despair. The terrible constellation of housing data, retail sales, and unemployment trends since the end of April suggests a downturn in the second half economic outlook will look very grim indeed.

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