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How to Avoid a Depression: First Reduce Unemployment

11/21/2012 10:34 am ET | Updated Jan 21, 2013

By Nake M. Kamrany and Samuel Kosydar

The twin deficit this time is high unemployment and high deficit/debt. As the current fiscal cliff fiasco unfolds it is pertinent for the United States to reexamine its economic priorities. Despite the high unemployment that continues to beleaguer the U.S. economy, Congress's concerns have lately been fixated on the deficit and the growing national debt while the president pushes for more taxes on the rich. Unless further action is taken by the end of this year, taxes will rise and an array of government services will be slashed as mandatory spending cuts go into effect. This double shock of an increased tax burden and sudden reduction in government expenditures will have a disastrous affect on an already feeble economic recovery and may well spiral unemployment above 10 percent. Plummeting employment levels accelerated by these twin shocks may plunge the U.S economy into a depression. Considering the destructive consequences of the administration and Congress's approach, it is prudent to examine an alternative approach that addresses the most immediate threat to U.S. economic growth, i.e., sustained unemployment levels. Reducing unemployment is more urgent than reducing debt. Macroeconomic theory contends that ultimately a strong healthy economy with low unemployment and high government revenues will put the U.S. economy in the best position to then tackle its debt. Congress and the administration must take action, but this time must be doing just the opposite: cut taxes and increase government spending in order to stimulate the economic growth needed to lower unemployment.

Despite the administration and the Congress's good intentions, economic theory predicts that reducing government expenditures and increasing taxes, especially during these recessionary times, will significantly shock aggregate demand and push up unemployment. Aggregate demand is a function of consumption and investment, which represents the largest portion of the U.S. GDP, investment, and government expenditures, among other factors[1]. If taxes are allowed to increase and the current spending cuts are implemented, all three of these major categories of the GDP would take significant hits. Nevertheless, Congress, while gripped with the fear of debt, legislated $109 billion[2] in sequestrations, or mandatory spending cuts, that is due to go into effect this coming year. In addition, the Bush tax cuts, the payroll tax reduction, and the long term unemployment benefit extension will all expire at the end of this year[3]. In total, the tax hike is estimated to be a whopping $200 billion[4]. If Congress's current approach is carried out, the Congressional Budget Office estimates that the American economy will shed 2 million jobs[5].

Moreover, this current plan will not only result in higher unemployment but will also fail to control the growing national debt. Government revenues would shrink as unemployment swells and it would become politically more difficult for Congress to continue cutting government services upon which the ranks of the growing unemployed depend. Ultimately we'd be left with high unemployment and limited means to curtail our bloating deficits. Nurturing a healthy economy by reducing unemployment -- not debt -- should be the highest priority.

Unemployment has devastating economic and social consequences that in the short term are far more destructive for the U.S. than rising debt. The economic cost of unemployment is the goods and service that would have been produced at the full natural employment level. While it is too soon to analyze the long term costs of unemployment for the current recession, examination of past recessionary periods provides insight into the economic loss suffered. It is estimated that during the dot.com bust when unemployment swelled to 5.5 percent, the GDP loss due to reduced output was estimated at $509 billion for the period 2001-2003, and during the Great Depression with unemployment levels on average of 18.2 percent, the GDP loss was gauged to be an outstanding $2.3 trillion, or 30 percent of the GDP for the period[6]. Over the past four years unemployment has scarcely dipped below 8 percent and currently hovers at 7.9 percent[7]. Such sustained unemployment is particularly devastating as it erodes the human capital of our economy. The longer a worker is unemployed, the more skills lost and greater likelihood that he or she will be unable to find another job[8]. The social impact of unemployment is equally deleterious. Unemployment cripples confidence and is associated with increased divorce and suicide rates[9]. Elevated unemployment, both economically and morally, undermines our society's ability to function.

Debt, on the other hand, is not toxic in the short term. Although the national debt has dramatically increased over the last decade, a close examination of debt to GDP ratio shows that the U.S has endured even greater relative debt levels in the past. The U.S public debt as a percentage of GDP was estimated to be 73 percent for the fiscal year 2012[10]. This may seem large, however, during World War II the debt/GDP ratio soared up to 112 percent[11]. In fact, it was the admirable economic growth following the Second World War that enabled the U.S. to outgrow its debt[12]. Although the growth rate of U.S. debt is of concern, we must be cognizant of the consequences of pursuing a debt reduction policy without regards to its impact on employment.

In order to address unemployment, the administration and Congress must find the resolve to stimulate aggregate demand. Economic theory predicts that reducing taxes and increasing government expenditures will spur consumption, induce greater investment, and entice growth. Greater growth invites higher levels of employment[13]. Although such tactics may temporarily raise the debt, the economic growth brought on by rising aggregate demand will expand government revenues and shrink the deficit. No doubt the national debt level must be eventually addressed, but as a Gallop Poll found, Americans think the most important thing that can be done to improve the U.S. economy is to create more jobs[14]. Quality job growth is the biggest issue. Perhaps Congress should take its cue from the America people and focus attention on delivering greater employment-only then can we tackle the national debt.

Nake M. Kamrany I professor of economics at the University of Southern California and Director of Program in law and economics and a member of California Bar. Samuel Kosydar is an economic and science student at the University of Southern California and an executive committee member of the Global Income Convergence Group at USC.

Sources:
1, 6, 13. Macroeconomics. Samuelson, Paul and Nordhaus, William. 19th edition. pg 85.
ISBN: 978-0-07-334422-5