In an effort to emphasize the “demand side” nature of the current recession, many economists have drawn clear lines of distinction between “structural” unemployment and that caused by “inadequate demand.” The attempt to distinguish caused some to lose sight of what “structural” unemployment really means in the context of the current business cycle. The truth is that “structural” and “demand driven” unemployment are two sides of the same coin. This also means, however, that “structural” advocates should stop stressing the relevance of concepts like “skills mismatch” and “zero marginal productivity” (ZMP), because the core of the problem is not lack of employability.
What brings me to make this argument is Peter Lewin’s comment on Edward Lazear’s WSJ op-ed. Lazear points out that, while the bulk of cyclical unemployment impacted a tight range of industries, it’s these same markets that have been seeing a rise in the pool of labor as unemployment falls. He suggests that the culprit is lack of growth, not the inflexibility of movement of labor between industries. Lewin is somewhat skeptical, because his explanation of the cycle is “structural” and there is evidence that resources had been misallocated during the boom.
If they were debating, I’d say that Lewin and Lazaer are talking past each other — but, this is essentially what’s occurring within the profession. I agree with Lewin that the cycle is characterized by the re-allocation of resources, responding to a previous period of malinvestment. But, this doesn’t mean that long periods of high unemployment are caused by large quantities of labor not having skills in demand. If this were the case then we’d also have to ascribe the same degree of rigidity to the use of capital goods, where capital goods in current form provide no use for what firms are looking to produce. Production decisions, though, have to consider income expectations and weigh these against the costs of production. If there is a “skills mismatch” the entrepreneur has to decide whether it’s worth the cost to re-train (much like she has to decide whether it’s worth the cost to scrap a certain capital good and manufacture the one she needs). Oftentimes, entrepreneurs simply have to choose to produce between a range of outputs dictated by the current state of inputs.
Both Lazaer and Lewin are right. Entrepreneurs have to allocate resources, including attracting labor. The allocation decision is made on the basis of profit and loss. This causes a lot of entrepreneurs to invest where there already exists a willing and able pool of labor. The question is, why hasn’t this investment taken place?
Here, the more traditional explanations for unemployment come into play: wage rigidity, ZMP, et cetera. All these probably have some influence on the rate of unemployment. I think that another proximate cause has much more explanatory power in this current recession, though: an “underemployment” equilibrium. That is, where a “fixed” (used in a relative sense) stock of firms, which prefer to higher less labor at a higher price, because they expect higher productivity (rather than more labor and a lower price). If I’m right, then Lazaer’s argument holds a lot of weight. If there were more investment — more entrepreneurs, more (or larger) firms, et cetera — then there would be higher demand for labor.
Why is there “inadequate demand?” I blame an illiquid banking sector.
In any case, we can apply the same argument to comment on the recession, in general. It was caused by a misallocation of resources, led on by “phantom profits,” and as such the recovery is characterized by changes in resource allocation. In this sense, we’re talking about a “structural” problem. At the same time, the decision to invest is a decision to demand, and an economy where the necessary re-allocations aren’t taking place is an economy beset by “inadequate demand” (more accurately, depressed production).