From the September 2009 issue of Research Magazine • Subscribe!

The Leveling Recession

Unemployment and job destruction is probably the first small step toward standard-of-living equalization.

Economists often derive ironclad "laws of economics" from very small samples of data observed over a very short time period. Remember the Phillips curve, which postulated that unemployment and inflation are inversely correlated? That went out the window in the 1970s, when both inflation and unemployment soared. Nor did full employment over the past decade produce inflation until very late in the cycle.

The natural unemployment rate, i.e., the unemployment that will always exist in a dynamic economy because employees change jobs or have to be retrained to acquire a new set of skills, was set by some economists above 7 percent as recently as in the early 1980s. This quickly proved too high, but when the jobless rate fell below 4 percent in 2000, economists adjusted the natural unemployment rate sharply downward. Now, all of a sudden, the rate is at its highest level since 1983. Much of it is no doubt cyclical, but a large number of the 6.5 million jobs lost so far since the start of the recession are not coming back.

Another 'law' debunked by recent reality has been the link between wages and productivity. In the early postwar decades, productivity rose rapidly and so did wages. Then, in the 1970s, both stagnated. But in the last recovery, in 2003-2007, despite persistently tight labor markets, this relationship broke down. Productivity increased by around 5 percent over this time period, while wages were flat and, in the case of high school graduates and women, declined. Now that the economy is in a deep slump, hopes that wages will somehow catch up with productivity growth can be safely laid to rest.

Moment in History

Over time, labor behaves very much like other goods and services, responding to the supply-demand function, which is the only law of economics that always holds true.

After World War II, there was enormous pent-up demand after prolonged privation, whereas Europe, a key producing region, was destroyed and divided. During the war, U.S. plants saw an enormous expansion in capacity, and were now willing to satisfy this demand by shifting to civilian production.

American workers were in an enviable position. Their supply, reduced by war losses which reduced the workforce by 2 percent, was also limited by the country's closed borders. Workers could demand -- and get -- major wage increases, getting the lion's share of productivity gains seen during the 1950s and the 1960s. Even after productivity began to stagnate, the institutional framework of the labor market allowed workers to maintain their living standards.

Since the 1980s, deregulation spurred U.S. economic growth and produced full employment, but the ability of labor, especially wage earners, to get an equal share of the growing pie has diminished. There have been various reasons for it. For instance, the power of trade unions, which greatly increased when labor was in short supply, now evaporated. At the same time, there was an influx of foreign workers. As many as 12 million undocumented aliens live in the United States, but legal immigration has increased as well. According to the Census Bureau, after bottoming out in the 1970s, the percentage of foreign-born Americans has increased to nearly 13 percent and is headed toward the 15 percent all-time peak seen in the 19th century.

So far, immigration has been the most visible impact of globalization on U.S. labor markets. Other aspects of globalization have been seen in other parts of the economy, but the U.S. standard of living has not been dramatically affected. Meanwhile, the world has become a single market.

First, Pacific Rim countries emerged as major producers and, more recently, Eastern Europe, Latin America, China and India became integrated into the global economy. At the same time, technology became increasingly transferable, transportation got cheaper and more efficient and logistics were perfected with the use of information technology, allowing companies to set up production in remote corners of the globe as though it were next door.

Not surprisingly, businesses moved production where they faced lower costs and less stringent regulations. For several years now, Americans have been competing directly with workers in India and China, as well as with a variety of countries where labor costs are even lower. Technology increasingly determines productivity, so that foreign workers are quickly becoming almost as productive as their U.S. counterparts.

Wages are notoriously sticky on the way down. For a while at least, rigidities in the labor market -- including such systemic constraints as minimum-wage laws, price levels and costs of non-tradable services -- have prevented wages from being more equalized across what is now increasingly a single labor market. Such major systemic adjustments typically happen in recessions, and it looks as though the current recession will be a watershed.

The loss of employment in the United States has been dramatic, far surpassing recent recessions. After the dot.com bust and 9/11, 2.5 million jobs were lost in the early 2000s recession, and 1.5 million were shed in the early 1990s. Even the severe recession in the early 1980s saw a decline in jobs of 3 million.

Even though China lost about 20 million jobs since the advent of the global downturn, losses in the United States will have a far greater impact on the U.S. standard of living. Moreover, 70 percent of job losses over the past year fell on men, as higher paying manufacturing, construction and managerial jobs were destroyed.

Unemployment and job destruction is probably the first small step toward standard-of-living equalization. Additional -- and severe -- blows to U.S. wealth may soon be forthcoming, such as rising inflation and devaluation of the dollar.

Meeting Half-Way

It wouldn't be so terrible if the standard of living in China, for example, rose a great deal toward the current American standard of living, while that in the United States declined a little way toward China's. Many economists see this as a way of increasing overall global demand, giving Chinese consumers an opportunity to afford more American goods and services and helping everyone live a little better.

Unfortunately, the trend has actually been moving in the opposite direction. Much has been made of China's $600 billion stimulus package and a spree of bank lending, which has helped China maintain its breakneck 8 percent growth rates with the help of domestic demand. This could certainly work over the near term, but longer-term, Chinese workers will be hard-pressed to maintain their existing standards of living.

Modern technology is not only portable, it is labor-saving. It has been relentlessly eliminating and replacing jobs performed by humans. Technology either completely eliminated some previously common professions -- such as secretaries -- or greatly reduced the need for others -- such as supermarket cashiers or bank tellers. In manufacturing, labor-intensive processes are disappearing as well with the development of robots. Robotics is making tremendous strides, particularly in Japan, where the indigenous population is aging and declining. Soon, manufacturing may return to rich industrial countries -- minus manufacturing jobs for humans.

It is the same process that has occurred in the countryside over the past century, where the technological revolution occurred earlier. At the start of the last century, more than 40 percent of Americans were employed in agriculture, while by the start of the current one the share had shrunk to less than 2 percent -- who produce enough food to feed the rest of us and make the United States a major food exporter. In 1900, 60 percent of Americans lived in rural areas.

Only around 20 percent still do today. In the 20th century, the cities took the overflow of the population, and manufacturing and service jobs around urban centers provided employment to yesterday's farmers.

The question is where will people migrate and what kind of employment will they find if their jobs are increasingly taken by robots?

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past six years, 2004-2009.

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