The Leveling Recession

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.