The Difficulties Of Reducing Long-Term Unemployment

Includes: DIA, QQQ, SPY
by: Antonio Fatas

Since the global financial crisis started, there has been a debate about how much of the increase in unemployment is cyclical versus structural. Arpaia and Turrini summarize the results of their analysis of the EU labor market in a recent Vox post.

They start by showing that there has been a significant shift in the relationship between vacancies and unemployment (what is known as the Beveridge curve) in many of the EU countries. This shift, combined with further analysis of how unemployment reacts to changes in labor demand, leads them to conclude that there has been a decline in the matching efficiency of the labor market in these countries. From their post:

"...a major drop in matching efficiency was recorded in 2009 in most countries. Unsurprisingly, matching efficiency has been falling mostly in the countries that witnessed a marked outward shift in the Beveridge curve, although some signs of stabilisation or even recovery are visible by 2013Q1"

They then try to understand the reason for matching efficiency to decline and they test several hypothesis: mismatch in skills, industry or regions. It is interesting that although the three play a role in the full sample none of them are statistically significant in the post-2007 period (only skills mismatch is close to being significant).

But out of the controls that they introduce in their regressions, there is one that shows up as a strong determinant of the change in labor market efficiency: the change in long-term unemployment. In other words, one cannot reject the view that a deep recession resulted in a large increase in cyclical unemployment that turned into long-term unemployment because of the duration of the recession and this has led to a decline in the efficiency of the labor market. This is not far from what Blanchard and Summers (back in 1986) labelled as hysteresis in the labor market when describing the performance of also European labor markets in the 70s and 80s. The added insight of Arpaia and Turrini is that the difficulty in reducing long-term unemployment is related to the effect that its high level reduces the overall matching efficiency of the labor market.

The role that long-term unemployment and hysteresis could be playing in the U.S. during the current crisis relative to more structural factors is also a source of debate. What is clear from the data is that the increase in long-term unemployment during this crisis is a lot more pronounced than in any previous crisis, which matches well the deterioration of other labor market indicators (such as the employment to population ratio).