Monetary and fiscal policies will never suffice to reduce long-term unemployment

One of the main policies to reduce long-term unemployment is an active labor market policy. The OECD publishes each year data on Government investments in labor market programs like training and wage subsidies. The term active programs is used to differentiate those measures from income support programs, like unemployment benefits, which are called passive labor market programs. The term passive is used to emphasize the fact that those measures do not act on employability or behaviour. They are nonetheless absolutely necessary. This is not the point.

Gemany and the Scandinavian countries are champions of active labor market policies. This is well known. But, less known  is the fact that the US are not. US investment in active labor market programs before the Great recession was below the OECD average, nearly 4 times lower: 0.16% of GDP vs 0.62%.

Source: Job Market Monitor with OECD date, % of GDP, US in red

It is generally admitted by labor economists that this is not the way out of the long-term unemployment trap.

In sum, an active labor market policy in an essential part of an employment policy. Left alone, monetary and fiscal policies will never suffice to reduce long term unemployment.

“Long-term unemployment rose dramatically during the recent recession and remains elevated. A primary cause may be the fact that more workers with inherently low job finding rates have become unemployed. This would suggest that the natural rate of unemployment has increased, and that additional monetary stimulus may have only a limited effect on reducing unemployment” write Andreas Hornstein, Thomas A. Lubik, and Jessie Romero in Potential Causes and Implications of the Rise in Long-Term Unemployment on richmondfed.org.

Source: https://www.richmondfed.org/publications/research/economic_brief/2011/pdf/eb_11-09.pdf

This increase in long-term unemployment is then of great consequences. It is an established fact that “ …the longer workers have been unemployed, the less likely it is that they will find jobs. This is called negative duration dependence” recalls Hornstein, Lubik, and Romero. This is also called the Hysteresis Effect.

“Data on workers who have been unemployed for fewer than 5 weeks, fewer than 15 weeks, and fewer than 27 weeks, …are consistent with negative duration dependence” as shown in Figure 2 reproduced below.

The authors conclude on the implications policy: “The natural rate of unemployment is the hypothetical rate of unemployment attainable in the absence of any distortions, such as impediments to the free adjustment of nominal prices and wages. The difference between the actual and natural rates is the “unemployment gap,” which represents the degree of slack in the economy.”

Shall we call that gap the surnatural or unnatural unemployment rate, the fact is “… that the prevalence of long-term unemployment is related to the decline in the exit rate from unemployment that occurs as unemployment duration increases. In addition, it seems that overall unemployment has increased because of the increased entry of workers with inherently low exit rates. After a long period of unemployment, affected workers may become effectively unemployable. If a large portion of long-term unemployed workers now finds it difficult to transition to employment, this suggests that the natural rate of unemployment may have increased, making the unemployment gap smaller than it appears. In this case, the level of unemployment may not be responsive to monetary stimulus, and inflationary pressures may be less constrained than it appears based on the unemploy­ment numbers alone. Policy options that increase the ability of unemployed workers to find work and reduce the costs of generating and maintaining employment relationships thus may be more effective at reducing unemployment than additional monetary stimulus.”

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Read More @: Potential Causes and Implications of the Rise in Long-Term Unemployment

Job Market Mornitor

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