Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Saturday, October 2, 2010

Theory Ahead of Language in the Economics of Unemployment

The language used to describe economic phenomena is frequently laced with economic theory, even if we do not realize it.  Labelling a measure of GDP as "demand," for example, betrays an underlying theory. The same is true of a lot of the language that surrounds discussion of unemployment these days.

How is unemployment defined? Well, it depends. A lot of people seem to have their own pet definitions. That's fine. But let's stick to the way it is defined officially, by the people who collect these statistics; see How the  Government Measures Unemployment. (For a list of alternative measures, see here).

So this is how it works. You are asked in a survey whether you have done any paid work in the previous four weeks. If you answer yes, then you are counted as employed. If you answer no, then you are nonemployed.

If you are nonemployed, you are asked another question: Have you been doing anything in the past four weeks to find work (and if so, what)? If your job search activity is judged to be sufficiently "active," then you are counted as unemployed; otherwise, you are counted as a nonparticipant.
 
One thing that should strike you about this procedure is that workers are never asked whether they are unemployed or not. It's not up to them to decide.

Nonemployment consists of both unemployment and nonparticipation. What is the distinguishing characteristic between unemployment and nonparticipation?  Clearly, it is not joblessness. The distinguishing characteristic is active job search.  (The only exception to this appears to be the small number of workers on temporary layoff).

I think it is important to recognize this distinction and what it might mean for how we go about thinking about unemployment (and what might be done about it). A lot of people (including macroeconomists writing introductory textbooks) are fond of equating unemployment with idleness. But is it right (that is, might it be misleading) to equate active job search with idleness?

One frequently reads that "unemployment represents wasted resources." But if  job search is an information-gathering activity, designed  to locate a high quality job match, in what sense does such an activity necessarily constitute wasted resources? (Does the existence of single people in the marriage market also represent wasted resources?) If the unemployment rate were to suddenly plummet because a large number of workers aborted their job search activity--accepting crappy jobs, or exiting the labor force--is this a reason to celebrate? Should the Fed, in this event, breathe a sigh of relief?
 
To the extent that unemployment (as measured in the data) represents job search activity, it seems to me that the fundamental cause of unemployment is a matching friction. Evidently, people do not know the "location" (broadly defined to include, sector, occupation, etc.) of their best job match; and so, it makes sense to go looking for your "soulmate," rather than matching with the first thing that comes along. This suggests that a theory of unemployment should model these matching frictions explicitly. A sticky wage is not going to do the trick. A sticky wage may depress employment; if so, it leads only to nonemployment, not unemployment (there is no reason to search if you know that jobs are not available).

Thinking in this manner is likely to influence our views about policies designed to "cure" unemployment. For example, it suggests that extending UI benefits during a recession may be part of a desirable policy. The idea here is to encourage unemployment (job search activity); that is, to help people find jobs that match their skills (and to smooth their consumption over difficult times). On the other hand, it leads to some scepticism over the idea of the government simply "creating jobs" in a recession. It may not be that easy--we need the "right kind" of jobs--jobs that are well-tailored to individual skills. Perhaps the market is a better judge of which skills are needed and which are not.

Anyway, I could talk a long time about this and related labor market issues. But instead, I think it might be better to point you to a paper that does the talking for me. The article is by Richard Rogerson (recently moved to Princeton) and is called Theory Ahead of Language in the Economics of Unemployment (JEP, 1997). Here is an excerpt, to whet your appetite:
One unemployment concept that macroeconomists have used extensively is the natural rate of unemployment. In a search of the literature, I came across the following uses or definitions of this term. Blanchard and Fischer (1989), in their graduate macroeconomics textbook, first equate the natural rate of unemployment to the average rate of unemployment (p. 349), only to later equate it to the equilibrium rate of unemployment (p. 545). In their chapter of the Handbook of Labor Economics devoted to the natural rate, Johnson and Layard (1986, p. 921) write: ‘‘In this chapter we deal with unemployment in the long run. We do not bother about the movement of unemployment over the cycle, but only with its average level. In other words, we are looking at what we call the equilibrium unemployment rate. . . . This is what Friedman called the ‘natural unemployment rate’. . . .’’ Also in the Handbook of Labor Economics, Hall and Lilien (1986, p. 1021) write: ‘‘The natural rate is the normal unemployment rate that results from this process of labor allocation when workers and firms correctly perceive the levels and rates of change of price and wages.’’ Lilien (1982, p. 777) had earlier written, ‘‘Because it takes time for separated workers to be matched to jobs, some positive level of unemployment will always exist. Economists have long recognized this fact and have labelled this necessary quantity of unemployment the frictional, natural or equilibrium unemployment rate.’’ In his undergraduate textbook, Mankiw (1994) defines the natural rate of unemployment to be the steady state rate of unemployment, whereas in their undergraduate text, Auerbach and Kotlikoff (1995, p. 426) refer to the natural rate of unemployment as the ‘‘lowest sustainable rate of unemployment.’’ Bean (1994) defined the natural rate to be the equilibrium rate, whereas Christiano defines the natural rate to be the trend component of unemployment generated by the Hodrick-Prescott filter. Clark and Summers (1979) suggest that it is the efficient rate of unemployment, and Hahn (1980) defines the natural rate of unemployment to be unemployment at full employment.

If transitivity is assumed to hold, then the above list of quotations would tell us something like: long run = frictional = average = equilibrium = normal = full employment = necessary = steady state = lowest sustainable = efficient = Hodrick-Prescott trend = natural. It would seem doubtful that any concept that is sufficiently ambiguous as to promote this many different uses can be helpful in guiding scientific inquiry. I am by no means the first to question the clarity of this concept. Solow (1986, p. S24) has written, ‘‘[I]t is not clear what we are talking about when we talk about the natural rate.’’

In a larger context, the natural rate of unemployment was only one of many terms that were introduced supposedly to clarify key issues and lead the search for a theory of unemployment. Primary among the other terms were several decompositions of measured unemployment; there was equilibrium and disequilibrium unemployment, voluntary and involuntary unemployment, and frictional and cyclical unemployment. There was also the notion of full employment unemployment. Milton Friedman (1968) was adding to this list in his presidential address to the American Economic Association when he introduced the concept of the natural rate of unemployment. Much of this ‘‘language of unemployment’’ continues to be used today. Is this because these terms have turned out to be the precise and powerful concepts that facilitate clear communication and allow issues to be defined sharply? In this essay, I will argue that they are not.
The full article is available here: Theory Ahead of Language in the Economics of Unemployment.

11 comments:

  1. Though I like the post I think at this point:

    " A sticky wage is not going to do the trick. A sticky wage may depress employment; if so, it leads only to nonemployment, not unemployment (there is no reason to search if you know that jobs are not available). "

    you are omitting some sticky wage stories. Efficiency wage stories are stories where sticky wages result in involuntary unemployment but the source of the stickiness is from the demand side of the labour market. Workers do actively search exactly because at the prevailing (or lower) wages they want to work, firms though won't hire them at the lower wage (for the efficiency reasons) and have all they want at the (higher) prevailing wage.

    Similarly a shock leads to layoffs instead of lower wages for everyone by the choice of the firm, not the employees. The firm believes it is better to fire its least productive workers than make its most productive upset and more likely to quit (say in the future when the labour market recovers).

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  2. Adam P:

    The efficiency wage theory can no doubt be construed as a theory of a type of unemployment. How the theory maps into measured unemployment data, however, is a different matter.

    To see whether unemployment (as it is measured in reality) exists in a model, we have to ask how the nonemployed agents in the model would fill out a standard labor force survey.

    In a neoclassical model, the nonemployed would never report themselves as actively searching for work. This is why there is no unemployment in a neoclassical model (and this is true whether wages are sticky or not).

    Would the nonemployed agents in an efficiency wage world report themselves as "actively searching for work?" Maybe. But probably not. The problem, in that model, is that work is rationed -- there is no need to search for better opportunities because they are not out there.

    Note: how we label such workers has no consequence for policy. The nonemployed agents in an efficiency wage model may still need help.

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  3. David,

    I, in principle, agree with what you say in your response (as I basically like the post). The efficiency wage story generates involunatry nonemployment, this is distinct from unemployment (as requiring active search).

    That said, I don't think your response makes the critiqued passage correct. Effeciency wage models don't need to endow workers with information as to whether or not there are any opportunities out there. You can have search frictions in the model or not, regardless of how wages of the employed are set.

    After all, you began that paragraph by saying:

    "To the extent that unemployment (as measured in the data) represents job search activity, it seems to me that the fundamental cause of unemployment is a matching friction."

    My point was that there can be search frictions but that doesn't make them the fundamental cause of the unemployment. In an effeciency wage world, with search frictions, workers would continue to search, all the while believing that they haven't been hired because they haven't found a match yet.

    Furthermore, such models still have labour turnover within those that are employed. There continue to be job separations and job matches so the group that is employed continually changes members. Thus, the unemployed are correct to keep searching. Each unemployed worker who continues to search long enough eventually finds a job, yet in aggregate you have involuntary unemployment, perhaps a lot of it.

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  4. Adam P:

    I don't want to beat a dead horse, but here is how I think about it. Imagine that there are no matching frictions. Then devoting time to job search is pointless. Ergo, unemployment (as conventionally defined) cannot exist. It follows that matching frictions are fundamental to any theory of unemployment.

    Now, I am not sure that this is entirely correct. In an efficiency wage model, nonemployed workers queue for jobs. If the LFS interprets "queuing" (waiting) as a sufficiently active form of job search, then they will be counted as unemployed. But apart from workers on temporary layoff, I do not think that standard LFS questions would register these folks as unemployed. But maybe I'm wrong.

    As for your use of the label "involuntary" unemployment, I do not find it very useful. To see what I mean, please read Rogerson's paper. There is a voluntary/involuntary aspect to most time-use categories. Indeed, I sometmes think that it makes more sense to think of involuntary employment, rather than involuntary unemployment. After all, for most of human history, people have wanted leisure, not work!

    Thanks for your comments.

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  5. "It follows that matching frictions are fundamental to any theory of unemployment."

    yes, they are fundamental to the existence of measured unemployment, as I've already agreed.

    The frictions are not necessarily fundamental the level of unemployment or to anything interesting about whether or not a particular level is desirable and what can be done about it if it's too high.

    So I agree that you're point is trivialy correct, I had just mistakenly assumed you were trying to say something interesting.

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  6. David: Yep. Good post.

    IMHO, we should *not* start out by defining the natural rate of unemployment. Instead, we should start out by defining "natural rate model". Because if you don't have a natural rate model, it makes no sense to define NRU. Plus, each NRM will generally have its own, peculiar, concept of NRU.

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  7. Great reminder, thanks. On the "demand" comment: not just words, a question of what we measure. As I recall, Canada has always been clear that when we report Y as the sum of C, I, G, and NX, it's GDE: Gross Domestic Expenditure. In the US, they say GDP, but it's really GDE. They're conceptually different, even in theory, as Tim Kehoe and Kim Ruhl keep reminding me.

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  8. Nick: Agreed. (Though the principle you suggest is violated all the time).

    Dave: Welcome! (I've been enjoying your NYU pages on the financial crisis). Can't say that I understand entirely what you are saying here though. I thought that GDE, GDI (or whatever) are equivalent by the conventions adopted by NIPA accountants.

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  9. what an interesting post!

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  10. Indeed, unemployed is not just what it is but it has a lot of types as well. And as far as I'm concerned, the unemployment rate here in the US was reported at 9.6 percent in October of this year. It's quite high because we are currently experiencing an economic crisis. There are a lot of job seekers in town, but still they are unemployed.

    In order to help them, here are certain workers' compensation claims management groups that provide workers' compensation program for those who are unemployed and want to get a job for them to live.

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