The limits of economic policy
Are the financial markets in denial about how soon the recovery will come and how impressive it will be? Mohamed El-Erian, for one, thinks so, and he points to the unemployment rate as a key reason why things are not going to get noticeably better any time soon:
The unemployment rate will increasingly disrupt an economy that, hitherto, has been influenced mainly by large-scale dislocations in the financial system.
In just 16 months, the US unemployment rate has doubled from 4.8 per cent to 9.5 per cent, a remarkable surge by virtually any modern-day metric. It is also likely that the 9.5 per cent rate understates the extent to which labour market conditions are deteriorating…
Notwithstanding its recent surge, the unemployment rate is likely to rise even further, reaching 10 per cent by the end of this year and potentially going beyond that. Indeed, the rate may not peak until 2010, in the 10.5-11 per cent range; and it will likely stay there for a while…
This possibility of a very high and persistent unemployment rate is not, as yet, part of the mainstream deliberations. Instead, the persistent domination of a “mean reversion” mindset leads to excessive optimism regarding how quickly the rate will max out, and how fast it converges back to the 5 per cent level for the Nairu (non-accelerating inflation rate of unemployment).
The US faces a material probability of both a higher Nairu (in the 7 per cent range) and, relative to recent history, a much slower convergence of the actual unemployment rate to this new level…
The combination of stubbornly high unemployment and growing government debt will not play well.
I completely agree with all of this. The markets seem to be having difficulty adjusting from a happy world where the key unemployment number is the first derivative, to the current unhappy world where the key unemployment number is the sheer deadweight number of unemployed Americans, who aren’t spending and who are going to be a major drag on economic growth for the foreseeable future.
As for the possibility of a higher Nairu, we’re so far away from there right now that for the time being such discussions are probably academic. But clearly the higher that Nairu gets, the higher the tail risk of a stagflationary spiral — and the less that policymakers can do to get us out of one. Governments managed to avert the most disastrous consequences of the financial crisis. But they might be powerless in the face of the current global economic crisis.