Unemployment and the Demand Deficit

The U.S. economy’s ongoing malaise has had rather peculiar treatment in the news media. The persistence of high unemployment has been gotten plenty of coverage. But almost nothing is being said about why unemployment remains so high (other than some vague references to government debt and uncertainty). In fact, there is a rather straightforward explanation, although certainly not a happy one. Needless to say, it has nothing to do with government debt.

Like all recessions, the recession of 2008 was in part a vicious circle. Businesses saw sales weakening and responded by reducing investment and laying off workers. Laid off workers had to cut their spending, further weakening sales and leading to more cutbacks by business … and down we go. In a recovery, the process runs in reverse, albeit more slowly.

However, the 2008 recession was also associated with changes that may be permanent. Two, in particular, are having major effects on the economy: (i) the collapse of housing construction and (ii) the largely ignored change in that least glamorous of economic variables, the savings rate. Together, these two factors account for much of the continuing high level of unemployment.

The plight of the housing market has mostly been reported in terms of its financial effects: the collapse of housing prices and the tsunami of foreclosures. But it also had serious real sector consequences – home construction (and the employment associated with it) has drastically declined.

After the recession of 1991, home construction in the U.S. grew enormously. Between 1991 and 2005 (the peak of residential construction), housing starts per capita increased by nearly 75% (figure 1). By 2007 (the year before the recession), housing construction had fallen back to the early 1990s level. Since 2007, it has been cut in half.

Source: U.S. Census Bureau

The change since 2007 is another matter altogether. Between 2007 and 2010, the savings rate more than doubled.

While an increased saving rate may eventually be a good thing, it’s immediate effect is an enormous decrease in the purchase of good and services.¹ The increase in the saving rate since 2007 represents a loss in demand for U.S. goods and service of between 337 and 848 billion dollars (2.3% - 5.8% of GDP).²

Together, the decline in home construction and the increase in the savings rate account for a large share of current unemployment. Suppose that the housing construction per capita and the savings rate were still at 2007 levels. That would yield an increase in GDP of between half a trillion and a trillion dollars.³ Let’s be conservative and use the lower value. At the current level of labor productivity, this ‘deficit’ in demand and output represents over four and a half million jobs, nearly 3% of the workforce.⁴ Between 2007 and 2010, the number of unemployed increased by 7.75 million. These two factors alone account for (at least) 59% of this increase Without them, the 2010 unemployment rate would be 6.7% or less.

This situation is ominous because both reduced housing construction and the increased savings rate may be permanent. While it is likely that home construction will recover somewhat, there’s no reason to think that it will return the level of the decade prior to 2007. And a decrease in the savings rate would really make no sense at all. On the contrary, it is quite sensible for U.S. households to maintain the current savings rate – which is still not high by historical standards (see figure 2).

If these are, in fact, permanent changes to the U.S. economy, then reducing unemployment to a tolerable level will require an increase in demand from other sources, an increase large enough to offset this ‘structural’ deficit in demand.

Where might an increase in demand come from? Well, let’s first be clear about where is will not come from. Monetary policy will not help, for the simple reason that interest rates are already extraordinarily low. The Fed has already pushed short term rates to nearly zero. Some economists have urged the Fed to intervene more aggressively in long term capital markets. While this won’t do any harm (inflation is really not a threat), it’s unlikely to do much good either. In 2010, the ten year Treasury rate was already down to 3.22%, the lowest it’s been in half a century. There’s no reason think that even lower rates will have any effect. More than anything else, capital investment is driven by expected demand, and current economic conditions simply do not warrant an increase in capacity.

Export growth would be the painless way out. And in fact, thanks in part to the declining value of the dollar, there was strong export growth in 2010 – 11.7% compared to 2.9% GDP growth. Unfortunately, our largest trading partners have growth rates lower than ours, and the situation could deteriorate in 2011. In Europe (which buys over a fifth of U.S. exports), a number of countries have imposed austerity budget for the current fiscal year. (The budget cuts in the U.K, are particularly severe.) It’s difficult to see exports growing enough to make a large dent in the demand deficit.

That leaves government. There are, at least in principle, a number of policies that could reduce or even solve the problem. But they range from politically unfeasible to politically unimaginable.

A sustained program of capital spending is the most obvious one. And, in fact, the U.S. has a backlog of unmet needs that require public investment: rebuilding crumbling infrastructure, updating the power grid, and creating an energy efficient transportation system, to name a few. Unfortunately, U.S. politics and policy are going in exactly the opposite direction. Both at the state and Federal level, government spending in 2011 will probably be lower than in 2010 (which is almost certain to further increase unemployment).

Over the last two decades, the U.S. has experienced a striking shift in income to the very richest Americans.⁵ Since the savings rate tends to rise with income, returning to a more equitable distribution of income would increase consumption and thus lower unemployment. A reform of the federal tax code could accomplish this (in a revenue neutral way, if necessary). But of course an increase in taxes on the rich is anathema to conservatives.

Finally there’s the thorny matter of trade policy. In the last decade, U.S. imports as a percentage of GDP have risen from 11% to 16%, which almost certainly has hurt U.S. employment. The causes for this trend are not necessarily simple, but it’s safe to say that at least some of this increase is due to the shift of production to low wage countries. In principle, a rational trade policy could mitigate the problem. However, there is almost universal support among politicians of both political parties for free trade in general and the World Trade Organization agreements in particular. (And of course free trade is an article of faith for most economists.)


In political as opposed to economic terms, it is difficult to see any means of offsetting the deficit of demand that has developed in the aftermath of the 2007 recession. And it is difficult to see how a deficit in jobs will not become a permanent part of the U.S. economic landscape.