The Economics of Recession: A Survey
Part 5/10, October 2022 [1]
Arturo Estrella

5. Labor market effects of recession

          When economists look at a single variable to represent the effects of recession, they frequently turn to real output, as in the two-negative-quarters rule and the OECD individual country indicators. However, the adverse effects of a recession on the labor market are significant and also clearly related to the level and growth of real output. In fact, we have seen that the level of employment figures prominently in the list of variables tracked by the NBER and the CEPR. From a labor market perspective, the key problems during recessions are involuntary unemployment and loss of labor income.

          Classical economic theory with flexible prices and wages has traditionally found it difficult to model involuntary unemployment in general and in particular during recessions. In contrast, the standard textbook approach to involuntary unemployment assumes that wages and prices are sticky, which results in recessionary unemployment if wages do not adjust sufficiently during recessions for the labor market to clear. Roberts [R23] bridges this gap by proposing a model that shows that inefficient “recessionary unemployment” is possible in theory even with wage and price flexibility.

          A common thread in much of the empirical literature on recessionary unemployment is an attempt to quantify the costs of the inefficiency it generates within the business cycle. Clark, Leslie, and Symons [R24] calculate the labor markets costs of recession by estimating the amount of income that a representative household would be willing to give up to avoid recessionary unemployment. Robert E. Lucas (1987) had performed a similar exercise with a somewhat different measure of cost and had concluded that the amount of income forgone was negligible.[2] In contrast, Clark et al. find that the amount a household is willing to give up is economically significant, with the implication that recessions produce of a large social cost through labor unemployment. The authors trace the difference between their results and those of Lucas to the respective definitions of loss from uncertainty. Lucas estimates the income that households would give up to eliminate cyclical fluctuations, whereas Clark et al. estimate a combination of the fall in expected consumption attributable to unemployment risk and a risk premium associated with household risk aversion.

          Macroeconomic models that assume sticky wages often invoke theoretical motivations such as union negotiations, implicit labor contracts, and efficiency wages. Bewley [R25] takes an empirical approach to the search for an explanation of sticky wages. In this reading, he summarizes the results of an extensive survey of “more than 330 business people, labor leaders, counselors of unemployed workers, labor market intermediaries (headhunters), labor lawyers, and management consultants” to try to ascertain why wages are sticky. The full results are presented in a book (Bewley 2002) with the suggestive title “Why Wages Don’t Fall during a Recession.”[3] The main conclusion of this research effort is that rigidity comes from management, not from workers, in an attempt to preserve morale. Managers in the survey found it preferable to fire workers during a recession rather than cut their wages and leave them disgruntled with the possibility of affecting the morale of others as well.

          The next two selections involve the use of longitudinal surveys to trace the long-term effects of recessions. Kahn [R26] examines “The long-term labor market consequences of graduating from college in a bad economy.” Data are obtained from a longitudinal survey of youth in the United States that includes tracking of the experience of white males who graduated from college between 1979 and 1989. The results are far from encouraging, suggesting that students graduating in a “worse economy” tend to earn less when they enter the labor market and tend to settle into lower-level occupations.

          Davis and Wachter [R27] examine U.S. Social Security longitudinal records from 1974 to 2008 for evidence of cumulative earnings losses resulting from job displacement. Their principal finding is that earnings losses from job displacement during recessions in the sample period, as represented by episodes in which the national unemployment rate was above 8 percent, are twice as large as losses from mass layoff events when the unemployment rate is below 6 percent. In their estimates, involuntary unemployment always brings a significant cost to wage earners, but the effects are clearly more troubling if they occur during a period of high unemployment such as a recession.

Readings referenced from book The Economics of Recession

R23    John Roberts (1987), ‘An Equilibrium Model with Involuntary Unemployment at Flexible, Competitive Prices and Wages’, American Economic Review, 77 (5), December, 856–74

R24    Kenneth Clark, Derek Leslie and Elizabeth Symons (1994), ‘The Costs of Recession’, Economic Journal, 104 (422), January, 20–36

R25    Truman Bewley (1999), ‘Work Motivation’, Federal Reserve Bank of St. Louis Review, 81 (3), May–June, 35–49

R26    Lisa B. Kahn (2010), ‘The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy’, Labour Economics, 17 (2), April, 303–16

R27    Steven J. Davis and Till von Wachter (2011), ‘Recessions and the Costs of Job Loss’, Brookings Papers on Economic Activity, 2011 (2), Fall, 1–55

[1] The original version of the survey was published in The Economics of Recession, Edward Elgar Publishing, 2017.

[2] Robert E. Lucas (1987) Models of Business Cycles, Oxford: Basil Blackwell

[3] Truman F. Bewley (2002) Why Wages Don’t Fall during a Recession, Cambridge, MA, USA: Harvard University Press