The Almost-Recession: A Simple Mistake and its Economic Ramifications

The Almost-Recession: A Simple Mistake and its Economic Ramifications

In recent times, renowned economists have sounded the alarm, asserting that the sole solution to tame inflation would be to increase unemployment, essentially inducing a recession. Former Treasury Secretary Lawrence Summers, for instance, prognosticated last summer that we would require five years of unemployment rates above 5 percent. Consequently, every robust jobs report became paradoxically disheartening, serving as a harbinger of imminent financial distress.

Yet, according to the latest official data, inflation has significantly subsided since last summer, despite the unemployment rate remaining low. It appears that conquering inflation may not necessitate throwing millions of Americans out of work. A recession seems increasingly remote, and the question arises: Where did the pessimistic forecasters go wrong?

The underlying premise of the notion that a recession was indispensable to combat inflation was rooted in a specific assumption—the labor market was excessively tight. During the initial two years of the pandemic, employers faced challenges in hiring the desired number of workers, resulting in an unsustainable surge in wages. The crucial qualifier here is "unsustainable." While wage growth is typically celebrated, it can spur hazardous inflation if it occurs too rapidly and endures for too long. This can transpire in two ways. Firstly, when employers are compelled to pay higher wages, they pass on the increased costs to customers through elevated prices. Secondly, if companies fail to recruit enough workers, they may struggle to meet the demand for goods and services. With an excess of money chasing a scarcity of goods, prices surge further.

Summers and other economists viewed a recession as the only remedy for this predicament since they believed that the economy had essentially reached full employment. Although unemployment was not literally at zero, economists typically perceive unemployment as having a lower threshold, below which a scarcity of workers leads to accelerating wage growth and inflation. Historically, a 3.5 percent unemployment rate is considered remarkably low, leading many economists to conclude that we were nearing this lower bound. Consequently, the only means to cool the labor market would be to reduce firms' demand for workers. The primary approach employed by the government to achieve this is raising interest rates. As borrowing money becomes more expensive, the demand for goods and services dwindles, and employers require fewer workers. Given the significant imbalance in the labor market by 2022, it was highly likely that interest rates would need to be increased until a recession was precipitated.

However, this argument holds true only if we consider the official unemployment rate as an accurate gauge of available workers. Summers and other economists who predicted a recession believed that there were no further potential workers who could be enticed into the labor market through improved opportunities. Yet, the unemployment rate fails to encompass everyone who is jobless; it excludes individuals who are not actively seeking employment. This distinction is sensible for retired individuals, full-time students, and others who genuinely opt out of the labor force. However, retirees and students are not the sole adults who are out of the workforce. Numerous individuals would seek employment if the opportunities were enticing enough. Workers like these could alleviate pressures in the labor market, as more people entering the workforce would translate into more available workers to fill job openings.

Recent economic data unequivocally highlight that the unemployment rate significantly underestimated the pool of available workers. Despite the official figure remaining at historically low levels, four million individuals have secured jobs over the past year. The labor market was in better shape than anticipated, with both inflation and wage growth decelerating. This did not necessitate several years of elevated unemployment, as Summers had suggested. On the contrary, the economy continued to generate jobs.

In the context of an unprecedented global pandemic, economists, including myself, are prone to errors. It is crucial to acknowledge that this particular misstep has occurred before. After the Great Recession, many economists believed that the proportion of individuals unwilling to work had permanently increased. Various reasons were posited, ranging from health issues to the allure of high-quality video games. However, as the recovery progressed, more and more people returned to the workforce, disproving the pessimistic predictions about the labor market year after year. Wages increased at a pace that improved living standards without fueling inflationary pressures.

The inclination of leading economists to lean toward excessively pessimistic views of the labor market poses a problem. If the perspective espoused by Summers had prevailed, the Federal Reserve might have felt compelled to thrust the country into a recession, resulting in avoidable and widespread suffering. The encouraging news is that the ongoing improvements in labor supply bode well for the possibility of a soft landing. The employment rate among prime working-age adults remains below its peak in the late 1990s, indicating that the workforce still has room to grow. This is not to attribute the slowdown in inflation entirely to labor supply, nor to suggest that we could have achieved this outcome without interest rate hikes to curb demand. Inflation still exceeds desirable levels, and in an era of continuous economic surprises, any forecast must be approached with humility. However, the more supply contributes to the equation, the less demand needs to intervene—and the lower the risk that the Fed will need to push the economy into a recession to quell inflation.

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