The labour market and the downturn

The Australian economy is entering a period of below average economic growth, a definite downturn in the business cycle. This downturn may well be a recession, with total production (real GDP) falling. The biggest danger of this recession is unemployment, with the number of unemployed set to rise rapidly to levels that haven’t been seen since the early 1990s recession. Are current policies doing enough to help the labour market get through the downturn?

The economic forecasts are dim. Even with the recent stimulus package Treasury predicts that economic growth will slow to 1 per cent for 2008-09 and then 0.75 per cent in 2009-10. Output contracted by 0.5 per cent in the December quarter according to the first estimates. Yet the situation won’t be as bad as in many other industrialised countries, which the IMF expects will contract by 2 per cent on average in 2009, with global growth slowing to just 0.5 per cent. The turmoil in global financial markets and synchronised recessions in many trading partners are ongoing negative shocks to both our banking system and net exports. Although unemployment will increase, the government and Reserve Bank have been doing what they can to minimise the damage through interest rate cuts and fiscal stimulus packages.

Labour market prospects

A recession is as severe as the unemployment it causes. Higher unemployment reduces consumer incomes and confidence further, with some external or government stimulus usually needed to generate an economy recovery. The unemployment rate rises swiftly in a recession and remains high for some time afterwards. Unemployment typically takes longer than economic growth to recover because employers only hire new staff once they are sure the upturn will last and they can afford to keep them. The average duration of unemployment and the number of long-term unemployed also rise in recessions, and while these people are out of work they miss out on experiences and skill development provided by the adjusting economy, making it harder to find jobs once the economy recovers (a process called hysteresis). These dynamics can be seen for the early 1980s and early 1990s recessions in Graph 1.

Graph 1: Australian trend unemployment rate, Feb 1978 - Jan 2009 (Source: ABS).

Unemployment is already rising now. There were 598,600 unemployed workers in January, with three-quarters looking for full-time work, up from 502,400 a year earlier. The number of unemployed is now at January 2006 levels, which was still part of the boom period. Unemployment has much further to rise. The unemployment rate hit a 34-year low of 3.9 per cent in February 2008 and has since risen to 4.8 per cent. In January employment grew by 1.2 per cent, already showing signs of a sharp slowdown. The number of vacancies is slowing sharply. The labour force participation rate has fallen slightly to 65.1 per cent, but is still near its record high of 65.5 per cent last April. In trend terms, full time employment has been declining slightly and part time employment growth is slightly positive.

The forecasts are much grimmer. Treasury expects total employment will grow by just 1 per cent in the 2008-09 financial year. During 2009-10 employment is anticipated to fall by 0.75 per cent, then grow by 1.25 per cent in each of the following two years. The unemployment rate is forecast to rise to 5.5 per cent by the end of this financial year, then to 7 per cent during 2009-10. Headline-grabbing job losses are already occurring. These forecasts imply that the number of unemployed will rise 30 percent to over 780,000. Yet like all economic forecasts, there is a risk that things could turn out worse than currently expected.

Implications

How much will the unemployment rate rise in the downturn? This depends on the “natural” rate of unemployment, which is determined by structural labour supply factors, such as the preferences, skills and employability of the workforce (but not cyclical changes in labour demand). Although this natural rate cannot be measured or observed, most economists believe that when the economy grows faster than its long-run growth rate, unemployment falls below the natural rate and inflation rises. When economic growth slows, unemployment rises above the natural rate.

If the natural rate is high (for example, at about the 7.2 per cent average unemployment rate since 1978) then we will see a big rise in the unemployment rate. Fortunately, estimates by Steven Kennedy of Treasury put the natural rate at somewhere between 4.5 and 5 per cent in June 2007, suggesting the unemployment rate will not go as high as it has in past recessions. (The natural rate is likely to have fallen in the past decade due to strong productivity growth and changes to labour market regulation and unemployment assistance.)

However, even if the forecast rise in the actual unemployment rate to 7 per cent is small by historical standards, there will be other developments in the labour market. Long-term unemployment will rise as those who have lost their jobs find it even harder to obtain new ones. The unemployment rate also excludes a large number of people who do not match the official definition of being willing and able to work while actively looking for it. This group includes discouraged workers (who give up looking for work, quitting the labour force), those who retire early because they can’t find a job, those who give up unemployment benefits and go on the disability pension instead, and those who might have entered the labour force had jobs been available (school graduates, some mothers, and so on).

An increase in the size of these groups - the “hidden unemployed” - typically occurs in recessions, and explains why the labour force participation rate is predicted to drop by a whole percentage point over the coming downturn (to 64.5 per cent).

Unemployment statistics are also headcount measures of people, and are thus poor measures of labour underutilisation. Underemployment, or the amount by which actual hours work fall short of workers’ desired hours, is also important. Full-time employment growth tends to drop much faster than part-time employment growth in recessions as employers cut back on hours and stop hiring permanent full-time staff.

The ABS estimates that 5.2 per cent of available labour hours were underutilised in September 2007. By contrast, the Centre of Full Employment and Equity at the University of Newcastle estimates that the hours-adjusted rate of total unemployment (which they term CU8) was 9.1 per cent around this time. In the November quarter of 2008 this was up to 9.3 per cent, yet still well below the 13.4 per cent recorded in early 2002. If this is any indication, the total amount of labour underutilisation is likely to rise a lot more than the unemployment rate will in the current downturn. Various measures of labour underutilisation are presented in Graph 2.