5 minutes

The Simple Mistake That Almost Triggered a Recession

For some time now, prominent economists have warned that the only way to break the fever of inflation would be by pumping up unemployment–in other words, by triggering a recession. Former Treasury Secretary Lawrence Summers, for example, predicted last summer that we would need five years of unemployment above 5 percent. Against that backdrop, every strong jobs report came to seem, perversely, like bad news–an omen of greater financial pain to come.

And yet according to the most recent official numbers, inflation has cooled significantly since last summer, even as the unemployment rate has remained low. Inflation so far seems to be conquerable without throwing millions of Americans out of work. A recession is looking less and less likely, let alone necessary. So where did the doomsayers go wrong?

The idea that a recession was needed to cure inflation was based on a very specific premise: The labor market was too tight. Throughout the first two years of the pandemic, employers struggled to hire as many workers as they wanted, and this drove wages up at an unsustainable speed. Unsustainable is the key qualifier here. Although we normally celebrate wage growth, it can spark dangerous inflation if it happens too much, for too long. This can happen two ways. First, when employers must pay workers more, they pass that cost on to customers through higher prices. Second, if companies can’t hire enough workers, they may not be able to make as much stuff as customers are demanding. With too much money chasing after not enough goods, prices rise even further.

Summers and others saw a recession as the only cure for this situation because they believed the economy was essentially out of workers. Unemployment wasn’t literally zero, but economists typically think of unemployment as having a lower bound below which a lack of workers leads to accelerating wage growth and inflation. Historically speaking, 3.5 percent unemployment is a very low rate, and so many economists concluded that we must be near that lower bound. The only way to cool the labor market in that case would be to get firms to want fewer workers. The main way the government does this is by raising interest rates. As it becomes more expensive to borrow money, demand for goods and services wanes, and employers don’t need as many workers. Given the level of imbalance in the labor market by 2022, this in all likelihood meant hiking interest rates until we tipped into a recession.

This argument only makes sense, however, if we treat the official unemployment rate as an accurate measure of the number of available workers. Summers and other economists predicting a recession believed that there were no more potential workers who would be coaxed into the labor market by better opportunities. In a paper released last year, Summers concluded that “the majority of the employment shortfall will likely persist moving forward.”

But the unemployment rate doesn’t really capture everyone who doesn’t have a job; it excludes people who aren’t looking for work at all. This dividing line makes sense for retired people, full-time students, and others who genuinely don’t want work–it wouldn’t make sense to call these people unemployed. But retirees and students are not the only adults who are out of the labor force. There are also people who might want a job if the opportunities were good enough. Potential workers like these are precisely who could help alleviate labor-market pressures. More people entering the labor force would mean more workers to fill job openings.

The most recent economic data make clear that the unemployment rate was significantly undercounting the pool of available workers. Even as the official number remains pinned to historical lows, 4 million workers have found jobs over the past year. The labor market was in better shape than many experts thought. Inflation and wage growth have both been slowing down. This did not require a multiyear span of high unemployment, as Summers suggested; to the contrary, the economy keeps adding jobs.

In the context of an unprecedented global pandemic, economists–myself included–are sure to get things wrong. But it’s important to note that we have seen this particular mistake before. After the Great Recession, many economists believed that the share of people who simply wouldn’t work had permanently increased. The supposed reasons were as varied as health problems and the high quality of video games. And yet, as the recovery progressed, more and more people returned to work, disproving the labor-market pessimists year after year. Wages rose at a pace that delivered real improvements in standards of living, but without inflationary pressure.

The fact that many leading economists seem drawn to excessively pessimistic views about the labor market is a problem. If the Summers perspective had carried the day, the Federal Reserve might have felt compelled to plunge the country into a recession, causing massive avoidable suffering. The good news is that, moving forward, the continued improvements in labor supply bode well for the chances of a soft landing. The share of prime working-age adults who are employed remains below its peak in the late 1990s, meaning the workforce still has room to grow. This is not to credit labor supply entirely for the slowdown in inflation, or to suggest that we could have gotten here without rate hikes to curb demand. Inflation is still higher than it should be, and in an era of nonstop economic surprise, any forecast must be made with a heavy dose of humility. But the more work that supply does, the less work demand needs to do–and the less risk that the Fed will need to push the economy into recession in order to whip inflation.

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