Recessions are costly

Robert Lucas has pushed the idea that business cycles are not that costly that they would need intervention, and the real business cycle literature, at least the early one, has anyway advocated that the government should stay out of this kind of business. It is true that long term growth and understanding why some countries are so poor are more important questions, yet one cannot shake the feeling that recessions are costly. The recent one is more severe than usual and can highlight how its costs can be high, and those costs may persist for some time if the much longer than usual unemployment durations translate into significant losses in human capital and ultimately wages.

Steve Davis and Till von Wachter provide some new evidence of a somewhat different kind. Studying US workers displaced in mass-layoffs, they calculate the present value of a job loss in terms of pre-loss wage years. When the unemployment rate is below 6 percent, the loss is of 1.4 years. Above six percent, as is typical in a recession, the loss is 2.8 years, i.e., much much more than the increase in unemployment duration. One can only imagine that these numbers are going to be much worse for the last recession. And keep in mind that these higher numbers apply to more people in a recession. And it matters in aggregate: if the unemployment rate goes from 5 to 10%, it means 5% of the population loses 1.4 additional years of wages. That is 0.7% of national labor income, or 0.5% of GDP. Not peanuts, and I have not even factored in anything about curvature in utility.

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