The U.S. economy tends to slip into recession soon after it reaches full employment due to resulting imbalances
The U.S. economy has never managed to sustain a low rate of unemployment without generating imbalances that lead to a recession, according to a new working paper by Antonio Fatas, Professor of Economics and The Portuguese Council Chaired Professor of European Studies at INSEAD. This suggests that a recession is near as the United States is currently at or near what economists consider “full employment”.
Analysing unemployment rates around the peak of the last five U.S. economic cycles, Fatas finds that unemployment reaches its lowest point around 12 months before the recession and, in most cases, unemployment starts to increase in the months preceding the recession.
In his research paper, “Is Full Employment Sustainable?”, he uses quantile regressions to understand how the low level of unemployment is associated with recessions.
“The pattern of U.S. unemployment and recessions suggests that low levels of unemployment are a strong predictor of sudden increases in unemployment, associated with crises. We do not observe in the data any sustained periods of low unemployment,” Fatas said.
But why is full employment in the U.S. unsustainable? “Recessions follow periods of low unemployment because imbalances are built during those years,” Fatas added.
Underpinning academic literature that analyses the factors leading to a recession are two sets of variables – macroeconomic imbalances like inflation and those associated with financial imbalances, which often arise in a booming economy.
Examining the data further, Fatas found that low unemployment doesn’t necessarily signal a recession, but is a contributor to financial imbalances: credit growth. Looking at credit growth over the four quarters preceding U.S. recessions, he finds that fast credit growth tends to precede recessions.
“Out of the imbalances we have considered, credit growth seems to have the strongest explanatory power,” said Fatas.
Fatas also found that the phenomenon is not present in other countries.
Australia, for example, has sustained a low unemployment rate for decades. After an Australian recession in the early 1990s, unemployment increased and then started a decline similar to the economic expansions in the U.S.. By 2000, unemployment reached a low level which has remained mostly flat for years. The Australian unemployment rate does not display a V-shape seen for U.S. unemployment but looks more like an open L-shape.
“There are other countries with similar patterns to the U.S., like Greece or Sweden. But others, like Germany or the United Kingdom, have been able to sustain longer periods of low unemployment”, said Fatas.
