Unemployment “rises like a rocket and falls like a feather.” When a recession starts and companies look for ways to manage slowing demand for the goods and services that they sell, many may resort to laying off workers to cut costs.
Those laid-off workers spend less, which weakens demand even further. Companies hire less (and may still be laying off), making it more difficult for newly unemployed workers to find their next jobs, and they stay unemployed longer.
Rising unemployment is one of a number of indicators that define a recession. It also makes the downturn worse.
- Recession and unemployment go hand in hand and reinforce one another.
- Unemployment rises quickly but drops slowly in a downturn, and its long-term effects are costly.
- Fiscal and monetary policies try to limit the impact of unemployment on recessions.
- Prompt, automatic aid for those who need it most tends to produce the most benefit.
Recession and Unemployment
A recession is a significant and broad decline in the economy, usually lasting more than a few months. In the United States, the National Bureau of Economic Research (NBER) uses a number of indicators to determine when recessions start and end, including:
- The monthly nonfarm payrolls report and household employment survey
- Real personal income less transfers
- Real personal consumption expenditures
- Wholesale and retail sales
- Industrial production
The simplest measure, used by some, is that if there are two consecutive quarters of negative gross domestic product (GDP) growth, then the economy is in recession.
While unemployment is an important recession indicator, it’s also important to remember that unemployment usually peaks long after the recession has begun and can last well into recovery. That’s because the NBER (and others) say a recession is over when the economic contraction hits bottom and starts to rebound, not when the recovery is complete.
For an example, the charts below show the change in unemployment and GDP growth during the 2008 Great Recession.
That recession began in December 2007 and ended in June 2009, according to the NBER. Yet in April 2008, five months into the recession, the U.S. unemployment rate was just 5%, up only slightly from 4.7% six months earlier. Unemployment continued to rise to hit 10% by October 2009, four months after the official end of the recession and seven months after the stock market hit bottom.
During the much shorter two-month recession set off by the 2020 COVID-19 pandemic, unemployment climbed from just 3.5% in February 2020 to 14.7% in April 2020, the month when the recession ended. But that was unusual: It was the first time in 70 years that unemployment associated with a recession peaked before the economy was well into recovery.
Economic growth (as measured by GDP) and unemployment experienced an unusual disconnect during the most recent 2022 recession as well.
GDP grew a healthy 7% in the last quarter of 2021, contracted by 1.6% in the first quarter of 2022, then shrank further (0.6%) in the second quarter before returning to positive growth in the third quarter.
But unemployment actually fell during this period, to just 4.6% by October 2022, again bucking the historic trend that unemployment tends to recover only long after economic growth does.
While many factors determine if the economy is in recession, the simplest definition is two quarters of negative economic growth. By that measure, the U.S. was in recession in early 2022, yet unemployment continued falling even as economic growth faltered.
Why Unemployment Rises During a Recession
Because a recession is a slowdown in economic activity and labor is a key economic input, along with capital, it is logical that unemployment would rise as output (what companies make and sell) declines as companies making less and selling less need fewer employees.
The relationship between employment and output growth is consistent enough that there is an economic principle that describes it: Okun’s law, named after Arthur Okun, the economist who first documented it. A related rule of thumb says the economy must grow two percentage points faster than its potential growth rate to cut the unemployment rate by just one percentage point.
The “potential growth rate” is an estimate of what GDP growth could be if labor and capital were fully used; that is, everyone who can work has a job and all money available to invest is invested. But because potential GDP is theoretical and not easily measured, there are a variety of ways to calculate it, and each way produces different results.
Thus, while Okun’s law is useful to understand the relationship between unemployment and economic growth, the law is not very useful in forming economic policy, as it is difficult to make accurate assessments.
Unemployment is contagious: Layoffs tend to snowball as job losses depress demand.
The Extra Costs of Unemployment in a Recession
Unemployment is contagious—initial layoffs when the recession starts cut demand as unemployed workers spend less, cutting demand further, which can in turn lead to more layoffs. The negative feedback loop eventually runs out of steam, but not before inflicting lasting damage on the economy and workers.
People who lose jobs during recessions, especially deep recessions, are more likely to become long-term unemployed and find it more difficult to reenter the labor market later. Among workers who lost their jobs during the Great Recession, only 35% to 40% were employed full time by January 2010. Reemployment rates remained unusually low as late as 2013.
Another survey found men lose an average of 1.4 years of earnings if laid off when unemployment is below 6%, but they lose twice as much if the unemployment rate is above 8%.
Beyond its immediate economic costs, long-term unemployment also damages public health and the economy’s long-term productive potential.
Policies That Limit Unemployment in Recessions
Governments around the world use fiscal and monetary policies to manage the highs and lows of the business cycle. This means that they usually spend more but also collect less in tax when the economy slumps, as they try to boost aggregate demand to avoid even more unemployment that could worsen the downturn. A similar rationale leads central banks to cut interest rates and buy assets to stimulate the economy during downturns.
There are also many automatic stabilizers that kick in during economic downturns. These mechanisms do not require the government to make a policy change or pass new legislation. They include programs such as unemployment insurance and other transfer payments. Automatic stabilizers are especially valuable because they can quickly direct aid to the people who need it most and often spend it fastest, increasing its benefit to the economy.
Most controversial of all is targeted government relief for specific industries or companies, the sort of assistance frequently labeled a bailout. Some critics object to public aid to for-profit companies on principle, while others argue that the relief is misguided and may not benefit the right companies, either out of incompetence or due to political motives.
In 2008–2009, the U.S. government spent nearly $80 billion to avert the bankruptcy of U.S. automakers. It did, however, later recoup 85% of that aid. Supporters note that the bailout saved hundreds of thousands of auto industry jobs and prevented a regional depression. Critics argue that it set a bad precedent and encouraged riskier business behavior by the industry.
Why does unemployment rise in a recession?
As economic activity slows in a recession, consumers cut spending. When consumers cut spending, there is less demand for the goods and services that companies sell, so companies manufacture less and may trim their service offerings. But making fewer products and offering fewer services also means companies need fewer employees, and layoffs often result. When people are laid off, they are forced to cut spending, which further crimps demand, which can lead to further layoffs. The cycle continues until the economy recovers.
Why does unemployment fall slowly after a recession ends?
Companies are usually quick to cut costs when demand for their products and services declines, but they are generally more cautious about adding that cost back by hiring new employees even as the economy recovers. Also, a recession ends when the economy hits bottom, but employment tends to recover only long after that point, after the economy is well into recovery.
How has unemployment been different in recent recessions?
Historically, unemployment improves long after the official end of the recession. This is because a recession ends when the economy hits bottom, and companies start to rehire only after that point, often well after the economy has started to recover. But in the COVID-19 pandemic-induced 2020 recession, employment recovered more quickly than the economy, for the first time in 70 years. The same thing happened in 2022, when the economy shrank during the first and second quarters, but unemployment actually declined, even as the economy shrank.
The Bottom Line
Recession and unemployment go hand in hand—a spike in unemployment and its persistence are hallmarks of a recession, and joblessness in turn aggravates recessions. The short-term and long-term costs of unemployment have led governments to develop a range of policy measures aimed at curbing joblessness during downturns. The two most recent recessions (in 2020 and 2022) have been different, as unemployment improved more quickly than in most economic cycles, recovering before economic growth did.