Unemployment and Recession—What's the Relation?

Unemployment tends to rise quickly, and often remain elevated, during a recession. With the onset of recession as companies face increased costs, stagnant or falling revenue, and increased pressure to service their debts they begin to lay off workers in order to cut costs. The number of unemployed workers across many industries spikes simultaneously, the newly unemployed workers find it difficult to find new jobs during the recession, and the average length of unemployment for workers increases. Here, we examine this connection of recession and unemployment.

Key Takeaways

  • A recession is a period of economic contraction, where businesses see less demand and begin to lose money.
  • To cut costs and stem losses, companies begin laying off workers, generating higher levels of unemployment.
  • Re-employing workers in new jobs is an economic process that takes time and flexibility, and faces some unique challenges due to the nature of labor markets and the conditions of a recession.

Recession & Unemployment

A recession occurs when there are two or more consecutive quarters of negative economic growth, as measured by gross domestic product (GDP) or other indicators of macroeconomic performance including unemployment. In part, the relationship between recession and unemployment is purely a matter of semantics; the official dates of recessions include a rise in unemployment as part of the definition of what constitutes a recession. 

For example, these charts illustrate the change in unemployment rates and GDP growth rates during the Great Recession of 2008 and 2009.

Unemployment and GDP Growth 2008
Unemployment and GDP Growth 2008.  Investopedia

In 2008 and 2009, unemployment rose sharply and GDP contracted, and the National Bureau of Economic Research declared that the U.S. economy was in recession from December 2007 to June 2009 based on these and other trends.

Why Does Unemployment Rise During a Recession?

During a recession a rash of business failures occurs. Why these business failures happen is explained by various economic theories as a result of negative economic shocks, real resource or credit crunches brought about by previously over-expansionary monetary policy, the collapse of debt-based asset price bubbles, or a negative shift in consumer or business mood. Regardless of the cause, as the recession spreads, more and more businesses curtail their activities or fail altogether and as a result lay-off their workers.  

During a recession many businesses lay-off employees at the same time, and available jobs are scarce.

When businesses fail, under the normal operation of markets the assets of the business are sold off to other businesses and the former employees are rehired by other competing businesses. In a recession, because many businesses across many different industries and markets are failing all at once, the number of unemployed workers looking for new jobs goes up rapidly. The available supply of labor available for immediate hire goes up, but the demand to hire new workers by businesses goes down. In a perfect, frictionlessly functioning market, economists would expect such an increase in supply and decrease in demand to result in a lower price (in this case the average wage) but not necessarily a lower total number of jobs once the price adjusts. 

However, this does not necessarily happen during recessions. The unemployed workers face difficulty in finding new jobs, and the result is a surplus of labor of many kinds that can persist for many months. The amount of unemployment that can be attributed to the job losses and delay in unemployed workers finding new jobs due to the recession (above and beyond the normal unemployment associated with day-today labor market turnover) is known as cyclical unemployment

Several factors particular to labor markets and to the conditions of a recession can interfere with the normal process of adjusting jobs, wages, employment levels:

Different Types of Labor (and Capital)

For simplicity’s sake, economists and statisticians routinely ignore the differences between various inputs to productive business processes in order to produce aggregate macroeconomic statistics that help measure overall economic performance, such as the aforementioned GDP and unemployment rates. While these broad, abstract numbers may have some use, they obscure the fact that there are many different types of workers, with various combinations of skills, experience, and know-how, that makes their labor more-or-less useful to different sorts of employers engaged in different types of business, in different locations, with different types of tools and capital equipment. This key aspect of labor (and capital) markets explains much of cyclical unemployment.  

Some industries and businesses (and their workforces) are harder hit than others in any given recession. For example during the Great Recession, construction, manufacturing, and the finance, insurance, and real estate (FIRE) sectors saw the greatest increases in unemployment.

In order for the labor markets for each of the many types of labor to clear the surplus of unemployed workers requires getting the right workers matched up to the right jobs, rather than simply balancing generic aggregate workers with generic aggregate jobs from a macro perspective. Workers (and capital goods) across different jobs and industries are not interchangeable blocks that can simply be plugged into the first available opening. Tab A needs to fit into Slot B or the machine of the economy simply won’t go back together.

This process of sorting the right workers into the right jobs takes time, and requires simultaneously sorting the right tools, equipment, buildings, and other capital to complement those workers skills and abilities into the hands of businesses that can use all these resources together in legitimately productive (and profitable) activities. 

Job Matching

Workers and jobs come in all varieties. The process of sorting the right workers into the right jobs to reduce unemployment takes time and market flexibility.

Moreover, both of these sorting processes require flexibility on the part of workers and employers. Flexibility not just in terms of the prices, wages, and quantities supplied and demanded around which classroom economic models revolve, but in terms of the ability to move and combine different types of workers and capital goods between firms and markets. If the markets for labor and capital goods were sufficiently flexible in these ways, then the pain of the recession might be short lived after the initial shock.

Market Rigidities

However, the bad news is that lots of additional complications can mean that labor and capital goods markets might not be flexible enough to avoid some persistent unemployment during a recession. 

One reason those who are newly unemployed have difficulty finding new jobs during a recession is that labor markets function a little differently from the perfect markets presented in a basic economic class. One way in which labor markets are different from many other goods is that wages may be “sticky”. In other words, employers and workers may be reluctant to agree to lower wages even in the face of decreased demand and increased supply for labor. 

A business generally employs a pool of workers of varying skill and ability levels, with the intent of finding and keeping the most productive workers but also including marginally less productive workers as needed. When businesses face pressure on the bottom line and want to cut payroll costs, they are often better off by laying-off their marginally productive workers than by cutting the wages or hours of all employees (including the most productive).

Cutting wages tends to cut worker productivity and can even lead the most productive workers to leave voluntarily for higher paying jobs elsewhere, while cutting marginal workers tends to motivate the remaining workers to increase productivity. Cutting employees instead of wages can be a major source of sticky wages. Contractually guaranteed wages, collective bargaining agreements, and minimum wage laws can further contribute to wage stickiness. 

Sticky Wages

Workers and businesses may both be reluctant to cut wages in a recession.

Unemployed workers may find that the jobs and professions, or even entire industries, in which they were employed disappear during a recession. This can be due to technological change and obsolescence or to a structural change in the economy related to an economic shock that may have triggered the recession itself. 

Even absent these factors, usually the build up to a recession involves heavy overinvestment in certain industries and business activities, and their associated human capital, that then see concentrated losses when the recession hits. Typically these are businesses and activities that are highly sensitive to or dependent on having abundantly available credit at low interest rates, which is not the case during a recession, especially early in the recession. The human capital that workers may have invested in for jobs in these businesses may not transfer very well or at all to new jobs. 

Government Policy

One of the great tragedies of recessions is that the adjustment of labor markets is often further hampered by government policies, which can increase and prolong unemployment. Technically this is not purely cyclical unemployment, but such policy responses are a consistent enough feature of recessions that they are relevant and necessary to discuss. There are several ways this can happen, but most important are fiscal and monetary policies that interfere with the adjustment of the structure of industry. To some extent, direct government interference with labor market incentives also plays a role. 

The normal policy response to recessions, over at least the past century, has been some combination of expansionary monetary and fiscal policy. Much or most of this effort tends to be directed toward subsidizing, stimulating, or bailing out distressed industries, particularly the financial sector and large business concerns in manufacturing and construction, but others as well in some cases. Unfortunately, but often by design in order to offer help where it appears to be needed, this prevents the liquidation and recombination of real capital goods across the economy under new business ownership. 

Stimulus and Bailouts

Government policy to protect banks and big businesses may do more harm than good for the economy.

In order for productive new jobs to be created for the unemployed, the tools, equipment, and physical plant required for those jobs have to be made available by new employers for them to use in their new jobs. Some capital goods are literally fixed in place in the form of building and other fixed capital. Some capital goods are bound up in the form of tools and equipment with very specific uses that are difficult to transfer to other uses except by scrapping them entirely. How specific capital goods are to a given use and how quickly they can be retooled, repurposed, or recycled into other uses varies considerably, but this is a necessary process to literally put the economy, and the job market, back together again. 

Anything that slows or stops the process of liquidating failed businesses and reallocating their assets among new owners and entrepreneurs who can put them to new uses, also delays or prevents the corresponding process of adjustment in labor markets that bring new jobs for the unemployed. For better or for worse (mostly worse) government policy during recessions is largely geared toward doing exactly that.  

In addition to interfering with capital market adjustments, governments also frequently extend various benefits to workers and consumers in the form of unemployment insurance, stimulus rebate checks, or other benefits. While these provide temporary relief to those who are jobless and economically distressed during the recession, they do not fix the problem of providing sustainable, productive employment. Despite unfounded criticism that unemployment aid incentivizes people to remain jobless, there is no evidence to support this claim. In fact, a recent study from Yale University revealed that receiving additional unemployment benefits from the CARES Act had no effect on the rate at which people returned to their jobs.     

The Bottom Line

Recession and unemployment go hand in hand—a spike in unemployment and persistence of joblessness is one of the hallmarks of recession. Businesses lay-off workers in the face of losses and potential bankruptcies as a recession spreads, and re-employing those workers is a challenging process that takes time and faces several economic and policy-driven obstacles. 

Article Sources

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  1. National Bureau of Economic Research. "Business Cycle Dating Committee, National Bureau of Economic Research." Accessed Aug. 19, 2020.

  2. YaleNews. "Yale Study Finds Expanded Jobless Benefits Did Not Reduce Employment." Accessed Nov. 12, 2020.