Unemployment and Recession—What's the Relationship?

Unemployment "rises like a rocket and falls like a feather." At the onset of a recession, as companies cope with diminished demand, declining profits and elevated debt, many start to lay off workers in order to cut costs.

As the number of unemployed workers rises while demand and output decline further as a result, newly unemployed workers find it harder to find new jobs, and the average length of unemployment increases.

Rising unemployment is one in a number of indicators that define a recession, and it exacerbates the downturn.

Key Takeaways

  • Recession and unemployment go hand in hand and reinforce each other.
  • Unemployment rises fast and drops slowly in a downturn, and its long-term effects are costly.
  • Fiscal and monetary policies aim to limit the extent of unemployment and recessions.
  • Prompt, automatic aid for those who need it most tends to produce the most benefit.

Recession & Unemployment

A recession is a significant and broad decline in economic output, typically lasting more than a few months. In the U.S., the National Bureau of Economic Research (NBER) dates recessions based on indicators including the monthly non-farm payrolls report and household employment survey, real personal income less transfers, real personal consumption expenditures, wholesale and retail sales, and industrial production.

While unemployment is one of the indicators used to assess whether a recession has begun, joblessness tends to peak later and to persist well into a recovery. That's because the end of the recession marks the trough of the economic contraction and the start of a rebound rather than its completion.

For example, these charts illustrate the change in unemployment and gross domestic product (GDP) growth during the Great Recession.

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

That recession began in December 2007 and concluded in June 2009, according to NBER. Yet in April 2008 the U.S. unemployment rate was still just 5%, up modestly from 4.7% six months earlier. Unemployment peaked at 10% in October 2009, four months after the official end of the recession and seven months after the bear market in stocks hit bottom.

During the much shorter two-month recession set off by the arrival of the COVID-19 pandemic in the U.S. in early 2020, the unemployment rate peaked at 14.7% in April 2020, the month the recession ended. That was the first time in at least 70 years that unemployment associated with a recession didn't peak when the economy was already in recovery.

Why Does Unemployment Rise During a Recession?

Since a recession denotes a decline in economic activity and labor is a key economic input alongside capital, it stands to reason that employment must decline as output drops.

The direct causal relationship between employment and output growth has been consistent enough to enter economics canon as Okun's Law, named after the economist who first documented it, Arthur Okun. A related rule of thumb suggests that the economy must grow two percentage points faster than its potential growth rate to reduce the unemployment rate by one percentage point in a year.

Potential GDP is an estimate of output an economy would have produced had its labor and capital been deployed at a maximum sustainable rate. Potential GDP is determined by the size of the labor force and the pace of productivity growth, as well as capital investment. Because potential GDP is a theoretical construct that is not directly measurable, different modeling approaches tend to produce divergent estimates.

While Okun's Law is a useful summary of the relationship between employment and economic growth, difficulties in estimating potential GDP and the natural rate of unemployment (unemployment not attributable to cyclical demand fluctuations) limit the rule's utility to policymakers.

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 at the outset of the recession produce large negative effects on spending and sentiment that spur additional job losses, which compound the economy's weakness, and so on. 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 re-enter the labor market later. Among workers displaced during the Great Recession, only 35% to 40% were employed full-time by January 2010. Re-employment rates remained unusually low for workers who lost their jobs as late as 2013.

Another survey found men lose an average of 1.4 years of earnings if laid off with the unemployment rate below 6% but twice as much if the unemployment rate is above 8%.

Beyond its immediate economic costs, long-term unemployment erodes public health and the economy's long-term productive potential.

Policies Limiting Unemployment in Recessions

Governments around the world use fiscal and monetary policies to limit the highs and lows of the business cycle. That means higher government spending and lower tax collections when the economy slumps to prop up aggregate demand, averting additional unemployment and a deeper downturn. A similar rationale leads central banks to drop interest rates and pursue asset purchases.

In lean times, fiscal policy comes to the rescue first with "automatic stabilizers"—relief embedded in the economic system and requiring no policy change or legislation. As output falls, tax collections decline. As layoffs spread, unemployment insurance and other transfer payments increase.

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 economic benefit. Some economists have called for additional automatic stabilizers including direct stimulus payments.

Fiscal relief requiring legislation arrives later or not at all, and is less likely than automatic stabilizers to be proportional to the need. It is also likely to be more controversial.

Most controversial of all is targeted government relief for specific industries or companies, the sort of aid frequently labeled a "bailout." Some critics object to public aid to for-profit companies on principle, while others may argue the relief is misdirected out of incompetence or political motives.

In 2008-2009, the U.S. government spent nearly $80 billion to avert the bankruptcy of U.S. auto makers, ultimately recouping 85% of that aid on an inflation-adjusted basis.

Supporters note the action preserved hundreds of thousands of auto industry jobs and forestalled a regional depression. Critics argue it set a bad precedent and has encouraged riskier business behavior by the industry.

The Bottom Line

Recession and unemployment go hand in hand—a spike in unemployment and its persistence are recession hallmarks, and joblessness 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. 

Article Sources
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  1. Federal Reserve Bank of San Francisco. "Why Has the US Economy Recovered So Consistently from Every Recession in the Past 70 Years," Page 4.

  2. National Bureau of Economic Research. "Business Cycle Dating."

  3. National Bureau of Economic Research. "Business Cycle Dating Committee Announcement September 20, 2010."

  4. U.S. Bureau of Labor Statistics. "The Recession of 2007-2009."

  5. FRED, St. Louis Fed. "Unemployment Rate."

  6. Board of Governors of the Federal Reserve System. "Recent Developments in the Labor Market."

  7. Brookings. "What Is Potential GDP, and Why Is It So Controversial Right Now?"

  8. Federal Reserve Bank of St. Louis. "Okun's Law: A Meaningful Guide for Monetary Policy?"

  9. National Bureau of Economic Research. "Great Recession Job Losses Severe, Enduring."

  10. National Library of Medicine. "Recessions and the Cost of Job Losses."

  11. Urban Institute. "Consequences of Long-Term Unemployment," Pages 11-13.

  12. IMFBlog. "Five Keys to a Smart Fiscal Policy."

  13. Congressional Research Service. "Fiscal Policy and Recovery from the COVID-19 Recession," Pages 10-12.

  14. Brookings. "Recession Ready: Fiscal Policies to Stabilize the American Economy."

  15. Congressional Research Service. "Federal Assistance to Troubled Industries: Selected Examples," Pages 19-21.

  16. Marketplace. "What Did America Buy with the Auto Bailout, and Was It Worth It?"

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