Milton Friedman's "Pluck" Gives Hope to Jobless

The U.S. unemployment rate skyrocketed to 8.5 percent in March, and there is every reason to expect that it will soon be above 10 percent. Given how bad things are, it will probably break the postwar record of 10.8 percent, set in late 1982.

Even if we don't challenge that record, this recession is already worse than its 1980s counterpart. Back then, unemployment had been quite high for many years before it spiked. The unemployment rate in late 1982 was just 2.3 percentage points higher than it had been a year earlier.

This time, the turnaround in our fortunes has been sudden and sharp. It seems almost impossible, given how bad things are now, that in March 2008 the unemployment rate stood at 5.1 percent--3.4 percentage points lower than it is now. That means the surge in unemployment over the past year is even more radical than the one that produced the modern record. The economy has fallen off a cliff.

Almost everyone has now been affected. A recent ABC News/Washington Post poll found that 60 percent of Americans had a close friend or family member who had been laid off.

Unemployment this high brings with it widespread suffering that hasn't been felt by an entire generation, suffering that feels worse because recent times were so good. Americans seem to be more somber now than at any moment in my lifetime.

Sixty percent of Americans have a close friend or family member who has been laid off.

But while the rapid reversal in fortunes is challenging emotionally, the steepness of our fall is cause for hope. The latest evidence from the economics literature shows that steep economic drops might actually portend good news ahead.

Friedman's Plucking

The reason is that economists have developed models that have, in many ways, confirmed an observation of Nobel Prize-winning economist Milton Friedman.

Back in 1964, Friedman speculated that the economy might be thought of as a plucked string: The farther you pull it, the more forcefully it snaps back. That analogy gave the Friedman idea its name, "the plucking model."

The economy can go down for many reasons. If the world suddenly and permanently demands less of our best product, then a decline today is a harbinger of bad times ahead.

If, however, panic drives everyone to stop buying just about everything, then buying will resume when the panic subsides, and we could easily--and quickly--end up back where we started. A panic like that would fit the bill for a Friedman "pluck."

So if the economy is going to decline, it's good news to find out that it's been plucked. That means a snap-back is imminent.

Butterfly at Ceiling

I find it useful when thinking about the Friedman model to use an alternate analogy. Imagine that you are in a room with an upward sloping ceiling. There is a butterfly in the room that wants to escape, and it follows the ceiling up and up over time.

If the height of the butterfly represents gross domestic product, we can say that the economy is generally trending higher. If it happens to flutter down far away from the ceiling, that means its next movement is likely to be steeply back up.

The hard part, of course, is figuring out whether a given decline is lasting bad news or a temporary pluck.

Until recently, that problem seemed intractable. But over the past few years, econometricians have developed sophisticated models that have solved the problem.

The frontier of this literature has been stretched by a fascinating new working paper by George Washington University's Tara Sinclair. Sinclair's model can take the data for an economy and filter out an estimate of whether any plucks occurred.

Cause of Recessions

Looking back at postwar U.S. history, Sinclair finds strong evidence that plucks explain many of our recessions, but not all. That is, she has confirmed that the Friedman analogy is a useful one for policy makers, who can better concoct responses if they know whether one should rationally expect a given slump to reverse itself on its own.

Sinclair told me last week that she recently detected something that may be good news for the outlook going forward: "My updated results show that the 'pluck' part of the latest recession began in the fourth quarter of 2008."

That means that the first part of this recession was a lasting adjustment to the collapse of our financial sector, unlikely to reverse itself anytime soon. On the other hand, the radical declines of the past two quarters are likely transitory, presaging strong quarters to reverse the pluck.

While Sinclair was reluctant to offer a forecast on the outlook, she added that "on average, plucks last just under four quarters."

With that history as a guide, then, it would seem that the recovery may well be rapid and begin later this year.

Sinclair's results also imply that the lateness of the pluck means that permanent damage has been suffered. When we do recover, we will go back to where we were late last year, with unemployment in the 7 percent range, rather than to the halcyon days. After that, we can expect a slow and painful drift to full employment.

Sadly, from where we are sitting, 7 percent unemployment looks pretty good, and the news that we have been plucked provides some comfort as more awful news arrives.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

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