There are two schools of thought on the primary cause of our current unemployment problem: Some claim that the unemployment is cyclical (low aggregate demand) whereas others think it's structural (mismatch in the labour market). The "Structuralists" point to the apparent shift in the Beveridge curve and the increased demand in healthcare and technology whereas the "Cyclicalists" point to the fall in employment across all other sectors. So who's right? In my opinion, neither explanation is entirely satisfactory. This post is an expansion of some thoughts I touched upon in my last post that describe the "persistent unemployment" problem as a logical consequence of a dynamically uncompetitive "Post Minsky Moment" economy.

Narayana Kocherlakota explains the mismatch thesis as follows: "Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work....the Fed does not have a means to transform construction workers into manufacturing workers." Undoubtedly this argument has some merit - the real question is how much of our current unemployment can be attributed to the mismatch problem? Kocherlakota draws on work done by Robert Shimer and extrapolates from the Beveridge curve relationship since 2000 to arrive at a implied unemployment rate of 6.3% if mismatch were not a bigger problem and the Beveridge curve relationship had not broken down. Jan Hatzius of Goldman Sachs on the other hand attributes as little as 0.75% of the current unemployment problem to structural reasons. Murat Tasci and Dave Lindner however conclude that the recent behaviour of the Beveridge curve is not anomalous when viewed in the context of previous post-war recessions. Shimer himself was wary of extrapolating too much from the limited data set from 2000 (see pg 12-13 here)  This would imply that Kocherlakota's estimate is an overestimate even if Jan Hatzius' may be an underestimate.

Incorporating Uncertainty into the Mismatch Argument

It is likely therefore that there is a significant pool of unemployment that cannot be justified by the simple mismatch argument. But this does not mean that the "recalculation" thesis is not valid. The simple mismatch argument ignores the uncertainty involved in the "Post-Minsky Moment economy" - it assumes that firms have known jobs that remain unfilled whereas in reality, firms need to engage in a process of exploration that will determine the nature of jobs consistent with the new economic reality before they search for suitable workers. The problem we face right now is of firms unwilling to take on the risk inherent in such an exploration. The central message in my previous posts on evolvability and organisational rigidity is that this process of exploration is dependent upon the maintenance of a dynamically competitive economy rather than a statically competitive economy. Continuous entry of new firms is of critical importance in maintaining a dynamically competitive economy that retains the ability to evolve and reconfigure itself when faced with a dramatic change in circumstances.

The "Post Minsky Moment" Economy

In Minsky's Financial Instability Hypothesis, the long period of stability before the crash creates a homogeneous and fragile ecosystem - the fragility arises due to the fragility of the individual firms as well the absence of diversity. Post the inevitable crash, the system inevitably regains some of its robustness via the slack built up by the incumbent firms, usually in the form of financial liquidity. However, so long as this slack at firm level is maintained, the macro-system cannot possibly revert to a state where it attains conventional welfare optima such as full employment. The conventional Keynesian solution suggests that the state pick up the slack in economic activity whereas some assume that sooner or later, market forces will reorganise to utilise this firm-level slack. This post is an attempt to partially refute both explanations - As Burton Klein often notedthere is no hidden hand that can miraculously restore the "animal spirits" of an economy or an industry once it has lost its evolvability. Similarly, Keynesian policies that shore up the position of the incumbent firms can cause fatal damage to the evolvability of the macro-economy.

Corporate Profits and Unemployment

This thesis does not imply that incumbent firms leave money on the table. In fact, incumbents typically redouble their efforts at static optimisation - hence the rise in corporate profits. Some may argue that this rise in profitability is illusory and represents capital consumption i.e. short-term gain at the expense of long-term loss of competence and capabilities at firm level. But in the absence of new firm entry, it is unlikely that there is even a long-term threat to incumbents' survival i.e. firms are making a calculated bet that loss of evolvability represents a minor risk. It is only the invisible foot of the threat of new firms that prevents incumbents from going down this route.

Small Business Financing Constraints as a Driver of Unemployment

The role of new firms in generating employment is well-established and my argument implies that incumbent firms will effectively contribute to solving the unemployment problem only when prodded to do so by the hidden foot of new firm entry. The credit conditions faced by small businesses remain extremely tight despite funding costs for big incumbent firms having eased considerably since the peak of the crisis. Of course this may be due to insufficient investment opportunities - some of which may be due to dominant large incumbents in specific sectors. But a more plausible explanation lies in the unevolvable and incumbent-dominated state of our banking sector. Expanding lending to new firms is an act of exploration and incumbent banks are almost certainly content with exploiting their known and low-risk sources of income instead. One of Burton Klein's key insights was how only a few key dynamically uncompetitive sectors can act as a deadweight drag on the entire economy and banking certainly fits the bill.


Jeremy Stark

Superb post as usual. How long might it take for new entrants to restore "evolvability"? What would help them along? Have you looked at other "Post Minsky Moment" economies like post-1873 U.S., Great Depression U.S., Europe in the 1840s, etc. for industries/companies that acted as deadweights and, for lack of a better word, catalysts?


Jeremy - Thank you! In a sector like banking, it is the regulatory process of starting a new bank that takes the most time - a new bank that just started up in London called Metro Bank took almost a year to get approved. The main problem is the advantage in funding costs that TBTF bestows on the big banks that makes it hard for any new entrant to compete. Nevertheless, we could have used the TARP money to seed new banks rather than recapitalise old banks for example. My knowledge of the details pre-Depression is very limited. In the Great Depression, the problem was much worse because of the pro-incumbent nature of some of the provisions in the NRA across industries (See here,9171,787937,00.html ). And for what it's worth, Burton Klein's analysis of the deadweight drag in the 70s lays the blame on the steel and energy sectors.


Once again a great post. More industries should resemble the structure of the resturant industry.

James Dailey

Hello Ashwin, As always your post is very thought provoking. Given your bent towards complex systems analysis, I'm not surprised at how you approach this issue. I've found the work/commentary ECRI has done on this issue to be informative. The unemployment figures are pretty clear in showing that there are two "classes" of unemployed. The Great Recession was actually the shallowest on record for the short term unemployed. However, it was the worst for the long term unemployed. Personally, I believe it is impossible to try and assigns a linear "calculation" as to the contributors to this issue. Qualitatively, it is very logical. The credit bubble created inefficient incentives and resulted in a tremendous misallocation of capital and resources. Your discussion about evolvability is likely spot on - particularly in the economic segments at the epicenter of the credit bubble - banking, financials and housing/construction. However, I also believe there are larger social/cultural forces at play, which are also part of the fabric of an aging empire, as well as the credit bubble. The "fat and happy" status society reached resulted in university attendance being about self actualization rather than a pathway to employment and providing for one's standard of living. I remain involved with my alma mater here in the US and the shift in student preferences in the past 3 years has been stark. We have 2 whole generations of students who are ill trained/prepared to be employed in the areas of growth in the US. We've produced far too few geologists, engineers, physicists, mathematicians, doctors, nurses, physical therapists, etc. We have far too many art history and women's study majors. US public schools and universities are far too concerned about making their "customers" happy than educating people in fields that will lead to productive employment. These "customers" are finally beginning to awaken to the harsh realities in the economy and a shift is occurring. However, this is likely to take time. In addition, the government's heavy handed involvement in areas like drilling/mining and healthcare are likely to make matters worse, as negative incentives make employment in those areas less attractive (I am married to a physician and I can assure you we are facing a MASSIVE shortage in the US over the next decade). My investment management business has been doing very well over the past few years and we've been hiring new people. Even in our area of the industry, it has been incredibly hard to find people that don't have their heads up their asses - i.e. willing to work hard and not require baby sitting to be productive. While training is part of it, I think the cultural psyche is still that of a fat/happy aging empire, in which work ethic is lacking and entitlement remains the norm. So while I agree that your concept of evolvability is certainly a contributing factor, I would argue that we reached a hyper critical state as a society in many ways (just as many aged empires have in the past) and that the best policy avenue would be to let the avalanche, while terribly painful, unfold in its natural fashion. Instead, government has been, and will continue to, intervene and screw things up even worse. What was a critical state in private sector credit is now a hyper critical state in public debt and the very backbone of our economy - the confidence in our fiat currency.

Paul e.

Just wanted to respond to James Dailey comment on too few grads becoming geologists, engineers etc. I think economic theory tells us people respond to incentives. One theme that has repeatedly appeared since the financial crisis is the excessive compensation going to the financial industry. Thomas Philippon has produced research showing the extent of this unprecedented (at least in post-WW2 era) diversion of resources to the financial sector. This growth of the sector in turn is a function of the hyper-interventionism of the state in the financial industry. And is there really a shortage of physicists and engineers? Didn't poor job prospects push them to follow the Emanuel Dorman route to Wall Street ? I agree with him however that removing the government subsidization of the financial industry is an excellent starting point for restoring the health of the economy.

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