Why the Jobless Recovery Isn't

In every economic downturn, Chicken-Little pundits squawk about how we can't have a sustainable recovery until employment figures show improvement. Any investor, and here I use the word "investor" in its broadest sense to include those who put resources to work, not just those who invest in stocks and bonds, who listens to this drivel is destined to fail, and fail disasterously.

Macroeconomics - the study of large-scale economic trends affecting an economy as a whole - is based feedback loops that drive business activity. These loops describe causal relationships between economic factors affecting business. For example, an increase in production levels generally pushes employment up. Each of these causal relationships involve a time delay. So, when production levels increase, especially from a depressed level, employment does not rise until production levels exceed capacity at the current employment level. This takes time, as does the process of hiring new employees.

These delays are what cause business cycles in the first place. If we use, say, buggywhip manufacture as a hypothetical example, we might say that it takes 18 months for the buggywhip business to respond to a sudden change in the overall demand for buggywhips. So, if New York City should pass a law banning motorized vehicles, so all the Yellow Cabs in the city had to be replaced by horse-drawn surries overnight, that would ratchet up demand for buggywhips. Because it takes 18 months for buggywhip manufacturers to respond, actual sales of buggywhips would not stabilize at a level reflecting the new demand until a year and a half later.

Business cycles occur because it is not possible for businesses to precisely meet demand. In the buggywhip example, assume that there are two buggywhip manufacturers in business at the time the New York law passes. They will both attempt to grab more than their fair share of the enormous new market. Part of driving sales is assuring customers that you can actually deliver the goods ordered. So, both manufacturers will expand production faster than necessary to just meet demand. In addition, during that first 18 months, it will be clear that the established manufacturers won't be able to meet demand. Outside entrepreneurs will see this as an opportunity to jump in to the expanding market, by starting rival buggywhip manufacturing operations.

The result is that some 18 months after the new law passes, worldwide buggywhip manufacturing capacity will greatly exceed demand. Inventories of unsold buggywhips will expand. Buggywhip prices will fall. Marginal buggywhip manufacturers will fail. Buggywhip production capacity will drop. By three years into the process, we'd be back to having inadequate production capacity to meet demand, and the whole thing would start over again.

Boom and bust cycles like that are not some aberration, or the result of faulty business strategies, or some market inefficiency that politicians can erase by passing laws, it's how things inevitably work. In fact, most complex systems, such as economies, consist of multiple such cycles that operate on multiple time scales. Basically, they're all chaotic systems, which is why long term charts of practically every economic indicator - from long-term jobs trends to prices for individual stocks - look like profiles of the Andes Mountains. They're all fractals, which is the pattern most often associated with chaotic systems.

Economic expansions, recessions, depressions, and recoveries are actually just business-cycle components. As any Taoist sage could tell you, whenever the economy is expanding, you know that a contraction is on its way. Similarly, a depression always presages a recovery. It's inevitable. The Great Depression of the 1930s was, when looked at from a longer perspective, just a particularly deep bottom of the overall business cycle. The huge expansion we experienced during the 1990s was, conversely, a particularly robust phase of the overall business cycle.

This latest contraction, which started about 2005, and will probably not completely play out until 2015, was another particularly nasty dip in the more or less regular cycle. It's as inevitable as the tide.

So, getting back to jobs data, and the usual panicky predictions of a so-called "jobless recovery," the reason employment data have not significantly improved is that it's just too early in the process for it to show up. Those who ask: "How can sales recover when employment is down?" simply don't understand how the business cycle works. Sales aren't driven by jobs, it's the other way around, with a significant time lag between.

Jobs are driven by production requirements. As any industrial engineer could tell you, production is driven by inventories, not by demand. Demand is an intangible that is very difficult to predict or measure. Inventory levels, on the other hand, are easily measured and better reflect a company's ability to sell the products it makes.

In the real business world, the first thing to recover after a recession is demand. It begins to recover when end users have had their belts cinched so tight for so long, that they have no choice but to by new stuff. Demand for food starts to rise, for example, when pantries start to look bare. It makes no difference whether the family bread-winner has a job or not, when there's nothing for dinner, somebody makes a run to the store. Even if you have to beg a cup of sugar from the neighbors, that sends the neighbors off to the store for more sugar, increasing the demand for sugar. Therein lies the disconnect between jobs and demand.

Demand seems to have hit bottom about six months ago. Since then, we've been working off inventory that built up at the start of the downturn, when production still exceeded demand. Next, production has to rise (pulled by further increases in demand) until it exceeds capacity at the present depressed employment levels. Only then will employment figures begin to rise.

Don't look for employment metrics to turn up until at least the end of the first quarter 2010. The reason it hasn't happened yet is that it's just too darn early.