The Downward Spiral of Unemployment

Unemployment is a highly talked about economic term in the modern economic world. Not a day passes by when we do not hear statistics pertaining to unemployment being mentioned in offices, streets or the media. Any change in these numbers is widely broadcasted and economists consider unemployment as a leading signal that will project the rate of all other economic metrics. In this article series, we will cover the topic of unemployment in great detail. However, in this particular video, we will list down the factors behind unemployment rate being such an important metric that it gets everybody’s attention immediately.

Unemployment: Scariest Metric

Unemployment is considered the scariest economic metric for the reason that it affects the common people i.e. the masses. Since the majority of the population in any nation depends on wages for their livelihood, when a threat appears to their wages, the masses react violently. Large scale unemployment is usually linked with political upheavals and social revolutions of catastrophic proportions. It is therefore the priority of any government that wants to stay in power to prevent any such situation from developing.

The Downward Spiral

The bigger problem with unemployment is that it tends to move in a spiral. This means that when unemployment starts, it leads to a vicious cycle which results in even more unemployment. This cycle, if left unchecked, can bring even the most prosperous economies to their knees. Let’s have a look at how this cycle of unemployment works.

Stage #1: Unemployment

Stage 1 begins with the rise in the unemployment rate due to some catastrophe. These catastrophes are usually related to asset market bubbles, socio-political upheavals or war. As a result of these events, the economy is affected and because government and private spending is dedicated towards other causes, some businesses are forced to lay off certain employees creating unemployment. The initial rate of unemployment is usually small and manageable.

Stage #2: Reduced Spending

Once there is a certain level of unemployment in the economy, the cycle begins. As the news of the newly created unemployment sets in, consumer confidence is reduced. Consumers, who are also workers, begin to worry that they may lose their job too. Hence, many of these consumers begin to cut back their spending and save for a rainy day. At a macro-economic level, this creates a marked reduction in the amount of spending in the economy thus perpetuating the economic downturn caused by unemployment.

Stage #3: Reduced Sales

As and when the consumers cut down their spending, the effect on the businesses is immediate. Businesses will record falling sales quarter on quarter. At this stage, the cycle that started in step 1 has matured into a self fulfilling prophecy. A small amount of unemployment in the economy sent panic and fear causing reduced spending and therefore reduced sales. Businesses are now therefore dealing with a full-fledged recession and need to cut spending themselves to survive the downturn.

Stage #4: Layoffs and More Unemployment

Businesses can reduce their spending by reducing the amount of goods they use as input. Alternatively, they can also lay off their employees to ensure their survival. Regardless of the decision they take, the decision is imminent, more unemployment. Less spending means less production is required which means fewer people can be gainfully employed. Hence, the cycle of unemployment has created even more unemployment.

Reinforcing: Unemployment is therefore a downward spiral. If left on its own, this cycle will reinforce itself over and over again, bring complete annihilation to an otherwise functional economy. The important part to notice is that unemployment is linked to another important economic parameter called the consumer confidence. A higher employment means a higher consumer confidence and vice versa. Also, it is important to note that consumer confidence is a leading indicator of what the employment rate of any economy will look like in the forthcoming future. The reinforcing loop is therefore created as a result of the interaction between unemployment and consumer confidence.

Broken Only By Change in Consumer Confidence: The cycle of unemployment is therefore broken only if a change can be brought about in the consumer confidence. This can be brought about in multiple ways.

1. First and the most preferred way is that of increased government spending. When businesses are reducing their spending, the government can increase its spending, thereby propping up consumer confidence and therefore propping up the employment rate. There is no doubt that government spending can boost the employment rates with almost immediate effect. However, there are several problems with government spending. Firstly, the government usually spends borrowed money and debt creates more problems than it solves. Secondly government spending is biased and inefficient.

2. Private sector spending can be induced by inviting foreign or domestic investors and offering them deals which are favorable. A good example would be opening the markets to global corporations or giving tax rebates. India suffered from a high unemployment rate in the 1980’s. However, once the markets were opened up in the 1990’s, the consumer confidence, consumer spending and employment rate have all been at an all time high.

The bottom line therefore is that, unemployment is dangerous as it creates a self reinforcing cycle. Governments and private parties can aid in controlling this downward spiral. However, the measures taken to do so need to be calculated and controlled as they can possibly cause even more harm.