How to Fix the U.S. Job Market

• Layoffs have abated since a year ago, but forced separations continue while hiring remains dormant..
• Productivity has soared, suggesting many firms are only now seeing the benefits of the information technology revolution.
• To kick-start expansion and employment growth, policymakers need to continue aggressively supporting the economy.
• Extending UI benefits, more aid for state and local governments and a job tax credit all should be on the table.

The Great Recession ended this past summer, as the nation's GDP began expanding again, but this growth has not been sufficient to stem the loss of jobs—now more than 8 million and counting—or the rising unemployment rate that now sits firmly in double digits. (This includes benchmark revisions to the payroll employment data already announced by the Bureau of Labor Statistics.)

The job market is arguably as bad as it has been since the Great Depression, with nearly every industry, occupation, and region of the country suffering from weak labor demand. Layoffs have abated since the financial panic of a year ago, but the number of forced separations remains uncomfortably high. Even worse, hiring and job creation remain dormant.

The struggling job market is the most serious threat to the fledgling economic recovery. In a typical business cycle, recession occurs when consumer and business demand is undermined by a shock such as a surge in oil prices, a stock market crash, or—as in the current cycle—the bursting of a house price bubble. Businesses respond by slashing investment and payrolls to cut costs and stabilize profits. As they do, investors, who had driven down stock prices leading up to the recession, now bid prices up. With better profit margins and higher stock prices, businesses stop cutting, and recession gives way to recovery. A self-sustaining expansion takes hold when businesses feel comfortable enough to invest and hire. In the current business cycle, profits and stock prices have risen, businesses have stopped cutting, and recovery has begun. But because employers have yet to resume hiring, expansion remains elusive.

Some firms may have found they can produce more with fewer employees. Judging by a recent astonishing surge in productivity, businesses may only now be seeing the full benefits of the information technology revolution of a decade ago. Making the changes needed to fully realize these benefits might have been too difficult in the good times, but in tough times, managers feel unfettered, and even compelled to do so, even (or particularly) if that means slashing payrolls. With so many out of work, managers may also sense they can require their remaining employees to work harder. Corporate profits and stock prices have jumped with the productivity surge, but businesses have yet to respond by expanding or hiring. Unless they do so soon, job and income growth will not be sufficient to support the spending necessary for a self-sustaining expansion.

Another somewhat hopeful explanation for the lack of hiring is simply that it needs more time to rev up. Many businesses suffered near-death experiences a few months ago, and their managers are not yet convinced that conditions are strong enough to justify expanding. Firms lack confidence that demand is strong enough to invest more and hire. It will take more time than in past business cycles for those animal spirits to return.

A lack of credit is also a problem, particularly for small and midsize firms that rely on credit cards and small banks for loans. Credit card companies and small banks remain under pressure and are pulling back. Lending standards have been significantly tightened, contributing to a sharp decline in the number of credit cards and commercial loans outstanding. Smaller businesses account for a surprisingly large share of the nation's job base, and if they are not able to get the credit necessary to expand their operations, the job machine will not start up.

Larger businesses may also be paralyzed by the uncertainty created by Washington's policy debates, over a range of efforts that have the potential to significantly impact the cost of doing business. Healthcare reform, financial regulatory reform, climate change legislation, and the expiring Bush tax cuts quickly come to mind. Businesses are always grappling with policy uncertainty, but the stakes have arguably never been bigger than now.

To make the leap from recovery to expansion, the Federal Reserve and fiscal policymakers need to remain aggressive in providing support to the economy. It is unlikely that the Fed will raise rates until unemployment has clearly peaked; the central bank may even expand its credit easing efforts early next year, rather than allow them to expire on schedule. Congress and the administration should also consider extending some provisions of the current fiscal stimulus package.

These most obviously include unemployment insurance benefits to millions of workers who will lose jobs in 2010, and increasing financial aid to hard-pressed state and local governments. Providing more resources to the Small Business Administration and temporarily easing lending terms for small-business loans also make sense. There is also a good case for a job creation tax credit, in the form of a payroll tax holiday for firms that add to their payrolls.

These policy efforts would be expensive, costing the federal government as much as $230 billion over the two-year period 2010-11. The costs are on top of the $45 billion for recently passed legislation to extend and expand the homebuyer tax credit, provide more UI benefits to those losing jobs this year, and provide tax relief to some money-losing businesses.

Yet the costs to taxpayers would be measurably greater if the economy does not turn the corner into expansion but instead retreats back into recession. With the unemployment rate already in double digits, a deflationary cycle of falling wages begetting falling prices, which leads to more wage cuts, could well take hold; at that point, policymakers will have no good response, given the 0% federal funds rate and the federal government's rapidly eroding balance sheet.

The nation has made significant strides in the last year; 12 months ago, major financial firms were disappearing, and the economy was in free fall. Yet the proverbial coast is not clear. The Great Recession has given way to recovery, but with firms still unwilling to add to their payrolls, it will take more policy help to ensure a self-sustaining economic expansion takes root.