The scarring effects of downturns on young workers

Dan Andrews, Nathan Deutscher, Jonathan Hambur, David Hansell 01 October 2020

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There is a growing recognition that young people bore the brunt of the labour market adjustment to the Great Recession (OECD 2016). The subdued recovery of youth labour markets that followed suggests scarring effects from the crisis, via poor initial firm-worker matching and skills atrophy. Indeed, studies spanning North America, Japan and Europe show that labour market entry during a downturn can reduce earnings for up to 10 years after graduation (Kahn 2010, Genda et al. 2010, Oreopolous et al. 2012, Raaum and Røed 2006). The COVID-19 shock has reignited interest in such scarring effects, with concerns emerging about the career trajectories of the ‘corona class’ (OECD 2020) and the class of 2010, which was likely still feeling the legacy of the Great Recession when COVID-19 hit.

Against this backdrop, our recent paper explores the consequences of labour market entry during a downturn – the first such evidence for Australia (Andrews et al. 2020). We contribute to the international literature by using a longitudinal linked employee-employer dataset to provide a nuanced account as to why scarring effects fade over time. This provides crucial insights into how policy can ameliorate the scarring effects of recessions.

The consequences of graduating in a downturn

We exploit variation within and between state-level youth unemployment rates to estimate how local labour market conditions at the time of graduation shape worker’s subsequent earnings and employment profiles. Crucially, we control for other factors that would influence a graduate’s earnings and job trajectories (e.g. national business cycles); and lead to differences in the unobserved characteristics of graduating cohorts (e.g. higher education policy reforms). Our results also appear unaffected by potential selection biases (e.g. if regional cyclical shocks drive further study or emigration decisions).

Empirically, a 5 percentage point rise in the youth unemployment rate – a typical contractionary episode — is associated with declines in earnings and the employment-to-population ratio of 8 and 3½ per cent, respectively, upon impact. The implied loss  declines to 3½ and ¾ per cent, respectively, after five years, before fading to around zero ten years on.

Heterogeneous effects also emerge. Scarring is less prevalent for graduates that either are older (who may already have a foothold in the labour market), obtained higher-level degrees, or attended more prestigious institutions. The same is true for young individuals who do not attend university (compared to those that do), suggesting that part of the scarring mechanism relates to poor match quality and/or human capital depreciation. Finally, scarring effects are more persistent for female graduates and for individuals that graduated after 2000.

Overall, shocks that hit workers at the start of their careers are more important than those that hit later. This may reflect young workers’ (i) greater need to sort into well-matched jobs (Topel and Ward 1992); (ii) reduced scope to shelter in existing jobs; (iii) greater tendency to work for young firms, which are less resilient to shocks (Davis and Haltiwanger 2019); and (iv) greater exposure to psychological scarring and signalling effects, given their lack of work history.

Figure 1 Impact of a 5 percentage point increase in the Australian state youth unemployment rate on graduate outcomes, 1991-2017

Panel A: Wages   

        

Panel B: Firm productivity  

Note: The figure show the estimated impact on wages (or firm productivity) of exposure to a 5 percentage point higher state youth unemployment rate at graduation, for up to ten years post-graduation. It is based on a regression of mean log annual earnings (or firm labour productivity) on the youth unemployment rate in the state and year of graduation, with year, state, cohort and cohort*experience fixed effects.
Source: Andrews et al. (2020).

Mechanisms

Our estimates capture both the direct effects of adverse labour market shocks at entry, as well as the shock’s persistence (Oreopoulos et al. 2012). Controlling for the latter yields qualitatively similar – albeit more modest – effects, suggesting that the subsequent evolution of the unemployment rate affects the earnings-experience profile. This highlights the potential role for timely macroeconomic stabilisation policies which, by supporting a rapid recovery, can reduce any scarring purely associated with a more drawn-out recovery. 

Adverse shocks also appear to disrupt worker-firm match quality. Graduates – especially young women – who enter the labour market during downturns initially find work (or remain in work) at lower productivity firms. Over time, however, this negative firm productivity differential shrinks, which underpins the process of earnings recovery, given the strong link between worker wages and firm productivity (Card et al. 2018).

Labour market dynamism is a key mechanism underpinning this catch-up process. While individuals who graduate in downturns initially have lower job switching rates, their mobility eventually rises relative to the control group, allowing them to switch to more productive firms.

The corollary is that factors that supress labour market dynamism will make it more difficult to overcome initial poor match quality, potentially explaining two sources of heterogeneity. First, after graduating in a downturn, women switch jobs less often than men, which may explain why scarring is more persistent for women. Second, the structural decline in job switching rates over recent decades – which has been particularly apparent for younger and highly educated workers – possibly explains why scarring is more prominent after 2000.

Policy implications

Our analysis highlights a powerful complementarity between macroeconomic and structural policy in mitigating the scarring effects of downturns on young workers.

First, timely macroeconomic policy action can potentially cushion the effects of adverse shocks on workers, suggesting that the stimulatory macroeconomic policy response to COVID-19 observed in many countries will help support the career trajectories of young workers.

Second, labour mobility-enhancing structural reforms can aid macroeconomic resilience given that job switching to more productive firms can help undo some of the damage of graduating during a downturn.

One consequence of the decline in labour market dynamism observed in OECD countries since the early 2000s is that young workers who graduated around the Great Recession may have been trapped in low productivity firms for longer. And in a world where COVID-19 triggers a large-scale reallocation of resources (Barrero et al. 2020), young workers may even have more to gain from labour mobility-enhancing structural reforms.

References

Andrews, D, N Deutscher, J Hambur and D Hansell (2020), “The Career Effects of Labour Market Conditions at Entry” Australian Treasury Working Paper No. 2020-01.

Barrero, J M, N Bloom and S J Davis (2020), “COVID-19 Is Also a Reallocation Shock”, Brookings Papers on Economic Activity.

Raaum, O and K Røed (2006), “Do business cycle conditions at the time of labor market entry affect future employment prospects?” Review of Economics and Statistics 88(2): 193-210.

Card D, A R Cardoso, J Heining and P Kline (2018), "Firms and Labour Market Inequality: Evidence and Some Theory", Journal of Labor Economics 36(S1): 13-70.

Davis S J and J C Haltiwanger (2019), “Dynamism diminished: The role of housing markets and credit conditions”, NBER Working Paper No. 25466.

Genda, Y, A Kondo and S Ohta (2010), “Long-term effects of a recession at labor market entry in Japan and the United States”, Journal of Human Resources 45(1): 157-196.

Kahn, L B (2010), “The long-term labor market consequences of graduating from college in a bad economy,” Labour Economics 17(2): 303-316.

OECD (2016), Society at a glance, OECD, Paris.

OECD (2020), Employment Outlook, OECD, Paris.

Oreopoulos, P, T von Wachter, and A Heisz (2012), “The Short- and Long-Term Career Effects of Graduating in a Recession”, American Economic Journal: Applied Economics 4(1): 1-29.

Topel, R H and M P Ward (1992), “Job mobility and the careers of young men,” Quarterly Journal of Economics 107(2): 439-79.

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Topics:  Covid-19 Global crisis Labour markets

Tags:  Great Recession, COVID-19, young workers, sorting

Senior Economist, OECD Economics Department

Senior Adviser, Macroeconomic Group, Australian Treasury

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