Yesterday, we discussed the reasons why our labor force has shrunk in recent years. Today, we’re going to talk about some of the consequences.
November's jobs numbers were released today, showing the U.S. economy added 203,000 jobs last month, with unemployment down to 7 percent.
Contrary to popular belief, the issue with the labor force participation rate (LFPR) is not the dramatic disappearance of 720,000 workers from the labor force in October.
The blip in the LFPR is likely the artifact of statistical noise in the BLS household survey, magnified by seasonal adjustment factors and the misclassification of workers furloughed by the government shutdown.
Rather, the issue lies in understanding what the unprecedented post-recession drop in the LFPR means for economic recovery and growth.
Size Does Matter
The size of the labor force is one of the strongest determinants of longterm economic potential and, hence, living standards. Failure to factor the LFPR into the employment situation can lead to a mischaracterization of economic conditions and inappropriate policy responses.
In the short-term, declines in the LFPR mean the economy is operating below full potential. Labor market slack creates downward pressure on wages and keeps consumer demand weak. More workers sitting on the sidelines also suggest that continued reductions in the unemployment rate are unlikely to create inflation.
However, the real problems with cyclical declines in the LFPR emerge in the long-run. As time out of the labor force lengthens, skills atrophy, networks shrink and reputations erode.
When jobs return, dropouts may remain unable or unwilling to find work, or when they do, perform them less adeptly. As a result, a temporary shock propagates into the future, and the economy suffers a permanent reduction in growth potential, a condition known as hysteresis.
The Productivity Problem
Unfortunately, trends in unemployment are already showing signs of labor market hysteria. In October, 36.1 percent of the unemployed were out of work for six months or more, an improvement from 41.1 percent in 2012 but still double its level before the recession.
Long-term unemployment feeds upon itself: the longer someone is out of work, the more difficult it becomes to find a job. The more difficult it is to find a job, the longer unemployment lasts, leading to productivity erosion.
Persistence is also evident in the gap between expected and actual labor force participation. The most recent BLS estimates projected the LFPR to reach 62.5 percent in 2020—two percentage points below predictions just six years earlier. CBO’s latest projections were even more optimistic, predicting the LFPR to reach 63.2 percent in 2020.
We are at these levels seven years ahead of schedule.
Low labor force participation also has fiscal consequences. The decline in the LFPR has been accompanied by a surge in disability benefits.
Today, 8.8 million former workers receive Social Security disability, a 24 percent increase from 2007. The bill is $137 billion annually—or roughly $40 billion more than the cost of food stamps and Temporary Assistance for Needy Families (TANF) combined.
At this pace, the disability insurance trust fund will deplete its reserves by 2016. Whether disability is a cause or a consequence of LFPR declines is open to debate, but it is clear the current structure of the disability program provides few incentives for the disabled to work.
Further, there is evidence to suggest when the economy is weak, more activity shifts underground, where workers are hired informally and paid in cash.
Such labor typically avoids regular government protections—and taxes. Recent estimates suggest the underground economy is worth $2 trillion, costing the government $500 billion in annual tax revenues.
On a brighter note, GDP growth has been positive 16 of the last 17 quarters. In addition, we’ve added an average of 181,000 jobs each month since 2011—roughly twice the amount necessary to keep unemployment in check—and a total of six million jobs since the end of the recession in July 2009.
If these trends continue, momentum may spill over into labor force participation—which means, like any good mystery, the saga of the disappearing labor force will keep us turning the pages. The further we read, the more likely we are to reach a favorable resolution.
If you’d like to read more about the disappearance of the labor force, I suggest this excellent post by WonkBlog, as well as the Calculated Risk blog, which has consistently strong coverage.
A good introduction to the economics of labor force trends is Chapter 4 of the 2013 Economic Report of the President.