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America s labour market has suffered permanent harm
IT TOOK barely a month for the bubble of optimism that formed over the American
economy at the start of the year to deflate. Job growth slowed sharply in
December, and stayed weak in January, suggesting more than bad weather was to
blame.
The unemployment rate, though, tells a much cheerier story: it dropped to 6.6%
in January from 7% in November. Indeed, it could soon hit the Federal Reserve s
6.5% threshold at which it may consider raising interest rates.
The jobless number has been sending a strangely upbeat message about America s
recovery for some years now. Yet the Fed and other researchers have downplayed
its significance, linking the rate less to buoyant demand for labour than to
stagnant supply, as discouraged workers stop hunting for jobs. On February 11th
Janet Yellen, in her inaugural appearance before Congress as chairman of the
Fed, called the recovery in the labour market far from complete and averred
that she would consider more than the unemployment rate in deciding when to
declare it healed.
Listen to the numbers
Even so, recent research suggests the unemployment rate is saying something
important. It s just that the message is a depressing one: America s labour
supply may be permanently stunted. If so that would mean that the economy is
operating closer to potential using all available capital and labour than
generally thought, and that there is less downward pressure on inflation than
the Fed has assumed.
Figuring out the gap between actual and potential output is tricky because
potential, always hard to discern, is more uncertain than usual. In a recent
report Lewis Alexander of Nomura Securities, a bank, calculated the output gap
using three different labour market indicators (see chart). The proportion of
people with jobs plunged from 63% of the population in late 2007 to below 59%
in 2009. It has barely budged since, suggesting the output gap has not closed
at all. The unemployment rate, in contrast, is 1.1 percentage points above its
estimated natural rate of 5.5%, suggesting most of the output gap has
disappeared. Finally, if one looks just at those who have been unemployed for
less than six months, the output gap appears to have closed completely.
Deciding which measure to use involves determining why so many people have left
the labour force. The labour participation rate (measuring those in work or
looking for it) is down to 63% from 66% in 2007. The Congressional Budget
Office (CBO) attributes just a third of that decrease to discouraged workers
who have temporarily stopped looking for jobs. The remainder it ascribes to
demographics, as ageing baby boomers retire early, or to people who have gone
jobless for so long they have permanently given up looking. This is one reason
the CBO has sharply revised down its estimate of America s potential, and with
it, the size of the output gap, which it now puts at a little over 4% of GDP.
Had its estimates of the economy s potential not shrunk since 2008, that gap
would be 10% of GDP.
So if the unemployment rate is understating the output gap, it is not by much.
Indeed, for the Fed s purposes, it may even be overstating the gap. That s
because the longer someone is unemployed, the less attention they get from
recruiters and the less vigorously they hunt for work. As a result they are not
much of a curb on wages.
Explore our interactive guide to the states and stats of America
In 2005 Ricardo Llaudes of the European Central Bank found that short-term
unemployment predicted inflation in European economies better than total
unemployment. This was less true for America, where short-term and long-term
unemployment have tended to move together. But the two have recently parted
ways, with long-term unemployment declining much more slowly.
Several researchers from the Federal Reserve Bank of New York recently
re-examined the relationship and found that short-term unemployment better
explained why wage growth has not fallen further. To be sure, inflation itself
has fallen to a little over 1%, well below the Fed s 2% target. But a report
accompanying Ms Yellen s testimony attributed some of that to falling commodity
prices and a stronger dollar. It noted that growth in wages has been weak but
that unit labour costs, which adjust wages for productivity, are growing at
about the same rate as before the recession.
This doesn t mean the Fed has to raise interest rates now, given how low
inflation is. But if inflation moves up, this debate becomes front and centre,
right away, says Mr Alexander.
The Fed could, of course, let inflation rise above its target in hopes of
getting unemployment down further. Ms Yellen played a central role in the
adoption of a strategy that allows for that. But it may be fighting a losing
battle. Unpublished research by Alan Krueger of Princeton University finds that
in 2010 about 18% of the long-term unemployed quit the workforce each month.
That has since risen to 24%. Meanwhile, the rate at which they find work has
edged down to 10% per month. The work they find is often transitory or
part-time. Thus, with each passing month, more of the unemployed are drifting
to the fringes of the labour market than re-entering it. More monetary and
fiscal stimulus may have saved them a few years ago, but are of much less help
now.
Policymakers will need to put more effort into making the long-term unemployed
once again employable. Barack Obama recently persuaded several hundred
companies to pledge not to discriminate against them. Unfortunately that will
probably not be nearly enough.