Is the US Labour Market Doing Well?

December 23, 2011

December 23, 2011

By Deepankar Basu. An update, written by the author on Dec 29, appears at the end – Ed.

Not if one looks at the world from the perspective of the U.S. working class.

Employment data released by the Bureau of Labour Statistics (BLS) of the U.S. Department of Commerce on December 2, 2011 showed that the official unemployment rate had declined by 0.4 percentage points to 8.6 percent; going by the trend of the past few years this is certainly a big drop [1]. To put matters in perspective, the unemployment rate for the US economy is depicted in Figure 1 for the last 5 years. Figure 1 clearly shows the massive increase in the unemployment rate during what has come to be called the Great Recession and its stubborn refusal to come down even after the recession has officially ended in the second quarter of 2009. Given this data, the decline in the unemployment rate in reported by the BLS on December 2, 2011 seems quite important.

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FIGURE 1: Unemployment Rate in the US (shaded area indicates recession)

So we need to ask: does the decline in the official unemployment rate in reported in December 2011 mean that the US economy is finally headed out of recession and that the labour market is improving? It would be premature to draw such a conclusion. Why? Because the decline in the unemployment rate is largely driven by workers leaving the labour market, not because of being absorbed into the pool of employed workers. Hence, the drop in the unemployment rate does not provide any evidence of improvements in the U.S. labour market.

To understand this, recall that the official unemployment rate in the U.S. is defined as the ratio of the total number of unemployed workers to the total labour force. The labour force, in turn, is defined as the sum of the employed and unemployed workers. For instance in November 2011, there were about 140.5 million employed and 13.3 million unemployed workers in the US. Thus the labour force, the sum of the two, was 153.8 million. The unemployment rate was 8.6 percent (being the ratio of 13.3 million unemployed workers to a labour force of 153.8 million).

Now think of a hypothetical scenario where 1 million unemployed workers stop looking for work because they have become discouraged due to long spells of unemployment. When workers stop looking for work, they are no longer counted in the labour force. Why? Because they are neither employed nor unemployed. Hence, along with the drop in the number of unemployed workers by 1 million, the labour force also shrinks by 1 million. But since the drop in the number of unemployed is proportionately larger than the decline in the labour force, the unemployment rate falls!

To get back to the hypothetical scenario, the number of unemployed workers drop to 12.3 million, and the labour force becomes 152.8 million. Even if no new jobs are created, the unemployment rate, in this scenario, drops to 8.1 percent (being the ratio of 12.3 million unemployed workers to a labour force of 152.8 million), a 0.5 percentage point decline!

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FIGURE 2: Labour Force Participation Rate in the US (shaded area indicates recession)

This is more or less what has happened in the US economy over the past few years, i.e., the unemployment rate has declined because workers have dropped out of the labour force. How do we know this? To arrive at this conclusion, we need to look at the evolution of the labour force participation rate (LFPR). The LFPR is defined as the ratio of the labour force to the total civilian noninstitutional population, where the latter is defined as all those above 16 years of age who are not in military service or in prison or in a medical institution. Thus, the civilian noninstitutional population is the total number of workers potentially available to work, and the labour force is the number of workers who are currently active in the labour market. If the LFPR decline that implies that a larger share of the potential working population has left the active labour market.

Figure 2 plots the LFPR for the US economy over the last 5 years. It shows that the labour force participation rate has been secularly declining over the whole 5 year period since 2007 (in fact, the LFPR has been declining since the early 2000s). It also shows that the labour force participation rate declined in November (the latest month for which data is available). This confirms that the decline in the unemployment rate in November is driven by the decline in the number of workers active in the labour market, rather than by the creation of new jobs to absorb unemployed workers. Moreover, a large part of the decline in the unemployment rate since the official end of the recession in the second quarter of 2009 is also explained by the same phenomenon: declining labour force participation rate. This is certainly no matter for cheer, certainly not if one looks at things from the perspective of the working class in the U.S.

Update (Dec 29, 2011)

Like many economists, I had interpreted the decline in labour force participation since 2000 but especially the decline since 2007 as being driven by discouraged workers dropping out of the labour force. This is not incorrect but there is an interesting aspect of the declining labour force participation that I had missed. An article in the New York Times today pointed out that more and more young women, aged 16 to 24 years, are dropping out of the labour force and entering college. As the graphics that came with the NY Times article shows (click here), this phenomenon has been going on since the early 2000, precisely the period that saw the beginning of the declining trend in the labour force participation rate in the US economy. Hence, a portion of the decline in labour force participation rates is being driven by young women joining college and not dropping out of the labour force for ever.

What is the implication of this? On the positive side, this will increase the skill levels and bargaining power of future women workers and might contribute to narrowing down the wage gap between the genders. On the negative side, since college fees have been rising and state support for higher education declining, this might lead to a growing burden of student debt on future women graduates. Entering the labour market with a huge debt will entail significant reductions in consumption expenditures as larger shares of their future incomes will go to servicing this debt.

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