How tight is the labor market?

• Author: Krueger, Alan B.
• Position: The 2015 Martin Feldstein Lecture

It is a great honor for me to give the Martin Feldstein Lecture. I first met Marty when I was a research assistant at the NBER in the summer of 1984, shortly after he returned from serving as chairman of the Council of Economic Advisers (CEA). Later that year, I was fortunate to learn public finance at Harvard from both Marty and Larry Summers. They taught me a tremendous amount and sparked my passion for using economics in public policy. Marty also often visited me when I was chairman of the CEA, and I benefited from his wise counsel and encouragement.

Today, I'm going to talk about a question that Marty and I have discussed on many occasions: How tight is the labor market ? In essence, I think this issue boils down to two questions. First, how should we think about the U-6 measure of labor slack? I won't delve into this question, however, because U-6 is elevated due to a large number of part-time workers who report that they would prefer to work full-time. The recent rebound in the average work week, however, suggests that there isn't substantial slack on the hours front. Hours appear to be back to normal. The second question, in my view, is the more important one: What's going on with long-term unemployment? Are the long-term unemployed more likely to leave the labor force or find a job? And if the long-term unemployed have already left the labor force, are they likely to come back?

By 2013 short-term unemployment had returned to normal levels. So at that time I argued that if we were going to make further progress in lowering the unemployment rate, it would be because the long-term unemployed either found jobs or left the labor force. My feeling at that time was that, unless we focused public policy on improving the odds of the long-term unemployed finding a pathway back to work, the natural forces that determine the ebb and flow of labor market participation would lead many of these workers to exit the labor force. Unfortunately, as we will see, the historical pattern in which the long-term unemployed tend to increase their labor force exit rate over the course of the business cycle has reasserted itself during the current recovery, and this is having a significant effect on the job market.

About a year and a half ago, I wrote a Brookings paper on this topic with two Princeton graduate students Judd Cramer and David Cho. Part of what I'm going to do in todays lecture is summarize and extend our results. (1) Specifically, I'll focus on where we got things right, where we got some things wrong, and what we can learn from this experience.

I've had the same diagnosis for the last five years: I think the outlook for the U.S. labor market has been one of gradual healing from the terrible wounds that were inflicted by the Great Recession. We've seen the unemployment rate come down from a peak of 10 percent in October 2009 to 5.3 percent as of June (Figure 1), which represents real progress. In fact, apart from the early 1980s, when Marty was CEA Chairman, the current recovery has produced the fastest drop in unemployment recorded in the postwar era. Moreover, the share of unemployed workers who have been out of work for more than half a year has fallen very rapidly, from a record high of 45 percent in 2010 to about 25 percent in June (Figure 2).

The picture isn't quite as rosy if you look at the employment-to-population ratio, which peaked around the time that the 2000 census was conducted. In a first for an expansion during the postwar era, the employment-to-population ratio declined over the course of the previous recovery, from 2001 to 2007. The share of the population that was employed then plunged an additional five percentage points during the Great Recession and has only recovered by about one point subsequently.

Of course, the reason for the divergence between the unemployment rate and the employment-to-population ratio is labor force participation, which also peaked around the time of the 2000 census (Figure 3). The share of those age 16 and over who were in the labor force actually fell over the course of the recovery from the 2001 recession. And despite the considerable rise in unemployment during the Great Recession, the labor force participation rate was fairly stable during the recession itself, only falling 0.3 percentage point. The decline in labor force participation didn't accelerate until after the recession officially ended.

Today, the labor force participation rate is nearly 5 percentage points below its peak. Sensible analyses suggest that about half of the 15-year decline in labor force participation is due to predictable demographic changes, particularly the aging of the Baby Boom generation.

As for the other half, I think there are two important factors. About half of this remainder (or a quarter of the overall decline) can be accounted for by trends that were taking place before the Great Recession and likely continued after it. For instance, the widespread entrance of women into the workforce that had fueled the great postwar rise in labor force participation in the United States peaked around 2000. Male labor force participation, which had been steadily declining throughout the postwar period, continued to fall during the 2000s. In addition, labor force participation of younger workers declined in conjunction with an increase in their school enrollment, which should be a net positive for the economy in the long run. The remaining quarter--or a little over a percentage point--of the overall decline in labor force participation is likely attributable to cyclical factors. I will present evidence suggesting that its unlikely we'll see much of a recovery for this segment of the population going forward.

Now, I've been on record predicting little cyclical rebound in labor force participation for quite a while. In March 2011, for example, I wrote an article for Bloomberg in which, with unusual understatement, I predicted "we might well see the labor force shrinking more even as the measured unemployment rate falls." (2) I faced some criticism at the time for this contrarian view. As an example of the conventional wisdom, Goldman Sachs's very well-respected economics research group has published a series of reports over the past four years in which they've repeatedly predicted that labor force participation would stabilize or rise as the recovery continued. (3) Instead, the data have clearly shown a persistent decline.

The following chart (Figure 4), an earlier version of which accompanied my Bloomberg article, shows why I was expecting labor force participation to continue to decline. Specifically, it shows the monthly labor force exit rate for the unemployed by duration of unemployment according to the Current Population Survey (CPS). These data suggest that there is a strong cyclical pattern in the probability that the long-term unemployed will leave the labor force. Workers who had been unemployed for more than half a year became more likely to leave the labor force as the economy strengthened in the late 1990s but their labor force withdrawal rate collapsed in the 2001 recession. The same pattern occurred again during the recovery in the 2000s as well as in the Great Recession. Thus, when I wrote the piece for Bloomberg in 2011, I expected a rise in labor force exits for the long-term unemployed, which has transpired. This cyclical pattern comes about because (1) the composition of the long-term unemployed changes over the cycle; (4) (2) extended unemployment insurance benefits and benefit exhaustions tend to be cyclical; and, I suspect most importantly, (3) the long-term unemployed become increasingly discouraged and detached from the job market the longer they are out of work.

Notice that while there is also a cyclical pattern in the labor force...