If there's one headline indicator that encapsulates everything you need to know about the economy, it's the unemployment rate. And for the last few months, the news has been uncommonly good. In just four months, the unemployment rate has plunged from 9.8 percent to 8.8 percent. That's one of the sharpest short-term declines on record, and it suggests that jobs are rapidly returning and the economy quickly healing.
But neither of those things is quite true, and the unemployment rate has become a misleading indicator of the economy's health. If anything, it may now be telling us more about the shifting patterns of work in America, and the new ways people are adjusting to a challenging economy. We may even be returning to habits of a few decades ago, when fewer people worked, incomes were lower, and buying habits were more modest.
Just a few months ago, most mainstream economists expected the unemployment rate to drift upward during most of 2011—perhaps peaking around 10 percent or so—then fall for good, as the recovery gained strength. That would have been a normal pattern, and a reassuring, if paradoxical, sign of an improving economy. In the midst of a recession, a lot of unemployed people typically get discouraged because they can't find jobs, and give up looking for awhile. Once they stop looking for work, they're no longer counted as unemployed or as part of the labor force. Then, as the economy improves, discouraged workers usually start looking for work again, returning to the labor force. Since it takes a while for them to find jobs, they're typically counted as unemployed at first, which drives the unemployment rate up. But as the jobless find work, the unemployed rate falls and the slack in the labor market tightens, returning the economy to "normal" employment levels.
That's not happening this time around. Instead, a surprisingly large number of Americans are choosing not even to look for work, which could be for any number of reasons. Despite some recent hiring, many long-unemployed workers in deeply troubled sectors like construction and certain types of manufacturing may still feel there are no jobs. Others may have gone back to school or committed to life as a homemaker. Some older workers may have retired early, even if that meant living off of a smaller nest egg and accepting lower living standards. Some families may be getting by with parents who work a combination of part-time, temporary, and under-the-table cash jobs instead of one or two full-time jobs.
These trends show up in the data in a couple of ways. First, the total labor force, which is the number of working-age people either working or looking for work, has plateaued since 2008, the first time since the end of World War II it has flattened out for more than a few months. Usually the labor force grows even during a recession, if only because the nation's population keeps growing. The labor force has flat-lined because the participation rate—which measures the percentage of adults who are working or looking for work—has been falling for more than a decade. The labor-force participation rate began a long rise in the 1970s, going from typical levels of about 58 percent to a peak of 67.3 percent in 2000. That was largely on account of more women joining the labor force, and continuing to work once they had kids. But the participation rate began to slowly decline after 2000, falling more sharply during the recession. It's now at 64.2 percent.
In plain English, that means fewer Americans are working, or want to work. And that distorts the meaning of the unemployment rate and other important indicators. Here, for example, are a few stats showing what the unemployment rate would be if participation rates were at levels of 2000 (67 percent), or 2007 (66 percent):
Actual unemployment rate: 8.8 percent. Actual participation rate: 64.2 percent.
Unemployment rate if the participation rate were 66 percent: 11.3 percent.
Unemployment rate if the participation rate were 67 percent: 12.7 percent.*
Nobody would feel good about the economy right now if the unemployment rate were above 11 or even 12 percent. Yet consumer confidence is improving (despite recent setbacks due to rising gas prices), consumers seem more comfortable spending money, companies are hiring again, and President Obama is gaining increased credibility for his handling of the economy.
Some of that is legitimate. The economy has added about 1.9 million new jobs over the last 15 months, and the pace of job creation has intensified, hitting levels that suggest the economy has turned an important corner. But overall, there are still 6.4 million fewer jobs than there were before the recession. At the current pace of job creation, it would take five years or so just to get back to those levels. That's a lot of people who used to have a paycheck but no longer do.
It's still not clear whether a flattening labor force will persist, and if it does, whether that would harm the economy. Economist Drew Matus of investment bank UBS says that while the declining participation rate is partly due to discouraged workers dropping out of the labor force—the traditional reason—demographic factors, like the gradual aging of the U.S. population and a pullback in the portion of middle-aged men who work, are much bigger factors. If so, that suggests the changes may be permanent, and the labor force won't suddenly surge in size, as it has done after other recessions.
That could be a problem. A slack labor market usually puts downward pressure on wages, which makes it harder for workers to keep up with inflation. That creates the powerful—and legitimate—sensation of falling behind instead of getting ahead. Fewer workers with money to spend also means there will be less economic activity overall, which contributes to slower growth. And the pace of growth helps determine whether prosperity feels abundant, or elusive.
But a stagnant labor force and a lower participation rate will also make the economy seem healthier, sooner. Economists, on average, expect the unemployment rate to be about 9.3 percent by the end of 2011, which is half a point higher than it is now. If current labor-force levels hold, however, the actual unemployment rate ought to be significantly lower, Matus says. That will create the misleading impression that job creation is outperforming expectations. And the "break-even" number of new jobs needed every month to keep unemployment steady would fall, too. Economists now think that number is about 165,000, which means any new jobs created above that number would help lower the unemployment rate. But Matus thinks the break-even number could end up being as low as 104,000 new jobs every month, a much easier target. In fact, the economy could even get back to the pre-recessionary unemployment rate of 5 percent—considered to be healthy, "full" employment—with half a million fewer jobs than it took to reach that happy number the last time.
Some of this is alchemy, of course. The unemployment rate is a mere number that doesn't change the reality of scarce jobs and, for many, declining pay. But improving statistics do tend to cheer economists and CEOs, and filter into the confidence levels of ordinary consumers. One person who won't be complaining is President Obama. He can already claim a victory of sorts for pushing the unemployment rate down. And if current trends continue, he'll be able to tell voters on Election Day in November 2012 than unemployment is lower than it was the day he took office. The details aren't quite so simple—but he probably won't mention that.
* I derived these figures by starting with the working-age population, which is 239 million, and computing the size of the labor force if the participation rate were 66 percent, and 67 percent. Then I calculated how many additional workers there would be under each scenario. Since those additional workers would all be unemployed, I added the number of new workers in the labor force to the current number of unemployed workers, which is about 13.5 million. Then I divided the number of putative unemployed people in each scenario by the size of the labor force, to get the theoretical unemployment rates. All of the data needed to do these calculations is available at www.bls.gov/data/.