The Dropout Puzzle

PAUL KRUGMAN

Many seemingly authoritative figures, not all of them partisan shills, say that the American economy has fully recovered from the recession that began in 2001. They point to the unemployment rate, which has fallen from a peak of 6.3 percent in 2003 to 5 percent last month. That's not quite as low as the 4.2 percent unemployment rate in February 2001, when the recession began, but it's fairly low by historical standards.

For some reason, however, the public isn't feeling prosperous. Gallup tells us that only 3 percent of Americans describe the economy as "excellent," and only 33 percent describe it as "good."

Maybe people are just ungrateful. Maybe they've been misled by negative media reports. Maybe they're grumpy about their paychecks: adjusted for inflation, average weekly earnings have been flat for the past five years.

Or maybe the figures on unemployment are giving a false signal.

Economists who argue that there's something wrong with the unemployment numbers are buzzing about a new study by Katharine Bradbury, an economist at the Federal Reserve Bank of Boston, which suggests that millions of Americans who should be in the labor force aren't. "The addition of these hypothetical participants," she writes, "would raise the unemployment rate by one to three-plus percentage points."

Some background: the unemployment rate is only one of several numbers economists use to assess the jobs picture. When the economy is generating an abundance of jobs, economists expect to see strong growth in the payrolls reported by employers and in the number of people who say they have jobs, together with a rise in the length of the average workweek. They also expect to see wage gains well in excess of inflation, as employers compete to attract workers.

In fact, we see none of these things. As Berkeley's J. Bradford DeLong writes on his influential economics blog, "We have four of five indicators telling us that the state of the job market is not that good and only one - the unemployment rate - reading green."

In particular, even the most favorable measures show that employment growth has lagged well behind population growth over the past four years. Yet the measured unemployment rate isn't much higher than it was in early 2001. How is that possible?

The answer, according to the survey used to estimate the unemployment rate, is a decline in labor force participation. Nonworking Americans aren't considered unemployed unless they are actively looking for work, and hence counted as part of the labor force. And a large number of people have, for some reason, dropped out of the official labor force.

Those with a downbeat view of the jobs picture argue that the low reported unemployment rate is a statistical illusion, that there are millions of Americans who would be looking for jobs if more jobs were available. Those with an upbeat view argue that labor force participation has fallen for reasons that have nothing to do with job availability - for example, young adults, recognizing the importance of education, may have chosen to stay in school longer.

That's where Dr. Bradbury's study comes in. She shows that the upbeat view doesn't hold up in the face of a careful examination of the numbers. In fact, because older Americans, especially older women, are more likely to work than in the past, labor force participation should have risen, not fallen, over the past four years. As a result, she suggests that there may be "considerable slack in the U.S. labor market": there are at least 1.6 million and possibly as many as 5.1 million people who aren't counted as unemployed but would take jobs if they were available.

There's both good news and bad news in that assessment. The good news is that the economy probably has plenty of room to expand before inflation becomes a problem (which implies that the Fed's decision to start raising interest rates was premature).

The bad news is that it's hard to see where further expansion will come from. We've already had four years of extremely loose fiscal and monetary policy. Tax cuts have pushed the federal budget deep into the red. Low interest rates have helped generate a housing bubble that has lifted real estate prices to ludicrous heights in major parts of the country.

If all that wasn't enough to give us a full economic recovery, what will?