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It sounds like welcome news. The unemployment rate dropped from 9.8 percent to 9.4 percent, the sharpest one-month drop since 1998. After months of grim news about jobs, it finally seems like things are heading in the right direction.

But the fine print is discouraging. The economy did add 103,000 new jobs in the latest month, which accounted for about half of the steep drop in the unemployment rate, according to forecasting firm IHS Global Insight. But the number of new jobs is much lower than economists expected, and the current pace of job creation is far too weak to offset all the jobs lost during the recession. The other reason the unemployment rate fell is a shrinking labor force. Nearly 400,000 unemployed people stopped looking for work in the most recent month, because they felt no jobs were available. They gave up, in essence, and dropped out of the labor force. And that is not what is supposed to happen as the economy recovers and workers, in theory, become more optimistic.

Such "discouraged workers" have become a key variable in the jobless numbers, and in the overall direction of the economy. There are now about 4 million Americans classified as "discouraged" or "marginally attached to the labor force," which basically means they'd look for work if they thought it were available—but they don't, so they're not. That's in addition to about 14.5 million people who count as unemployed, because they're actively looking for jobs. Four million labor-force dropouts may not sound like a lot compared with a total labor force of nearly 154 million, but those marginal workers represent the difference between healthy growth that would bring the economy roaring back, and the kind of tepid growth we have now, which leaves millions of consumers feeling unsure about their jobs and anxious about the future.

A shrinking labor force also masks deeper weaknesses in the economy. The size of the U.S. labor force peaked at about 155 million in October 2008, right after the collapse of Lehman Brothers (OTC:LEHMQ) and the financial panic that led to millions of layoffs. Back then, the percentage of adults either working or looking for work was 66 percent, about average for the last two decades. The labor-force participation rate has since fallen to 64.3 percent, the lowest level since the early 1980s. Fewer Americans are working, and fewer Americans want to work. If the participation rate were still 66 percent, unemployment would be closer to 12 percent—a number nobody would tout as cheerful news.

There's usually a decline in the size of the labor force during recessions, as people who might ordinarily work decide to go back to school, or to stay home and help out around the house, until the job market improves. But the decline in the size of the labor force over the last two years is the sharpest since World War II, and economists now think the labor force could be shrinking permanently. Bank of America Merrill Lynch (BAC) recently predicted that labor-force participation will tick upward as the recovery picks up, but then resume a gradual downward trend that's been in place since 2000. Their analysis shows that a shrinking labor force could whack a full percentage point off of GDP growth annually.

That would have a tangible impact on millions of Americans. Slow economic growth means an indefinite oversupply of workers, which would continue to hold down pay levels--even for those with jobs that feel secure. That would make it harder to save, pay down debt, and keep up with inflation. Fewer earners in the economy also means fewer people paying taxes, which would exacerbate federal deficits and state and local budget shortfalls, which are already a big problem. And of course the unemployed will continue struggling to make mortgage payments, maintain health insurance, and in many cases simply put food on the table, straining the social safety net that working Americans pay for.

Economists still expect the unemployment rate to go back up as the economy improves, which, paradoxically, would be good news because it would signal that discouraged workers are regaining some hope and treading back into the job market. IHS Global Insight, for instance, predicts that unemployment will drift back toward 10 percent in 2011, then turn around and end the year close to 9 percent. But that up-and-down trend, typical at the end of recessions, was already supposed to be happening by now. Instead, workforce discouragement seems to be lasting much longer than usual. Optimism, for many, remains as elusive as a job itself.

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Source: The Bad News Behind a Falling Jobless Rate