Media pundits have emphasized that the recent decline in the unemployment rate is a product of the drop in the labor force participation rate (LPR) and not the result of actual employment gains. That is an unjust analysis at best and an oversimplification at worst of a trend that has been unfolding for more than a decade and which is expected to continue over the foreseeable future.
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The truth of the matter is that nearly half of the decline in the LPR rate is the result of the aging population as opposed simply to poor economic conditions inflating the number of discouraged workers. As the population worker ages, older workers are less involved in the labor force. This leads to a lower LPR, regardless of how the economy is performing.
Even if the Great Recession had not occurred, the aging of the population would have driven the LPR down two percentage points from its 2001 peak and one percentage point below its rate at the end of 2007.
Typically, the majority of a country's workforce is between the ages of 25 and 54. Since peaking in 1997, the percent of the population made up of "prime workers" has fallen from 58% to 52%. Using the latest Census Bureau projections, the number is expected to decline to 49% in 2020.
Since these workers make up the bulk of the labor force, with a participation rate over 80%, the decline in the percentage of the population consisting of prime workers is a substantial factor behind the overall decline in the LPR.
Adjusting the LPR for Economic Conditions
The entire decline in the LPR, however, cannot be attributed to aging. The pundits are correct in their assessment that a spike in the number of discouraged workers since the start of the Great Recession has deflated the LPR and the unemployment rate. What they are wrong about is the magnitude of the recessionary effects on the LPR.
The output gap - the percentage difference between real GDP and real GDP if the economy always performed at potential (2.7% - 3.0%) - is a measure of where the economy is in any given business cycle.
An output gap below 0% shows an economy that is struggling with high unemployment.
The further the output gap is below zero, the more difficult it is for laid off workers to find a job. Conventional wisdom suggests that lower output gaps lead to more discouraged workers and a lower LPR.
The opposite is also true.
To control for economic conditions, we ran regressions on 14 age cohorts using gender, race, and the output gap on each cohort's LPR. We then calculated the expected LPR from the regression results assuming that the economy was performing at potential. That would determine an LPR based on demographics and absent of economic effects.
To get a total population LPR, we multiplied each result by its respective percentage of the total population and then summed them together.
Media pundits will find the results to be shocking.
Age Cohort (Q4 2011)
Interestingly, the structural deficiencies between available jobs and the skill set of the unemployed that leads to discouraged workers - and which is often associated with the current lagging labor market recovery - are not seen in the data.
Poor economic conditions lowered the LPR of the "prime work force" by 1.13 percentage points from its natural demographic and aged-based rate and contributed only 0.59 percentage points to the decline in the overall LPR.
Adverse economic effects on young and old workers contributed 0.51 percentage points to the lower LPR. That does not necessarily mean, however, that the drop in the LPR among young and older workers is the result of more discouraged workers.
For the younger cohorts, some of the decline comes from discouragement due to large competition with more skilled workers for scarce entry-level positions. Most of the drop in LPR, however, comes from lower opportunity costs to return or to stay in school. There are stronger, long-term economic benefits in schooling than entering the workforce.
For the older cohorts, there is an opposite effect. Instead of adding to the discouraged worker count, the old cohort actually subtracts from it.
Economic downturns typically lower net worth by causing deep pullbacks in the equity market. This lowers potential retirement funds and forces people to remain in the labor force longer than they originally wanted.
Adding it all together, 1.00 percentage of the decline at most in the LPR since the start of the recession can be attributed to economic conditions. That is a far cry from the 2.06 percentage point decline (66.1% Q4 2008 to 64.0% Q4 2011) generally cited by the media in discussing the increase in discouraged workers.
This is hardly indicative of structural problems in the labor market causing an increase in discouraged workers.
Looking specifically at Q4 2011, the unemployment rate dropped from 9.1% in the third quarter to 8.7%. At the same time, the LPR fell from 64.1% to 64.0%. If the LPR had remained at third quarter levels in the fourth quarter, an additional 78,000 unemployed workers would have been counted in the labor force.
Those lost workers are portrayed as discouraged, and they artificially lowered the unemployment rate by an extra 0.1 percentage point by leaving the labor force.
Yet, according to our estimates, the LPR would have fallen from 65.1% to 65.0% simply due to demographics and aging effects. That means that the labor force was expected to naturally decline by 223,000 workers in the fourth quarter. If all those workers had actually left, the unemployment rate would have fallen to 8.6%.
Since only 78,000 workers actually dropped out of the labor force in the fourth quarter, the labor force actually increased by 145,000 above its natural trend. In other words, the number of discouraged workers not included in the labor force fell by that same amount.
Estimate LPR 2020
The aging of the population is not expected to turn around any time soon. The older population will continue to put downward pressure on the LPR. Using the latest (2009) Census population projections, the LPR should naturally fall to nearly 63% by 2020.
Demographics for the U.S. will prevent the LPR from returning to pre-recessionary levels.
Media pundits are painting the decline in the unemployment rate almost entirely as the result of more discouraged workers leaving the labor force. That is simply untrue.
The U.S. population is naturally aging, and older workers are less involved in the labor force. This leads to a lower LPR, regardless of how the economy is performing.
By controlling for economic conditions, the natural demographic and age-adjusted LPR would be 65.1%. That means, at most, only one percentage point of the decline in the LPR since the start of the recession is due to an increase in discouraged workers.
In other words, if the entire decline in the LPR from its peak was actually from economic conditions, the unemployment rate today including discouraged workers would be 11.5%. After adjusting for the aging of the population, we find that the unemployment rate is actually 10.1%.
Clearly, the labor market has plenty of room for improvement, yet the influence of discouraged workers on the declining LPR is being overstated by many pundits who fail to recognize the natural impact of workers leaving the labor force to retire.
Aaronson, Daniel; Davis, Jonathan; and Luojia Hu. 2012. "Explaining the Decline in the U.S Labor Force Participation Rate" Chicago Fed Letter No. 296. [Online] Available at: www.chicagofed.org/webpages/publications
Census Bureau. 2009 National Population Projections.
[Online] Available at: www.census.gov/population/www/projections/
LPR for Different Cohorts