The biggest question facing the U.S. economy: Why are people dropping out of the workforce?

January 10

The U.S. labor force is still shrinking rapidly. Back in 2007, 66 percent of Americans had a job or were actively seeking work. Today, that number is at 62.8 percent — the lowest level since 1977:

U.S. Labor Force Participation Rate:

latest_numbers_LNS11300000_1948_2013_all_period_M12_data

Why has the participation rate been dropping in recent years? There are a couple big things going on here. Older Americans are retiring, younger Americans are going back to school, and many workers have been discouraged by the weak U.S. economy. But economists are still debating how big a role each of these factors played.

Here's an updated breakdown of the three major theories for the decline:

1) The aging of America. One major reason the participation rate dropped involves long-run demographic trends that have little to do with the current economy. Baby boomers are starting to retire en masse, which means that there are fewer eligible American workers.

Demographics have always played a big role in the rise and fall of the labor force. From 1960 to 2000, the labor force in the United States surged from 59 percent to a peak of 67.3 percent. That was largely due to  more women entering the labor force. But it was also due to improvements in health and to the fact that the types of jobs available allowed Americans to work more years.

Since 2000, however, the labor force rate has been declining steadily as the baby boom generation has been retiring. That's why, in 2012, the Federal Reserve Bank of Chicago predicted that the labor force participation rate would be lower in 2020 regardless of how well the economy does.

One way to see the demographic shift is in this chart by Bloomberg Businessweek (via Derek Thompson).

Americans over the age of 65 are much less likely to work than prime-age Americans. And since that subset of Americans is expanding its ranks, that drives the labor-force participation rate down. Note that this shift is happening even though older Americans are staying on the job for longer than they did during the 1990s.

Economists disagree, however, on exactly how much demographics are responsible for the current fall in the participation rate. The Chicago Fed estimated in 2012 that retirements accounted for one-fourth of the drop in labor force participation since the recession began. Other analysts, including Barclays, have suggested that aging Boomers could account for more than half the drop.

Meanwhile, a recent paper by Shigeru Fujita of the Federal Reserve Bank of Philadelphia staked out a more nuanced view: Demographics, he argued, didn't play a huge role in the labor-force drop between 2007 and 2011. But since then, retirements are responsible for basically the entire fall of the participation rate. One possible reason is that many older Americans postponed retirement immediately after the financial crisis to rebuild their battered 401(k)s. By 2012 or so, they began retiring en masse.

2) The bad economy is keeping workers in school and out of the labor force. Demographics can't entirely explain of the labor force slide. For one, the number of Americans working or actively seeking work has actually fallen faster than demographers had predicted:

And here's another clue that this isn't just a demographic story: The participation rate for workers between ages 25 and 54 fell sharply during the recession and still hasn't recovered. Obviously, retirements can't explain this:


Credit: Calculated Risk

So, what's going on? One theory is that the weak job market is causing people to simply give up looking for work — they're crumpling up their résumés and going home. An recent study from the Boston Fed suggested that these "non-inevitable dropouts" might even account for most of the decrease. Among other things, the authors noted that the labor-force decline has been far sharper for all age groups than simple demographics would predict.

There's a big challenge all of these studies face in teasing out the factors involved: It's hard to make a neat distinction between demographics and economic conditions. Imagine a 62-year-old worker who gets laid off from his job. He'd like to keep working and looks around, but can't find anything. So he decides to retire early — and he tells the people doing economic surveys that he left the labor force to retire. Is that a demographic story or an economic story? Or both?

Other analyses have added their own twists. According to a recent paper from the Urban Institute, the rate at which people are leaving the labor force is actually lower than it was during the aftermath of the 2001 recession. That is, labor-force dropouts aren't the only story here.

Instead, the Urban Institute notes, many workers aren't entering the workforce at the same rates they used to. That's especially true for  women, who are much less likely to enter the labor force today than they were in 2002 and 2003. Many of them may be going back to school or deciding to start families instead.

That's not always a bad thing: The fraction of 16- to 24-year-olds pursuing an education has been growing over time. That could give us a more skilled workforce in future years (though it could also give us more young Americans weighed down by student debt).

But the economic narrative here is also bleak in places, particularly for older workers: Another recent paper noted that the decline in U.S. manufacturing jobs may be partly responsible for the fall in the participation rate. During the housing boom in the 2000s, many of those manufacturing workers were able to find new jobs in the construction sector. But once housing went bust, they were left adrift, unable to find new work.

3) More workers are going on disability insurance: There are now roughly 8.8 million Americans receiving disability benefits, a number that has doubled since 1995. Could that be a factor pulling people out of the labor force?

(Source: This American Life)
(Source: This American Life)

Possibly, although this is likely a smaller part of the story than the other two factors. Back in 2007, about 5.3 percent of working-age Americans were disabled and not in the labor force. By 2012, 6 percent of Americans were in this category. That's an increase of about 1.8 million people. But it's still less than one-third the total number of people who left the labor force altogether during that span.

Why did more Americans go on disability after the downturn? There are a few possibilities. One is that this could be simple demographics — as Americans get older, they're more likely to get disabled. A second theory is that workers are using disability as a safety net of last resort once their unemployment insurance runs out.

Economist Jesse Rothstein has examined some of these theories and found them lacking. (For instance, there's little evidence that workers simply shift over to disability once their jobless benefits expire.) His preferred explanation is that it's simply easier for people with moderate disabilities to qualify for aid if there are fewer suitable jobs to go around. For example, a construction worker who hurts his back may be able to find a desk job in boom times but possibly not during a recession, which makes it easier to meet federal eligibility standards.

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So, why does the size of the labor force matter? If people are leaving the labor force for economic reasons (and they're not going back to school), it would mean that the economy is in much worse shape than the official unemployment rate suggests. The jobless rate is officially 6.7 percent, but that only counts people who are actively seeking work — not labor-force dropouts.

The size of the labor force also goes a long way to determining America's growth prospects. If, say, baby boomers are retiring faster than expected, then long-run U.S. economic growth will be lower than projected.

Even worse, if discouraged workers are dropping out of the labor force entirely (or retiring for economic reasons), they may never make their way back into jobs. Companies won't even bother to look at their applications. They essentially become unemployable.

That's a human tragedy. It could also mean the U.S. economy will be significantly weaker in future. One recent paper from the Federal Reserve estimated that America's economic potential is now 7 percent lower than it was before the financial crisis — in part because workers who lost their jobs during the downturn have become less-attached to the labor force. That's a bad sign.

Further reading:

-- My colleague Jim Tankersley had a great discussion with the Wall Street Journal's Ben Casselman a few months ago on why the labor force participation rate matters.

-- Note that as people drop out of the labor force, the nation's underground economy appears to be growing. By some estimates, the informal "shadow economy" is now worth $2 trillion.

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