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Labor force dropouts are dragging down wages

How much "slack" is there in the labor market? In other words, how much room does the economy have to grow before inflation starts rising? This is a crucial question for the Federal Reserve moving forward. The key issue here is whether the current unemployment rate overstates or understates the economy's ability to supply additional labor in response to increased demand. Some say that the large number of long-term unemployed people are, in effect, out of the labor force permanently. Others say that the decreasing labor force participation rate indicates that there's more slack than the unemployment rate alone would indicate.

A new study from Adam Posen and David Blanchflower, two economists with experience at the Bank of England, offers evidence for the latter hypothesis and argues that there's ample room for new monetary stimulus.

What's the evidence?

Posen & Blanchflower's key piece of evidence is a regression analysis of hourly and weekly wages. Controlling for a variety of demographic factors (age, gender, schooling, and race) and including fixed effects for years and states, they find that the "inactivity rate" — the share of the working age population that is neither employed nor actively seeking a job — is negatively and significantly associated with wage growth.

In other words, in places and times where the inactivity rate is high wage growth is more moderate than it would otherwise be. This indicates that low labor force participation levels exert an anti-inflationary impact on the economy. That means that given the currently depressed participation rate, there is more room for monetary stimulus than the unemployment rate alone would indicate. If demand rises strongly, we won't just see a spate of inflation we'll see a lot of people who've dropped out of the labor force go back in and start working.

What are some doubts?

As is typically the case with regression analysis, it is difficult to move from correlation to causation. It could be that low participation rates cause low wage growth (because a "shadow supply" of workers is killing the bargaining power of the employed) or it could be that low wage growth is depressing participation. To the extent that low wage growth is itself a product of a lack of monetary stimulus, that doesn't matter for the policy prescription. But to the extent that supply-side factors are driving down wages, and then low wages are driving down the participation rate, additional monetary stimulus may not help.