The Fed Needlessly Undermined Growth, Study Confirms

For much of the past decade, America’s foremost economic thinkers have been struggling to resolve two “mysteries”:

1. Why was the prime-age labor-force participation rate (i.e., the percentage of workers ages 25 to 64 who have a job or want one) stuck so far below its precrisis level?

2. Why was wage growth tepid, even as the unemployment rate dropped near historic lows? Which is to say: If jobs were relatively plentiful, and available labor relatively scarce, then why weren’t workers feeling more emboldened to demand higher pay? Or, viewed from the other end, why weren’t employers finding themselves incapable of filling positions without raising wages more aggressively?

Our esteemed technocrats produced a cornucopia of creative explanations for each of these phenomena. Overly generous disability benefits had lured able-bodied Americans out of the labor force and into irrevocable dependency. Or else excessively entertaining video games had persuaded a generation of young men to pursue a life of PlayStation and poverty over one of work and prosperity. Regardless, the decline could not be averted through economic stimulus—the labor market was not failing these workers; they were failing the labor market.

As for wages, globalization and automation had placed new limits on American workers’ bargaining power; ask for too much, and the boss will simply replace you with a robot or a less-demanding worker from the developing world. Or else workers simply hadn’t earned raises — productivity growth was too low for firms to increase wages without eating into profits. Or sluggish wage growth merely reflected demographics; as the population aged, senior-level workers were being replaced with entry-level ones with lower salary expectations. Or (more credibly) perhaps the long death of the American labor movement had left workers too atomized and demoralized to ask for what they’re worth.

Regardless, wage growth couldn’t be significantly improved through further fiscal or monetary stimulus. The economy was already nearing full employment. The labor market simply couldn’t get much tighter.

A few lonely voices disputed this consensus. In their view, these two distinct mysteries weren’t actually distinct — or all that mysterious. The reason wage growth wasn’t rising as one would expect with the economy near full employment was that the economy wasn’t near full employment. And the reason the economy wasn’t near full employment was that all those prime-age workers who’d supposedly exited the labor force for reasons totally unrelated to the strength of the economy hadn’t actually exited the labor force for reasons totally unrelated to the strength of the economy.

In this view, both of the supposed mysteries stemmed from the same mistake: Economists had too much faith in the official unemployment rate. That rate counts only those who say they’re actively seekingemployment as available workers. And yet many Americans who say they aren’t looking for a job (and are, therefore, classified as nonparticipants in the labor force) also say that they would like a job if one presented itself. Meanwhile, survey data show that even those Americans who say they aren’t looking for a job – and don’t want one – can abruptly change their minds. Such workers often go from being “outside the labor force” to being employed without ever registering as “unemployed” in the government’s data.

This reality has a major implication: The pool of surplus labor that employers have at their disposal at any given time is much larger than the unemployment rate lets on. Americans who are prepared to say that they’re looking for work when asked by government pollsters aren’t the only Americans who are actually keeping an eye out for employment opportunities.

Labor markets were, therefore, looser than mainstream economists appreciated in recent years. And this was why firms felt little pressure to raise wages. Wage growth was low by historical standards, when measured against the unemployment rate; but measured against the prime-age nonemployment rate (which includes sidelined workers who say they aren’t looking for jobs), wage growth was right where models would predict.

The upshot all of this was that America was nowhere near exhausting its productive capacity. If policy-makers allowed the demand for labor to rise — by keeping interest rates low and increasing fiscal stimulus — the supply of workers would rise to meet it. In a sufficiently tight labor market, employers would find ways to accommodate the special needs of disabled workers, enabling them to once again contribute to the economy. Meanwhile, firms would eventually be forced to increase compensation, and the promise of decent pay would lure millennial gamers out of their parents’ basements and onto the payrolls. America’s political economy would remain grotesquely unequal and in need of structural reform. But to make economic growth more robust and broadly shared, policy-makers only needed to refrain from deliberately “cooling” the economy out of a delusional fear that labor demand would soon outstrip supply and trigger runaway inflation.

But refrain they did not.

Instead, the Federal Reserve began raising interest rates in 2015, while most mainstream economists opposed proposals for additional fiscal stimulus on the grounds that America was already on the cusp of exhausting its labor supply in 2016.

Since then, the lonely voices appear to have been vindicated. Once Trump was in office, Republicans stopped caring about the debt and showered the economy in deficit-financed tax cuts and defense spending. Meanwhile, after much browbeating from the president, the Fed eventually backed off its rate hikes. Contrary to conventional wisdom, these moves have not sparked inflation. Instead, they ostensibly helped bring more Americans into the workforce and have sustained wage growth for those already in it. By the first quarter of this year, the prime-age participation rate hit 82.6 percent — nearly two percentage points higher than it had been in 2015, when many economists believed that the U.S. had little hope of significantly increasing that rate.

This has been a bit embarrassing for America’s economic Establishment — especially for the inflation and deficit hawks within it (to take one example, conservative economist Marvin Goodfriend warned in 2012 that if the Federal Reserve allowed the unemployment rate to dip beneath 7 percent, it would likely “give rise to a rising inflation rate in the next few years, which would just be disastrous for the economy”). Nevertheless, some have persisted in rejecting the counsel of their dovish critics. And last month, the Federal Reserve Bank of San Francisco gave the recalcitrant some cause for comfort.

In an “economic letter,” the bank’s research adviser, Regis Barnichon, argued that, “contrary to a popular and appealing hypothesis, the tight labor market is not bringing new workers into the labor force.” Rather, Barnichon maintained, the tight labor market was slowing the rate of “labor exit,” which is to say, the rate at which existing workers leave the labor force. The reason for this was simple: “Because unemployed workers are finding jobs faster [due to the hot economy], they are less likely to leave the labor force.”

Barnichon’s thesis still tacitly concedes that monetary and fiscal stimulus has helped expand the size of the workforce and thus our economy’s productive capacity. But it also suggests that neither of those things has much more room to grow. In Barnichon’s analysis, economists were largely correct when they insisted that prime-age labor-force dropouts could not be cajoled back to work by more favorable conditions. For this reason, we are likely to run up against the limits of our nation’s labor supply sooner rather than later.

But on Friday, former Treasury Department economist Ernie Tedeschi published what looks (to my very untrained eyes) like a devastating rebuttalto Barnichon’s report. Tedeschi’s analysis is rather technical and wonky, but the core of his critique is straightforward: As purveyors of conventional economic wisdom did throughout the recovery, Barnichon failed to account for the flaws in the government’s employment survey (technically known as the Current Population Survey, or CPS).

Barnichon derived his analysis entirely from month-to-month changes in the Current Population Survey. But those changes are often distorted by a problem we’ve already examined: To ordinary people, the distinction between being “unemployed” and “nonemployed” is often hazy. For this reason, some survey respondents fail to classify their labor status in a consistent way.

Most respondents to the CPS appear to have consistently-coded labor force status over time. But some labor force status records appear to be susceptible to classification error. For example, Ahn & Hamilton (2019) notes duration inconsistencies: some people who are nonparticipants in the CPS one month and then switch to being unemployed the next consecutive month also report that the duration of their unemployment spells have been greater than a month. But this is internally inconsistent within the CPS: a person switching statuses into unemployment should report being unemployed no more than one month. Meanwhile, Abowd and Zellner (1985), Poterba and Summers (1986), and Elsby, Hobijn, and Şahin (2015) also identify cases of spurious transition, where households will move from, say, unemployment to nonparticipation and back again over three consecutive months. In principle this is entirely possible, but in practice these temporary flows may effectively be noise rather than signal.

When Tedeschi accounts for these inconsistencies, he finds that between one-third and one-half of the increase in labor-force participation since 2015 is attributable to new workers coming in off the economy’s sidelines.

America’s current participation rate is still well below its precrisis peak. Which means that, if Tedeschi is right and the hot economy is expanding the labor force by reactivating discouraged workers, then our economy still has plenty of room to grow.

A stronger, longer recovery is possible — if the Fed’s brilliant economists, and the White House’s very stable genius, get out of its way.

Source: New York Magazine

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