EconSouth (First Quarter 2005)

Julie Hotchkiss is a research economist and policy adviser in the regional group of the Atlanta Fed’s research department.


Economics 101:
Demand and Supply


Labor demand has been getting quite a bit of attention lately. Since the latest recession officially ended in November 2001, the media have spent a great deal of ink focusing on slow job growth, and recent labor market performance has actually been something of a phenomenon. More than three years after the end of the recession, the economy has finally reached the number of jobs it had prior to the recession. Replenishing the jobs lost during the 1990–91 recession took about two years.

There are two sides to the labor market, however: the demand for workers (which is the source of job creation) and the supply of workers. The supply—also known as the labor force—is made up of those currently employed and all the unemployed people who want to work and would be able to take a job if one were available. Unemployment results when the economy demands fewer workers than the number of people who want a job, and that condition slows overall economic growth. If the growth in jobs is less than the growth in the labor force, unemployment increases.

Oddly enough, during the recovery from the most recent recession, even with the poor showing of labor demand, the unemployment rate has been declining fairly steadily, albeit slowly, since June 2003. This decline leads us to examine the labor supply.

Where have all the workers gone?
If the growth in the number of people wanting jobs slows down, then the number of jobs that the economy needs to create to absorb them (and thus keep unemployment in check) also declines. Indeed, the percentage of the population wanting jobs has been steadily and consistently declining since 2000, lasting well beyond the end of the 2001 recession. As a result, the economy has been able to get away with meager job creation without unemployment going through the roof. But why has the labor force participation rate been declining? There are a number of reasons.

First, labor force participation has a cyclical component. When the economy is not doing well, as in a recession, fewer jobs are available and people find better uses for their time than hunting for those elusive jobs. The observation that people drop out of the labor force when job prospects are poor implies that as job creation picks up, people will find it worthwhile to start looking for those jobs again, reversing the decline in labor force growth.

Another possibility is that this decline in labor force participation is the start of a longer-term trend. The fact that the decline in labor force participation actually began well before the recession suggests that the post-recession decline is not entirely part of the cyclical nature of the job market. In fact, the decline began in 1997 and accelerated in 2000. While it’s difficult to identify a new trend, it’s also difficult to rule one out. The persistence of the decline beyond the end of the recession raises the question of what the future holds for the labor force as the largest cohort of workers in U.S. history—the baby-boom generation—begins to retire in 2011. There’s no doubt that whatever path labor force growth is on in six years, baby boomers reaching age 65 will slow that growth during the following 20 years.

Fueling economic growth
The possibility that labor force participation will continue to decline and perhaps drop even faster with the retirement of baby boomers is a source of some concern for policymakers. The ability to sustain a desired level of growth in the U.S. economy requires an increasing infusion of labor. Several options have been suggested to enable the United States to fuel its economic growth while facing the projected natural decline in labor force participation that will occur as the population ages.

The first possible policy response is Social Security reform, which could come in a combination of forms. For instance, requiring workers to wait longer before receiving Social Security payments would provide incentive for workers to stay in the labor force longer. Workers can also be induced to delay retirement by changing Social Security from its current form as essentially a defined benefit plan to a structure best described as a defined contribution plan, which would be the result of privatization.

Given the unpopularity of making people wait longer to receive their retirement payments and of putting those retirement payments at greater risk through privatization, some policymakers have suggested relaxing U.S. immigration policy to compensate for the anticipated decline in native labor force growth. This plan, however, has its own issues and considerations. First, the United States is not the only economy facing the imminent retirement of a large portion of its workforce, so competition for educated immigrants will be fierce. Second, the labor force benefits of relaxing immigration policy need to be balanced with concerns about homeland security. And, third, encouraging immigration can leave developing countries drained of the human capital resources they need to grow and develop.

A touchy alternative
An alternative to Social Security reform and immigration for fueling gross domestic product (GDP) growth lies in what has become somewhat of a dirty word during the jobless recovery from the 2001 recession—offshore outsourcing. The advantages to this solution are that U.S. businesses and consumers benefit from the lower production costs available in many foreign countries while the returns to the human capital used in that production stay in the workers’ home countries. The disadvantage, of course, is that the costs of offshore outsourcing, including reduced demand for domestic labor, are not spread evenly across workers.

While it is far from clear what the best solution for fueling future GDP growth will be, it is certain that labor supply will grab some of the attention from labor demand as the economic recovery continues.


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