Run the Economy Extra-Hot

(Bloomberg View) -- With the unemployment rate down to near four percent, and new claims for unemployment insurance at a 48-year low, maybe the economy can't accommodate more workers without zooming out of control. That's the conventional wisdom, but few economists, myself included, are skeptical of this narrative. We see an economy that is still well below its long-term trend line. How do we square this with such low unemployment?

The key is a phenomenon known as hysteresis, a term borrowed from physics that's used to mark the way past recessions leave scars on the labor market.

Hysteresis was used by economists to explain the economic evolution of Western Europe in the 1970s and 80s. Like the U.S., Western Europe went through a period of stagnant growth during the 1970s that was accompanied by runaway inflation. Unlike the U.S., however, Europe's recovery saw meager job growth, even as other parts of the economy improved.

Many explanations were offered. Europe's strong labor unions and high taxes, it was argued, made firms unwilling to take risks with new unskilled labor. Generous unemployment benefits might have discouraged people from returning to the job market.

While these structural effects were real, economist Laurence Ball argued that they didn't prevent the labor market from reaching maximum employment, but did slow things down. The solution, he suggested, was to run the economy hot.

That meant allowing the unemployment rate to fall below the level that economists usually associate with full employment and stable inflation. By this reasoning, an extra-tight labor market would draw workers off the sidelines and back to jobs. Competition to attract talent would overcome the disincentives imposed by high taxation — and with workers in the driver's seat, labor unions would be less worried that the return of sidelined workers would be used to bid down members' wages.

Today's U.S. labor market faces restraints quite different from those experienced by Europe a generation ago. The scars left by past economic problems, however, are just as real.

Adam Ozimek, a senior economist at Moody's Analytics, has shown that the percentage of potential employees in their prime working years of 25 to 54 is still below its historical average. U.S. labor markets were so weak for so long that millions left the labor force. Some have returned, but not nearly all.

Former Treasury department economist Ernie Tedeschi has broken down the reasons for the reduction in prime-aged labor-force participation since 2001 based on data from Bureau of Labor Statistics.

Run the Economy Extra-Hot

The largest reduction over those years has come from an increase in the number of people who are disabled or ill.

That makes sense because workers with a disability or chronic ailment are at a particular disadvantage in a difficult job market. When labor is plentiful, employers are less likely to take on the risks of employing them. Without steady employment, those workers may not be able to afford the therapy or devices needed to allow them to work. This creates a Catch-22 that leads to hysteresis — a drag on employment left over from past downturns.

The chart shows that as the job market worsened starting in 2001, disabilities took an increasing number of people out of the workforce. That effect leveled off as the job market improved during the housing boom, but collapsed again as the Great Recession began. The trend has turned around in the last few years.

If the economy is allowed to run hot, as Ball prescribed, many employers will find ways to accommodate more of those workers. Then, improved incomes will let even more of them afford the measures needed to improve their career prospects.

The same phenomenon can be seen in education. Remember, prime-aged workers are not traditional students. Their decision to attend school is responsive to the business cycle. Many would prefer part-time education programs as they continue to earn a living. Some wouldn't go to school at all if they could find a good job. In either case, as the labor market becomes tighter, the work options for these students expand.

This is similar to the pattern that seemed to be at work with those who left the workforce to care for their families. The number of caregivers who left the workforce increased dramatically as the labor market soured and has fallen as the labor market healed. Many probably would have preferred part-time employment that they couldn't find when the market was tight.

By Tedeschi's estimate, 3.7 million more workers — 2.3 percent — are out of the labor market than the trends would have predicted back in 2001. Bringing them back will require allowing unemployment to keep falling. Joblessness could reach historically low levels, even scary ones, but that's how to make the economy healthier.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is director of economic research at the Niskanen Center and founder of the blog Modeled Behavior.

To contact the author of this story: Karl W. Smith at ksmith@niskanencenter.org.

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