The answer to the U.S. labour participation riddle may lie in disability claims

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Even for those of us who are still horrified in the imbalances in the U.S. economy four years after the recession, it is hard not to find a silver lining in this year's fall in the unemployment rate. From a peak of 10 per cent in 2009 ,the U.S. unemployment rate slipped to 7.8 per cent by the end of 2012, and as of August had slipped further to 7.2 per cent. It is a genuine bright spot, and one that presumably is being noted by the U.S. Federal Reserve. It may not have turned off the stimulus tap yet, but it is hard to think that the Fed will continue to see the need to pump up an economy where things are starting to look so reassuringly normal.

But is it normal?

If you look at the U.S. labour force participation rate (the proportion of the working age population that is either working or looking for work), it is clear that things have shifted over the past few years. From 66 per cent in 2007, the participation rate fell to a 35 year low of 63.2 per cent in August. Something has changed.

Figuring out what has changed is an important thing, particularly for those who want to know where U.S. interest rates are going over the medium term. If the reason for the fall in the U.S. participation rate is that young people have dropped out to go to school, for example, there could be a big spike in the unemployment rate when they come back into the market. However, if the reason why they have dropped out is that older people have retired earlier, then there is no reason to expect the unemployment rate to rise in the future. There are a lot of different trends behind the drop in the U.S. participation rate, all of which have gotten some attention over the past few years and all of which are clearly well-known to the Federal Reserve.

But what if the U.S. labour force participation rate has fallen so much because more people are now getting disability payments? That's the premise behind the research cited in this article in The Economist. In a nutshell, what has happened over the pasts few years is that many Americans have simply run out of jobless benefits and have found ways to get disability benefits. These range from things like back pain through to mental health issues – the latter surely completely legitimate due to the stress of long-term unemployment.

If you are getting jobless benefits you are generally counted as unemployed, but if you are getting disability benefits you are not; you're out of the labour force. So the shift from one category to another would clearly make the participation rate – and the unemployment rate – fall. How much of the recent drop in the U.S. rate does this explain? Maybe not the most significant portion of it, but certainly a chunk. According to research by the Federal Reserve Bank of San Francisco (cited in the Economist article), as much as 31 to 59 per cent of the drop in participation could be explained by the number of people getting disability benefits (the range is due to the fact that some applicants may not ultimately get benefits although they have applied for them).

So what does it all mean for interest rates? Well, since the disabled are not likely to re-enter the labour market, there are no worries that the unemployment rate is going to shoot up in a year or two and thus disrupt policy. Then again, if it is really a technicality that has caused the unemployment rate to drop, that is not a particularly positive indicator on the U.S. labour market, so perhaps you can make the case for further stimulus now – and for a while longer.

Linda Nazareth is a Senior Fellow at the Macdonald-Laurier Institute. Her book Economorphics: The Trends Changing Today into Tomorrow will be published by Relentless Press in January, 2014. www.economorphics.com