With the unemployment rate down to near 4%, 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 a 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.
