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Pre-recession study predicted historic labor market drop

January 10, 2014: 2:46 PM ET

One of the signs of the weak economy may not be as worrisome as it looks.

labor-participation-rate-614

U.S. labor participation rate

FORTUNE -- The big news of Friday's jobs report? Things are looking ugly. Employers added just 74,000 workers in December, the lowest monthly growth in nearly three years.

But the other seemingly terrible news was this:

In December, the number of people who gave up looking for work was five times as large as those who actually found jobs. As a result, the labor force participation rate, which measures the percentage of Americans who are working or looking for work, fell to 62.8% -- the lowest level since 1978.

That drop seems bad, until you consider this: A bunch of economists saw it coming, even before the recession. In 2006, five Federal Reserve economists published a paper on labor force participation, which was falling even back then. Their prediction: By 2013, the average annual rate would fall to 63.3%. The actual average, which we found out on Friday: 63.3%. (The table is on page 131.)

MORE: Job report blues: Did the Fed screw up?

The study focuses on the demographics. Aging baby boomers will retire but stick around (among the living) longer than their parents. Another factor: fewer dropouts. The percentage of teens in the workforce was 31% in 2005, down from 50% in 1977. The study does not predict a recession.

What does this mean? A lot of people like to make the point that the actual unemployment rate should be 10%-plus.

That's clearly bogus. Even if the recession hadn't happened, the participation rate would have dropped. The job market and the economy in general, despite Friday's numbers, may actually be stronger than they seem. The actual participation rate, once you factor in the recession, should be lower.

Second, the 2006 study lends some credence to the theory that today's high unemployment figures are a result of structural changes in the economy, not cyclical changes, and not on account of weaknesses within the economy. The Federal Reserve, then, might be right to back off on its stimulus, and may even be justified in moving faster than it is.

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To be sure, the study is about labor force participation, not absolute unemployment. That might actually strengthen the argument for more stimulus. High unemployment coupled with a dropping labor force is a powerful one-two punch in the economy's stomach. Getting people back to work may take more effort than it used to. And since the absolute number of unemployed people remains large, there is no real fear of inflation.

In the end, the Fed should stop treating the unemployment rate as an indicator of whether we need more stimulus. If the 2006 study continues to be correct, the labor force participation will continue to drop, taking the unemployment rate, which hit 6.7% in December, down with it. That means the unemployment rate needs to drop a lot more before the economy can be considered healed.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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