The Unemployment Rate: A Poor Economic Indicator

People seem curious about the unemployment rate. Among the most common questions I am asked is “How high do you think the unemployment rate will get?” Most askers seem obsessed with the 10 percent barrier.

They are asking the wrong question.

The unemployment rate is calculated from the household survey. It is the number of unemployed persons divided by the labor force. Simple enough and an easy standby measure.

The problem is, of course, in the definition of an unemployed person. To be unemployed, one must be out of work and actively seeking employment. If you are not actively seeking employment, then you are out of the labor force. The problem is that many people give up looking when there are no jobs to be had (a logical course of action, but statistically problematic).
Think of a mill town. In a typical mill town, most of the employment is related to the operation of the mill. The mill workers are directly employed, but even the grocer is simply there to provide groceries to mill workers. When the mill shuts down, there are no jobs. So what answer does a household from this mill town give, if surveyed by the BLS. Most likely, they respond that they are not in the labor force. They would work if the mill were open but it is not.

This is a wide-spread and typical example. Although not every discouraged is from a mill town, the principle is widespread. When the unemployment rises, this rise is likely associated with a large number of discouraged workers. Hence, the increase in the unemployment rate is muted. The more people out of work; the greater the effect.

Take a look at the picture below. The bottom line is the unemployment rate as measured by the BLS. In the top line, I have added to the pool of unemployed persons the change, over the previous two years, of the persons out of the labor force. This swath is too broad, but without delving into microdata I cannot do systematically better.

Notice, the Adjusted Unemployment Rate (AUR) is not always above the Unemployment Rate (UR). In 1997, when people were reentering the workforce to join the tech boom, the two rates coincided. Then in the 2000 recession there is a large divergence as discouraged workers leave the workforce.

Notice, these workers did not permanently leave the workforce. As soon as labor market conditions improved in 2004, they rejoined the workforce en masse (this can be seen by the narrowing gap between the two lines). And, by the summer of 2006, the two rates almost coincided once again. These workers should have been included in the unemployment rate. (By the way, I have long suspected, but never examined, that one of the reasons European unemployment rates are higher than in the U.S. is a differential treatment of out of the labor force individuals.)
Using, the adjusted unemployment rate, we are already approaching 10 percent, a two percentage point gap over the unadjusted rate. When the economy reaches 10 percent and above in terms of the reported unemployment rate, the gap may widen sharply as it did during the 1970 recession or the gap may narrow (as UR rises faster) as it did in 1974. It is a horse race between a falling workforce (driven by discourage workers) and the unemployed. Either could win the race. The UR could move dramatically (1974) or level out at a low level (1970, 2001).

Do not focus on the unemployment rate. If you want to know the state of the labor market, either look at initial claims for unemployment insurance or the total number of jobs lost. Don’t look for a short cut summary statistic.