Maximum Employment and the Participation Cycle

Bart Hobijn and Ayşegül Şahin, "Maximum Employment and the Participation Cycle," National Bureau Of Economic Research, September 2021, https://www.nber.org/papers/w29222

Bart Hobijna and Aysegul Sahin argued that labor force participation is cyclical and lags the unemployment cycle; that LFP is driven by upticks in employment stability, for example lower job-loss risk and tight labor markets as opposed to labor force entry and exit. Unemployed workers are more likely to drop out of labor force than employed worker, ultimacy employment stability (or instability) is driving the participation cycle, "....The decomposition reveals thatthe source of the participation cycle is fluctuations in job-loss and job-finding rates, rather than cyclical movements in labor force entry and exit rates. The magnitude of the participation cycle is large. Cyclical downward pressures on employment from participation are two-thirds that of unemployment. Moreover,the participation cycle delays the recovery in employment because it lags the unemployment cycle. It also amplifies the unevenness of the impact of recessions. Groups that see large increases in their unemployment rates also experience more pronounced participation cycles. Despite differences in their magnitudes, the source of the participation cycle is the same for all groups..."

This implies that, "...the bulk of the drop in the participation rate since the onset of the pandemic is cyclical and that the cyclical recovery in participation likely will trail that of the unemployment rate.....They result in the estimate that 1.5 percentage points of the 1.7-percentage-point decline in the participation rate from February 2020 to June 2021 is due to the cyclical drag on the participation rate associated with the deterioration of job-loss and job-finding prospects since the onset of the pandemic. This result holds not just for the aggregate data. For all groups in our sample, the bulk of the decline in their participation rates is due to the participation cycle...."
Their dynamic, “..The entry and exit component captures the part of changes in the participation rate that can be traced back to changes in the probabilities of workers flowing across the participation margin, i.e., into and out of the labor force. This component puts upward pressure on participation at the beginning of recessions when the likelihood that the employed and unemployed drop out of the labor force goes down. Mostly, however, it captures the time-varying long-run trend behavior of the participation rate. The procyclical pressures on the participation rate come from the cycle component, which we call the participation cycle in the rest of this paper. These are the pressures exerted on labor force participation by job-loss (flows from employment to unemployment), and job-finding (flows from unemployment to employment). At first glance, it might sound puzzling that the flows that do not involve crossing the participation margin are the source of the procyclicality of the labor force participation rate. The intuition comes from recognizing that those who are unemployed are substantially more likely to drop out of the labor force than the employed.Specifically, the exit rate from the labor force for the unemployed averaged around 25 percent in 1978-2019. This is almost an order of magnitude larger than the labor force exit rate of employed workers which averaged 2.8 percent during the same period. The difference in these exit rates from the labor force creates a wedge that we refer to as the attachment wedge. The higher the fraction of the labor force that is unemployed, i.e., the higher the unemployment rate, the more likely workers are to drop out of the labor force in the future, which lowers the participation rate going forward. Since movements in job-loss and job-finding are the main drivers of fluctuations in the unemployment rate (Elsby et al., 2015), the unemployment cycle and the participation cycle are closely tied together. In terms of magnitude, we find that the procyclical forces that affect the labor supply during business cycles are large. Our analysis reveals that the downward pressure that the participation cycle puts on the employment-to-population (EPOP) ratio is about two-thirds that of the unemployment cycle. Moreover, the participation cycle lags the unemployment cycle. On average, the participation cycle bottoms out nine months after the unemployment rate peaks. This lag is even longer for deeper recessions. The participation and unemployment cycles tend to converge during labor market recoveries, moving in tandem especially in later phases of expansions. When the unemployment rate gets close to or is below its natural rate, declines in unemployment and cyclical upward pressures on participation have about the same effect on the EPOP ratio. This observation is consistent with the Perry-Okun rule that during strong labor markets a 1-percentage-point decline in the unemployment rate results in cyclical upward pressure of 0.65 percentage point on the participation rate. Using a very different methodology and more recent data we find a rule of thumb very similar to Perry (1971) and Okun (1973)... Our results establish that increases in employment stability for those in the labor force during strong labor markets put upward pressure on participation. That is, the reductions in job-loss and increases in job-finding when labor market conditions improve result in fewer and shorter periods of unemployment (see Marston, 1976), which reduces the likelihood that participants drop out of the labor force...."

Implications, "...The source of the upward pressures on participation during expansions has important policy implications especially in light of the maximum employment mandate being a broad based and inclusive goal. If the prevailing view were true, progress towards maximum employment when the labor market is hot and the unemployment rate is low mainly would be made through the re-entry into the labor force of workers from marginalized groups. Therefore, it would be important for policymakers to focus on movements in the participation rates of the groups of workers that bear the brunt of labor market downturns when the unemployment rate is low. Instead, our results suggest there is little need to shift the attention from the unemployment to the participation rate, especially of marginalized groups, at the tail end of expansions because the same forces are at play for all groups in the labor market. For all groups, the Perry-Okun rule is a reasonable rule of thumb. This means that, during the latter stages of the business cycle when the unemployment rate is low, cyclical upward pressures on participation move almost in lockstep with changes in unemployment rates. This is because for all groups the main procyclical forces on participation are driven by fluctuations in job-loss and job-finding rates that also account for the bulk of the movements in the unemployment rate. However, the magnitude of the participation cycle is highly uneven across groups as a consequence of the differences in the cyclicality and levels of unemployment rates. We find that the participation cycle amplifies the well-documented unevenness of recessions, as captured by different increases in group-specific unemployment rates. Groups with a higher increase in the incidence of unemployment also have larger procyclical pressures on their participation rate. Therefore, the groups hardest hit during recessions have the largest cyclical upward pressures on participation during recoveries and expansions. This includes low-skilled workers and workers who identify as Black, or African American, and Hispanic. Our new finding complements Wolfers’ discussion of Aaronson et al. (2019) where he shows that disadvantaged groups with higher unemployment rates also tend to have more cyclical unemployment rates….”

Evidence"... Figure 7 plots the cumulative contribution of the entry/exit and cycle to the change in the LFPR since the start of 1978 for the total population for 1978-2019 in panel (a).25 The entry/exit component is the main driver of the long-run trend in the LFPR. Interestingly, it also exhibits a countercyclical pattern putting upward pressure on the LFPR during recessions and a downward pressure later in expansions. This finding challenges the popular view that the procyclicality of the participation rate has its origins in discouraged workers leaving the labor force during recessions and re-entering the labor force as labor market conditions improve. We find that the net contribution of labor force entry and exit is not procyclical at all. On the contrary, the entry/exit component is decisively countercyclical, pushing against the procyclical forces we identify. It is the exit component that is responsible for the upward trend in participation from 1978 through 2000, largely driven by women (panel (c)). The increase in labor force participation among women was not because women was not because those who were not part of the labor force became more likely to join. Instead, it was driven by the increased attachment to the labor force of those women who already were part of it. While the entry component was relatively muted for women until the 2000s, it accounts for most of the decline since early 2000 in the participation rate of both men and women...."

"...The results are reported in the bottom half of Table 3. The “cycle” column of the row labeled “Total” shows that the estimated cyclical downward pressures on participation in 2021 are 0.4 percentage points lower than those in 2014. This finding has three important implications. First of all, in spite of a lower participation rate, the cyclical downward pressures on participation in 2021 are close to those in 2014. Thus, the similarities between early fall 2014 and the summer of 2021 extend beyond the unemployment and labor market flow rates to the participation cycle. The second is that it provides information about the average annual trend decline in LFPR. If the participation cycle now is comparable with that in September 2014, as the table suggests, then this implies that most of the 1.2-percentage-point decline in the participation rate from September 2014 through June 2021 is due to the secular downward trend in the participation rate. This observation suggests that the annual average decline in trend participation was about 0.17 percentage points a year during that period.41 This is in line with the estimate of the CBO of around 0.2 percentage points a year and slightly lower than the cohort-based estimates presented in Figure 3. The third implication is that the cyclical gains in participation that accumulated from 2014 through 2019 have not completely been erased by the COVID-19 Recession. On the contrary, the results by group in the “cycle” column of the second half of Table 3 show that cyclical downward pressures on the participation rates of young workers, those with less than a high school education, as well as Black or African Americans are all estimated to be a percentage point or more lower now than in the wake of the Great Recession. Put differently, the expansionary labor market in the 2014-2019 period helped create employment stability for these groups, which increased their attachment to the labor force. Even though the COVID-19 shock brought the participation cycle to a similar point as in September 2014, these groups still carried over part of the gains of the previous expansion, as evident in the differences in the cycle component in the second half of Table 3...."