- The Washington Times - Thursday, February 23, 2006

The U.S. economy’s utilization of labor and capital resources is out of balance. A greater share of available physical capital than of available labor unemployed in the last recession has returned to productive use.

The economy’s manufacturing capacity idled by the 2001 recession has been largely returned to production. By comparison, the utilization rate of the economy’s labor resources, measured by the ratio of employment to the working-age population, has thus far recaptured only a third of its recession and early post-recession decline. (The unemployment rate is an incomplete measure as it excludes potential labor supply outside the labor force.)

It’s doubtful that changes in industrial structure and the pace of obsolescence have materially affected the comparability of the capacity utilization rate over a few years. However, manufacturing is a shrinking sector, and international trade and competition have probably weakened the relationship between elevated capacities and inflation pressures.

In contrast to the pattern in the current economic expansion, in the previous upswing that ended in early 2001, industrial capacity utilization regained its 1990-91 recession loss while the labor utilization rate not only recovered but surpassed its prior cyclical peak of early 1990.

What are the chances the utilization of human capital will return to a more balanced relationship with that of physical capital? Is an improvement likely in the depressed labor utilization rate as the economy continues to expand?

Not according to the economic forecast of the President’s Council of Economic Advisers (CEA). In its recently released 2006 economic report, the CEA forecasts employment growth out to 2011 at 1 percent annually, the same rate as the working-age population. With just enough job growth to absorb population additions to the labor force, it’s not possible to lower unemployment further or lift the labor utilization rate.

The CEA forecast is not unrealistic or out of line with consensus forecasts. So it appears likely we will continue to have a lopsided expansion, carrying the burden of excess labor capacity for some years to come.

The current shortfall in labor utilization from its pre-recession high translates to more than 4 million workers. However, not all the unused labor supply may be readily employable because of ongoing structural and demographic changes in the economy. Just how much is structural versus cyclical is uncertain.

Looking at another estimate, the Bureau of Labor Statistics says 5.1 million people outside the labor force last month told government interviewers they wanted a job. That number is unchanged from a year ago and up from 4.4 million in 2000.

What is Federal Reserve Chairman Ben S. Bernanke’s view? His Feb. 15 Fed Monetary Policy Report to Congress said: “With the economy already operating in the neighborhood of its productive potential… higher resource utilization would risk adding to inflation pressures.” The report said effects of tightening monetary policy “should keep the growth in aggregate output close to that of its longer-run potential.”

Some economists would argue the economy is still some distance from the neighborhood the Fed refers to and that it’s too soon to slow output to its potential growth rate.

Potential economic growth (the maximum noninflationary rate of increase in output) is estimated at around 31/4 percent, close to the Fed’s real output forecast of 31/2 percent this year and 3 to 31/2 percent next year.

The Fed doesn’t reveal its employment forecast, but its expectations for economic growth suggest little or no improvement in the employment-population ratio, partly because of the slowing effects of its monetary tightening.

Since the Fed believes the economy is near its safe potential rate of growth despite a depressed labor utilization rate, the question arises whether the majority of Fed policymakers believe the unused labor capacity is primarily structural rather than cyclical and unemployable at noninflationary wages.

Fed Vice Chairman Roger W. Ferguson Jr., in a paper delivered at the Allied Social Science Association meetings last year, spoke about the drop in work force participation since 2000, acknowledging, “At least some portion of the unusually large declines in labor force participation has been associated with the business cycle.” The statistical evidence supports this view.

Some cyclical slack remains in labor markets and there may well be more room for further labor utilization recovery without labor shortages threatening inflation.

However, the Fed’s preferred path for the economy seems to preclude the additional impetus needed to lift the labor utilization rate. The latter stages of economic upswings help employ the lesser-skilled and the hard-pressed, so it’s unfortunate if the current expansion doesn’t allow that.

There is reason to believe that to some degree a growing share of the available labor supply has become structurally unemployable, underscoring the importance of education and the need to continually upgrade skills. But if the demand for labor is strong enough, many so-called structural jobless become employable and are hired.

Well into the 1990s expansion, Fed Chairman Alan Greenspan defied conventional wisdom and raised growth above the economy’s potential rate. The employment-population ratio achieved a 64.7 percent postwar high with unemployment below 4 percent. Inflation did not get out of hand.

Today, however, the risks and costs of accelerating inflation appear to have increased with higher energy costs threatening to spill over into the prices of other goods and services. So, all in all, the Fed’s prudence is defensible. Unfortunately, pushing for economic growth with stable prices is likely to have an unusually high cost in foregone employment, wages and output.

Alfred Tella is former Georgetown University research professor of economics.

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