A Great Vacation or a Great Recession?

[Update: Beveridge Curve analysis added below]

Casey Mulligan is back:

A high ratio of unemployed to job openings means that the unemployed are competing a lot for jobs, many news reports say, when in fact it could indicate the opposite.

It’s true that a reduction in labor demand — from, say, a new tax on employers — would motivate employers to get by with fewer employees. As they do, employers would reduce job openings and lay off workers. One result would be fewer job openings and more unemployed people, and thereby more unemployed people per job opening.

But a reduction in labor supply in the form of additional subsidies for unemployed people would have similar effects. Unemployed people would be choosier about the jobs they accept, especially the low-wage ones. With more help for people after layoffs, employers and employees in struggling industries would do less to avoid layoffs, especially layoffs from low-paying positions. Either way the result would be more unemployed people.

I agree that labor supply incentives matter, but fail to see this as an important explanation for the weak recovery. Most of the evidence I have seen suggests weak labor demand and demographics to be the more important story in labor markets over the past few years.  In regards to Mulligan's specific claims above, unemployment across all groups has been slow to come down, not just with the low-skill laborers looking for low-paying jobs. For example, college-educated individuals have seen similar changes in their unemployment rate as the nation overall.  

Weak labor demand is a powerful explanation for much of these developments and is borne out by the data from the NFIB's Small Business Economic Trend survey.  Among other things, this survey asks firms what is the single most important problem they face.  The answers to this question include government regulation, taxes, inflation, labor quality, labor costs, financing costs, etc. The number one answer over the past few years has been concerns over a lack of sales (though regulatory concerns have been growing).  Labor concerns are near the bottom of this list, not something one would expect if the labor market distortions were as important as Mulligan thinks they are.  What is even more remarkable about this finding is that how close concerns about the lack of sales fits to changes in the unemployment rate:

Note how sales concerns tend to lead the unemployment rate.  No other small business concern has this relationship with the unemployment rate.  The easiest way to interpret this finding is that owing to weak aggregate nominal expenditures growth during the Great Recession firms were reluctant to hire workers and, as a consequence, the unemployment rate rose.  Now, with sales concerns falling, these firms are hiring more and the unemployment rate is falling.

As noted above, weak labor demand is not the whole story.  Demographics are important too as shown by the Kansas City Fed, Chicago Fed, CBO, and the Center on Budget and Policy Priorities.  The point here is that changes in the labor force over the past few years can be explained in part by long-term trends in the baby-boom population.  Specifically, many of them are now retiring which is causing the labor participation rate to shrink.  This is why observers should be careful when looking at measures like the employment-population ratio which currently is flat lining at its new low even as the unemployment rate falls.  Some might conclude this is because of structural changes in the labor market.  But looking at the employment-population ratio for prime-age workers (which controls for retiring baby boomers) in the age bracket of 25-54 years shows that this ratio is recovering in a pattern similar to that of unemployment:

So between weak labor demand and demographics, most labor market developments over the past few years can be explained.  There is no need to resort to implausibly large labor supply effects arising from distortionary government policies.  There is no doubt in my mind that these effects are there--incentives matter--but it is hard to believe they are large. There are far easier ways to explain the Great Recession than claiming it was a Great Vacation.

Update: Below is a modified Beveridge Curve. It shows the relationship between employment and   job vacancies.  Presumably, employment would rise with increasing job vacancies. Following Soberlook, I have drawn the Beveridge Curve with job vacancies plotted against the employment to population ratio for prime age workers (to avoid the demographic changes noted above).  

The figure shows the expected positive relationship up through August 2009, after which it seems to break down for about 20 months.  Some have attributed this to structural shifts in the economy.  However, this figure also shows that the relationship picks back up in early 2011 as seen with the red triangles.  I am not sure how to interpret the black diamond period, but given the return of the relationship I would wary to attribute it to structural shifts.  Especially with studies like these.