Evan Soltas
Mar 1, 2014

What If Labor Markets Are Tight?

Maybe the unemployment rate isn't as misleading as we might think. Maybe it doesn't massively overstate the amount of progress and healing in the labor market. I'm working on a piece for next week, and I thought I'd post this chart and some comments as a preview.

It's a scatterplot of the U3 unemployment rate on the horizontal axis and the quit rate on the vertical axis. In tighter labor markets, people tend to quit their jobs and find better ones. In looser labor markets, people cling to their jobs because unemployment is terrible. The data goes from January 2001 to December 2013.

What the chart shows is that we're seeing the expected number of people quitting their jobs given the current unemployment rate. I've put the most recent data point in red.

This is new and, in my view, compelling evidence that labor markets are pretty tight. Why? Think about the decision to quit. It's a function of your confidence that you'll find a better job quickly -- which embodies some unobserved but holistic measure of labor-market tightness. The fact that the unemployment rate appears to be a robust predictor of the quit rate both before and after the 2007-2009 recession suggests that the unemployment rate, our imperfect observation of labor-market tightness, is a close proxy for the tightness people think is important when they decide to quit or not to quit.

That the unemployment rate is not such a good proxy for an unobservable measure of labor market tightness is exactly the empirical claim underlying current monetary policy and, quite frankly, much of what I've spent the last two years writing about.

It's worth explaining why this particular way of looking at labor-market tightness is pretty clearly superior to the alternatives.

Previously, I've looked at the relationship between unemployment and broader measures of underemployment, and Paul Krugman has done some similar stuff, if a bit less formally. The point that comes out of those analyses is that the U.S. has a lot of slack labor capacity sitting around.

But that slack might not matter. If the long-term unemployed are disconnected from the labor market, they really can't matter much in a macroeconomic sense -- that is, their unemployment no longer has the power to restrain wage growth or discourage the employed from quitting and switching jobs. It's worth pointing the reader here to ideas like the insider-outsider theory of unemployment and labor-market segmentation.

That's why you can't look at underemployment directly to conclude that the unemployment rate is misleading -- because it assumes that underemployment is macroeconomically relevant, which is what you're trying to prove.

What the graph above suggests is plainly that job-switchers don't think the long-term unemployed are any competition at all. If they were -- if the unemployment rate overstated the amount of labor-market tightness -- then we should have seen the relationship break down. In particular, the curve should have shifted downwards and to the left. There should be fewer quits for any given rate of unemployment.

It's also the kind of evidence you should take seriously if you take the Diamond-Mortensen-Pissarides model of labor-market search seriously. The DMP model, to explain it informally, says that labor markets are messy in that the jobless can't find vacancies instantly -- that is, there are "frictions" in the labor-market that put the search problem at the center. If search matters, then quits matter, and then the unemployment rate can't really be understating labor-market tightness in the meaningful sense.

There is also a close intellectual connection in my chart to the Beveridge curve. It seems about as important. The Beveridge curve broke down during the recession because of long-term unemployment, as economist Rand Ghayad has shown. Mine could too. But if it did, that would be exactly the kind of evidence we'd need to say that labor markets are looser than they look.