Meet the ‘missing millions’ who’ve vanished from the economy

As you’ve probably seen, there’s good economic news. Since the election in November, employers have created about 200,000 jobs a month, the unemployment rate has dipped to 7.7%, and overall spending has held up pretty well in the face of tax hikes and the imposition of reductions in federal spending. At least for now, the economic optimists — myself included — have been vindicated. With house prices and disposable income both rising, we can be fairly confident that the recent progress will be sustained.

But before anybody starts celebrating, take a closer look at the U.S. labor market, which remains a case study in frustrated hopes and wasted resources. Some 12 million Americans are out of work, 8 million are working part-time for economic reasons, and 2½ million say they want a job but have given up looking. Yet the jobless figures don’t fully capture the damage that the Great Recession has wrought upon the country’s stock of human capital, which, after all is said and done, is what keeps the economy going.

At the start of 2008, when the recession began, the civilian population of the U.S. ages 16 and up (and excluding prisoners and members of the armed forces) was 232.6 million, of whom 154.1 million were in the labor force. That is, they were working or looking for work. Over the past five years the working-age population has grown steadily. In February it was 244.8 million — an increase of 12.2 million since 2008. But the labor force has hardly grown at all. Last month it stood at 155.5 million, a rise of just 1.4 million in five years. The “participation rate” — the proportion of the population in the labor force — has fallen from 66.2% in January 2008 to 63.5% in February 2013.

That falloff might not sound very dramatic, but it is. If the participation rate were still at its level of five years ago, there would be 162.1 million people in the labor force instead of 155.5 million. Another way to put it is that as many as 6.6 million workers — about the number of people who live in the cities of Los Angeles and Chicago combined — have vanished from the economy, robbing it of their effort, skills, and creativity. The results are legion: more personal hardship, weaker GDP growth, lower spending, and less wealth creation.

Where have all these folks gone? Perhaps a third of the fall in the participation rate can be explained by long-term demographic factors, such as the fact that the baby boomers are reaching retirement age. However, most of the decline was a product of the recession and a chronic lack of vacancies. When people see that jobs are hard to come by, some older workers retire early — perhaps applying for disability benefits; younger people stay in college longer or loaf about; and some people of all ages drop out completely, subsisting as best they can. Once people leave the labor force, their skills atrophy, their self-confidence declines, and they find it increasingly hard to think about returning to work. Even when the economy recovers, as it’s doing now, the participation rate remains depressed, and the labor force doesn’t grow very rapidly — if it grows at all. (In February it fell by 30,000.)

There’s a great deal of human misery involved, and tremendous economic costs. Deep recessions don’t just lead to a temporary drop in output; they reduce the economy’s long-run growth potential. While GDP and employment eventually rebound, they never reach the levels they would have done if the slump had been avoided. And therein lies a message for policymakers. Given the enormous costs of slumps, some of which aren’t immediately obvious, it’s imperative to do all we can to shockproof the economy. That means more effective regulation, less encouragement of debt-fueled risk taking, and the Fed and other authorities showing a willingness to remove the punch bowl as the party gets going. Steady as she goes beats boom and bust. It’s an old lesson, but one that was forgotten during the “great moderation” of the 1990s and 2000s. For the sake of the missing millions, current and future, it needs relearning.

John Cassidy is a Fortune contributor and a New Yorker staff writer.

This story is from the April 08, 2013 issue of Fortune.

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