The Empirics of Hidden Labor Force Dynamics in Germany

Abstract The unemployment rate is the core indicator when researchers and policy-makers assess the level of underemployment in an economy. However, accumulating evidence suggests that the unemployment rate is biased and underestimates the true level of underemployment. Closing this gap is especially important because the distortion systematically changes along the business cycle and affects the various subgroups of the population differently. Neglecting these effects when setting up policies might flaw its effectiveness and result in unexpected outcomes. Although the existence of these effects is widely agreed upon only little is known about the magnitude of these effects across various subgroups. Using a highly disaggregated dataset from Germany, this study examines the dynamics in labor force participation that go beyond the unemployment rate. Ample evidence is found that the discouraged and the added worker effect significantly affect particular subgroups in the German labor market. In addition, the discouraged and the added worker effect are generally found to be very symmetric in economic upturns and downturns. Moreover, the labor market reforms in Germany between 2003 and 2005 are found to have reduced the discouraged worker effect on average by 25%, leaving the added worker effect unchanged.