My Two Cents

The Unemployment Rate Is Too High

Chris Farrell Jul 25, 2007

Why do we think a 4.5% unemployment rate is too low or, to put it somewhat diferently, is acceptable. Far too many people are unemployed these days. Yet here is a typical headline, this one from a page 2 story from Friday’s Wall Street Journal:

Fed Keeps Eye on a Tight Labor Market
Bernanke Tells Congress
Jobless Rate Remains
A Pressure on Inflation
July 20, 2007; Page A2

WASHINGTON — Federal Reserve Chairman Ben Bernanke suggested the Fed won’t be convinced that the risk of higher inflation has subsided until the unemployment rate rises and businesses are operating farther from full capacity…..
I’m not picking on the Journal. You can find similar statements almost everyday in business news.

The reason is that Wall Street economists worry about a tight labor market. Here’s the basic dynamic: With labor scarce, companies will be forced to raise wages; higher wages will push management to hike prices to preserve profit margins; higher prices will erode the value of a worker’s paycheck and workers will start demanding bigger pay increases; and so on. In other words, the risk of inflation goes up if too many people are employed. Doesn’t this mean that Wall Street economists are fellow-travelers with Karl Marx, who believed that capitalism depended on an army of unemployed workers?

The trade-off between inflation and unemployment is flawed. When Jerry Jordan was head of the Federal Reserve Bank of Cleveland he was a well-known known inflation hawk. He was also a hardnosed monetarist deeply influenced by the late Milton Friedman. I remember a talk Jordan gave in the 1990s (I haven’t been able to track it down yet on the Internet). has stuck with me: In a paper given several years ago by Jerry Jordan, In essence, he argued the idea that more people working and producing more goods and services leads to inflation—or reduces the purchasing power of money—is highly questionable. If you go back in our history, said Jordan, “the periods with the highest growth in output and employment, with the most rapid rises in the standard of living, are those periods where you have proximate price stability.”

The current belief that there’s an inevitable trade-off between economic growth and inflation largely rests on the theoretical foundation of NAIRU, or the “noninflationary accelerating rate of unemployment.” The NAIRU idea took root when inflation soared into double-digit territory in the 1970s. Here’s the basic idea: In any economy, worker preferences, job changes, labor market institutions, and other factors add up to a “natural” rate of unemployment. The natural rate is defined as the jobless rate consistent with stable wage and price inflation. When the unemployment rate drops below its natural rate, wage pressures build and inflation takes off.

Okay, but where is the natural rate of unemployment? In the early 1990s, many mainstream economists assumed it was somewhere between 6% and 6.5%. But unemployment fell to 3.6 % in 1999. And inflation came down, too.

I tend to agree with the late Robert Eisner, professor of economics at Northwestern University. Eisner’s suggested that the unemployment/inflation relationship is asymmetric. High unemployment is associated with lower inflation rates. But low unemployment doesn’t tell us much — if anything — about the future direction of inflation. “Can I guarantee that measures — short of war — to reduce unemployment to 3.4% will not increase the rate of inflation? No!”, said Eisner. “Can anyone be sure it will increase inflation, let alone by how much, or that the inflation will continue accelerating? I daresay no.

I realize that this is getting to be a long post, but one of the originators of the NAIRU idea is Edmund Phelps, the brilliant professor of economics at Columbia University and Nobel laureate. (The Nobel laureate Milton Friedman as his co-idea generator.) Anyway, in recent years Phelps has been working on ways to eliminate unemployment. That’s right, he’s focusing on “economic inclusion.” Work is a central institution in our society, and its one way people gain a sense of self-worth. He also wants to raise the wages of disadvantaged, low skill workers. He has a series of proposals built around subsidies trageted at private sector firms to not only higher low skill workers but to pay them well. (Here is his home page.Here is a link to one of his papers on inclusion. And this is a link to the paperback version of his 1997 book, Rewarding Work.

Phelps is right. In a capitalist society unemployment is unacceptable. Instead of worrying about a too low unemployment rate lets worry about why there are unemployed people in mour society, and what to do about it.

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