The Perverse Assumption That Low Unemployment Causes Inflation

One might believe, naively, that when an economist talks about full employment, a state where everyone has a job is being described.  In fact, most economists believe that low unemployment can be a dangerous situation that inevitably leads to runaway inflation.  Consequently, they have created a level of unemployment that is deemed safe and described it with a number of terms such as “full employment,” the “natural rate of unemployment,” “structural unemployment,” and the phrase constructed to imply an unwarranted level of precision: Non-Accelerating Inflation Rate of Unemployment (NAIRU).  The theory behind these concepts holds that there will always be a non-zero rate of unemployment as people leave jobs in order to look for better ones, and there will always be people who are unemployable due to a mismatch in skills possessed and skills required in the labor market. 

This summary of the concept is provided by Wikipedia.

“It is defined by the majority of mainstream economists as being an acceptable level of unemployment somewhere above 0%. The discrepancy from 0% arises due to non-cyclical types of unemployment, such as frictional unemployment (there will always be people who have quit or have lost a seasonal job and are in the process of getting a new job) and structural unemployment (mismatch between worker skills and job requirements). Unemployment above 0% is seen as necessary to control inflation in capitalist economies, to keep inflation from accelerating, i.e., from rising from year to year. This view is based on a theory centering on the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU); in the current era, the majority of mainstream economists mean NAIRU when speaking of "full" employment. The NAIRU has also been described by Milton Friedman, among others, as the "natural" rate of unemployment.”

The NAIRU is a quantity that is a function of current reality, which is a moving target that also is dependent on concurrent public policies.  To provide an indication of what economists do with this concept, the article provides some NAIRU values produced by the OECD.

“For the United Kingdom, the OECD estimated the NAIRU (or structural unemployment) rate as being equal to 8.5% on average between 1988 and 1997, 5.9% between 1998 and 2007, 6.2%, 6.6%, and 6.7 in 2008, 2009, and 2010, then staying at 6.9% in 2011-2013. For the United States, they estimate it as being 5.8% on average between 1988 and 1997, 5.5% between 1998 and 2007, 5.8% in 2008, 6.0% in 2009, and then staying at 6.1% from 2010 to 2013.”

Others will produce different NAIRU values, but the basic point is that economists insist that unemployment be kept at a significant nonzero rate in order to provide stability to the economy.  Note that the current rate of unemployment in the United States is viewed as getting dangerously low according to the NAIRU concept.  Consequently, there are those who demand that that the Federal Reserve raise interest rates to head off the threat of runaway inflation—and in so doing increase the number of unemployed in the nation. 

Those who are still seeking employment might be a bit startled to learn what economists have in store for them.  The author of the article thought it necessary to include a comment from Keynes on the subject of a nonzero ideal unemployment rate.

"The Conservative belief that there is some law of nature which prevents men from being employed, that it is 'rash' to employ men, and that it is financially 'sound' to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable - the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years. The objections which are raised are mostly not the objections of experience or of practical men. They are based on highly abstract theories – venerable, academic inventions, half misunderstood by those who are applying them today, and based on assumptions which are contrary to the facts… Our main task, therefore, will be to confirm the reader’s instinct that what seems sensible is sensible, and what seems nonsense is nonsense."

The article in Wikipedia also provides us with the oft-forgotten fact that legislation by congress also provides the Federal Reserve and federal legislators with a level of unemployment that it is supposed to target with policy moves.  Such a target is incorporated in the Full Employment and Balanced Growth Act of 1978.

“The law states that full employment is one of four economic goals, in concert with growth in production, price stability, balance of trade, and budget, and that the US shall rely primarily on private enterprise to achieve these goals. Specifically, the Act is committed to an unemployment rate of no more than 3% for persons aged 20 or over and not more than 4% for persons aged 16 or over (from 1983 onwards), and the Act expressly allows (but does not require) the government to create a "reservoir of public employment" to effect this level of employment.”

“However, since the passage of this Act in 1978, the US has, as of 2012,….never achieved this level of employment on the national level, though some states have neared it or met it, nor has such a reservoir of public employment been created.”

The goals of this law are clearly broader than the single issue of price stability, yet the media, congress, and many members of the Federal Reserve policy team allow a bunch of economists “fuddled with nonsense” to control the discussion.

Peter Coy provided an article for Bloomberg Businessweek that addressed the pressure on the Fed to raise interest rates: Will the Jobs Boom End Too Soon?

Coy opened with this lede.

“People who have a hard time landing jobs are finally getting hired. A Fed hike may stop that.”

Coy is pointing out that there are people in society who are rendered unable to be the “rational” participants in the labor market that economic theoreticians demand. These include minorities, those with a criminal record, the disabled, and those lacking at least a high school diploma.

“Employers can be blinded by habit or discrimination. They fish in the small pool of their preferred job candidates rather than consider less-familiar applicants. The plight of black college graduates illustrates the problem. Even though college graduates in general are only half as likely to be unemployed as high school grads, in October black college grads were slightly more likely to be unemployed than white high school grads, according to Bureau of Labor Statistics data.”

“As the labor market tightens across the country, employers are stepping up their hiring of people who often have a hard time landing jobs: ex-convicts, people with disabilities, African Americans, Hispanics, teenagers, and those without a high school education. Starbucks, for example, is leading a coalition of more than 30 companies facing talent shortages that have committed to giving jobs or apprenticeships to 100,000 ‘opportunity youth’—young people who are out of school and out of work. ‘When the items are flying off your shelves and you can’t keep up, you get a little more open-minded’ about whom you hire, says Laurence Ball, a Johns Hopkins University economist.”

The notion of a non-zero “natural” rate of unemployment weighs heavily in Fed policy deliberations.

“The betting is still that the Federal Open Market Committee will raise interest rates at its Dec. 15 to 16 meeting and continue to nudge them higher sporadically thereafter. One reason is that Milton Friedman, the late, great conservative economist, continues to loom large at the Fed. In his presidential speech to the American Economic Association in 1968, Friedman said there’s no free lunch: Efforts to suppress the unemployment rate below what he called its natural level might work briefly but are destined to fail eventually, resulting in nothing over the long run but spiraling inflation.”

“The ghost of Friedman lives on in a computer model the Fed’s staff consults in making economic projections. It builds in an assumption that very low unemployment will result in unacceptably high inflation. The latest version projects that all the extra labor and other resources in the economy will be used up by early next year, which, if true, implies upward pressure on wages and prices, says Michael Gapen, chief U.S. economist at Barclays.”

The net effect of the concept of a “natural” rate of unemployment, and the conservative claims as to what that rate should be, is to condemn a significant number of people to a lifetime of unemployment. Those who employers traditionally discriminate against are also discriminated against by those who base policy decisions on the unproven assumptions of economists.

As Coy points out, the Fed has the choice of deciding which of its policy goals to focus on. Is keeping inflation low more important than decreasing unemployment?

“Yet as the great pivot toward fighting inflation begins, U.S. employment remains far from full. The jobless rate for blacks, 9.2 percent in October, was equal to the highest that the white unemployment rate got in 2009, when joblessness was still considered a national emergency. Chronic unemployment is deeply damaging, says Joseph Carbone, chief executive officer of WorkPlace, a nonprofit based in Bridgeport, Conn., that trains and places the long-term unemployed. ‘You get complacent, detached. You lose skills,’ he says. ‘Depression and family difficulties develop. They militate against your being successful’.”

Coy provides this appropriate conclusion.

“Ultimately, how hot to run the U.S. economy comes down to a judgment about what’s important. The Fed’s decisions, while couched in the antiseptic language of monetary economics, are unavoidably bound up in hard questions about fairness, race, and inequality.”

As this piece was being written, the Fed announced a small—initial—increase in interest rates.  There are no blacks, Hispanics, ex-felons, or disabled in economic models.  Simple theories demand simple conditions.  However, economists need not be blind to the real world due to their inadequate education.  There are conditions out there that demand solutions balancing a variety of social goals.