How low an unemployment rate can we tolerate? — November 20, 2013

How low an unemployment rate can we tolerate?

On the occasion of Jared Bernstein’s and Dean Baker’s publishing an essay on how low an unemployment rate we can tolerate before inflation spirals out of control, it’s worth linking back to a something I wrote in 2010 about James Galbraith’s views on the matter.

Even supposing that there actually is a NAIRU (i.e., a level of unemployment below which inflation will start accelerating), and even supposing that something bad will happen if we cross below that line, it’s not as though we lose control of the ship right then. At that point we know what happens: the Federal Reserve jacks up interest rates, unemployment skyrockets (particularly as mortgage rates rise and employment in the housing sector collapses), and inflation drops back down. It’s happened before. We have control over this. Doesn’t the Federal Reserve just need to signal that it takes its dual mandate seriously? If everyone believes that the Federal Reserve will bring the hammer down if inflation rises too high, what’s the big deal? Better to let inflation rise too high because unemployment was allowed to drop too low, and correct the problem later, than allow millions of people to remain involuntarily idle.

Jamie Galbraith and the NAIRU — September 10, 2010

Jamie Galbraith and the NAIRU

I linked on Twitter to Jamie Galbraith’s old NAIRU paper, but explaining why it’s important to people who don’t care about economics, in 140 characters or fewer, turns out to be really hard. Here’s a quick note.

Basically, economists envision that there’s a tradeoff between the rate of unemployment and the rate of inflation. Suppose unemployment is very low. Now workers have more bargaining power. So they can demand higher wages. Enough of them do this, and prices rise. Eventually one can even end up with the dread “embedded inflation”: workers anticipate lots of inflation in forthcoming years, so they ask for wage contracts that guard against that inflation. Let’s say inflation was 10% per year. Now their contracts command, say, 11% raises per year. Now, inasmuch as prices depend on the costs of labor, prices will rise even more. And so the spiral goes.

There’s supposed to be a “natural rate” of inflation, an idea which apparently goes back to Milton Friedman’s 1968 presidential address to the American Economic Association and Phelps’s paper from the preceding year. This natural rate corresponds to a particular rate of unemployment called the NAIRU, for the “non-accelerating-inflation rate of unemployment”. As the name suggests, it’s supposed to be the rate of unemployment at which inflation stays where it is.

The only problem, says Galbraith, is that no one knows where the NAIRU is, and what economists say about it changes over time. Oh wait, there’s another problem: it’s not clear that labor costs have actually been responsible for inflation; it may just be that we got inflation when an “external shock” like a war or an oil embargo intervened. [1]

Most importantly, the focus on the tradeoff between inflation and unemployment takes our eyes off other, more-important things, like the unemployment-inequality tradeoff. Galbraith presents an alternative to Friedman’s “natural” rate of unemployment, which, again, is a rate above which inflation is supposed to start accelerating; Galbraith’s “natural” rate is the one above which inequality is supposed to start increasing, and he estimates it “quite stably” at 5.5 percent.

I need to emphasize just how important this is. The Federal Reserve emphasizes one goal — price stability — to the exclusion of others. Which would be fine — price stability is in the Congressional mandate — if the Fed weren’t using a phantom to achieve that goal. And the Fed is too cautious, too worried about the effects of labor costs, which likely keeps unemployment higher than it needs to be. Which, in turn, is a weapon to maintain increasing inequality.

[1] — It’s oddly unremarked-upon that the U.S. government took very active control over the U.S. economy during World War II. With the government printing so much money and dumping so much of it into the economy to get war production going, inflation would be inevitable. To avoid that end, the government had to enforce strict price controls. Jamie Galbraith’s father, the great John Kenneth Galbraith, was one of the folks in charge of these controls; he writes a bit about this in [book: Money: Whence It Came, Where It Went], and probably in other works.

At another time, I will write about how silly I find the usual American mythologizing of World War II. Yes, maybe it had something to do with “Americans coming together, as never before, to defeat a common enemy.” A more straightforward explanation is that World War II was the natural endpoint of two centuries of capitalist development, centralized control, and the deployment of industrial processes toward warmaking. “Total war,” the idea that an entire nation’s resources are devoted toward destroying one’s enemies, and that war should naturally be brought to bear against the civilians of other countries, helped. There may be room for patriotically beating hearts in here, but these other explanations seem more fruitful.