William Watson, Fraser Institute: The natural rate of unemployment—are we there yet?
The economics profession is getting ready to celebrate the 50th anniversary of Milton Friedman’s presidential address to the American Economic Association (AEA), which Friedman (pictured above) delivered in Washington on December 29, 1967. That was an unusually eventful Boxing Day week. Two days earlier Columbia Records had released Songs of Leonard Cohen and Pierre Trudeau had introduced his “state has no place in the bedrooms of the nation” legislation decriminalizing homosexuality. Never say nothing interesting happened in the past. (Looking back, you could say the Trudeaus constitute a decriminalizing conspiracy, given what the son is about to do for marijuana.)
Friedman’s speech was as big for economics as Cohen’s album was for Canadian culture and the elder Trudeau’s legislation for Canadian society. It challenged—in the end successfully—the Keynesian orthodoxy of the day that there was a permanent trade-off between inflation and unemployment and that governments could consciously choose between less unemployment and lower inflation (a trade-off that those who believed it existed almost always decided in favour of less unemployment).
He argued the principle that, controlling only their own nominal liabilities, central banks could not fix real economic variables such as output, employment or even interest rates. The best they could hope to do was control nominal variables, like the money supply, though the decade that followed (the 1970s) showed that even this was easier said than done.
Partly because the word “natural” offended people who didn’t like the theory’s conclusion that policy faced constraints, the natural rate eventually came to be known in much of the economics literature as the NAIRU (pronounced “Nehru,” like the Indian prime minister), for “Non-accelerating-inflation rate of unemployment,” which is an awful inelegant mouthful.
Friedman didn’t deny the existence of a short-run trade-off between inflation and unemployment—a “Phillips Curve,” after the New Zealand economist who had first noticed it—which central banks could exploit to bring about temporary reductions in unemployment. The problem was the longer run. Before such a policy move, people’s economic behaviour would have been predicated on the expectation inflation would be lower than the central bank had now opted for. The higher inflation the bank did choose would boost employment because it meant that what people were currently being paid now represented a lower real wage.
But once people saw that prices had risen more than they had thought they would they’d obviously want their wages to catch back up and that would bring real wages back to where they had been, with the result that employment would go back to where it had been. If central banks insisted on trying to keep unemployment below the natural rate, they would have to double-down on their initial labour market surprise and boost inflation still more. Only surprises have real effects, Friedman argued, but their effects last only until people realize what’s going on.
I was a teenager in 1967 and completely oblivious to Friedman, the AEA and even economics. But in the mid-1970s, when in graduate school at Yale, a centre of Keynesianism where eventual (1981) Nobel laureate James Tobin was leading the defence against Friedman’s then-ascendant monetarism, I got a sense of how vigorous and sometimes bitter the disagreement over ideas could be. (It’s interesting in this light that in his acknowledgements Friedman thanks Tobin, among others, for comments on a draft of the address. In all, four of the people he thanked, including Tobin, went on to win the Nobel Prize in Economics, which was introduced two years later and which Friedman himself won in 1976.)
The natural rate continues to be debated in economics. In fact, the blue-chip University of Chicago IGM Forum this week takes on the question of whether the United States. has hit “maximum sustainable employment,” which is a concept quite like the natural rate. (The Forum consensus is that such a maximum does exist but Forum opinion is almost perfectly evenly divided on whether the U.S. has reached it.)
Olivier Blanchard, a prominent “New Keynesian,” has a new paper out for the Peterson Institute for International Economics titled Should we reject the Natural Rate hypothesis?. His answer is a qualified “No.” He notes that over the last few decades the way people form expectations about inflation seems to have changed. Consistent with the original Phillips Curve story, current rates of inflation didn’t have much effect on expectations before inflation ramped up in the 1970s. After it did, however, they were almost all that determined expectations. But now, after a couple of decades in which most central banks have been targeting inflation and doing a reasonable job of hitting their targets, current inflation is back to having not much effect on expectations.
It seems people dismiss yesterday’s news, possibly because they’ve been convinced central banks can and will hit their declared targets. Of course, the link having been cut between today’s inflation and people’s expectation of future inflation, we’re back to a situation in which purposefully generated inflation can cut unemployment, at least in the short run—which in effect is what Blanchard recommends.
Friedman did emphasize in 1967 that it’s very hard to know the exact value of the natural rate at any time—it changes with demographics, employment laws, welfare spending, unemployment insurance levels, social mores and the like—most of which governments, though not central banks, can influence.
Blanchard believes that, with many Americans having dropped out of the work force because they’ve had trouble finding jobs, the official unemployment rate currently understates unemployment, so there’s still room for a policy-led expansion of unemployment. Other economists will argue that with the U.S. rate at 4.1 per cent, a 17-year low and not that far from where it was (3.8 per cent) when Friedman spoke in 1967, we’re getting close to the natural rate. Given the Fed’s historic tendency to, as Friedman put it in 1967, do “too little, too late,” it may be time to continue easing onto the brakes.
Note: In Canada we’re at 6.1 per cent unemployment vs. 4.4 per cent in December 1967. But the way unemployment is calculated went through a major change in 1976 so the numbers aren’t strictly comparable and the labour force contains many more “secondary” earners than it did then.