Why, as an economy, should we care about large amounts of unemployment?Are too many Americans at work these days for the economy's own good?
Absolutely, says Martin Feldstein, a Harvard University professor and former head of the Council of Economic Advisers under President Reagan. By Mr. Feldstein's calculations, unemployment already has fallen way below the level he believes is sure to trigger steadily rising inflation--even if the economy begins slowing soon on its own. 'We are . . . into the danger zone,' he says.
Why, as an economy, should we care about large amounts of unemployment?
Nonsense, retorts Dana Mead, chairman of Tenneco Inc. in Houston. Economists who talk that way, he maintains, just don't understand how American companies have tied wage increases to productivity gains, shifted work overseas and learned to produce more with fewer people. Even if the expansion continues, he says, 'companies are not going to be in as hot competition for workers as pure economic theory might suppose.'
As the economy continues heating up, so too does the battle between the ivied halls and the factory floor. On one side, the weapon is economic theory. On the other, day-to-day experience. Much hangs in the balance: If theory bears out, the Federal Reserve Board courts inflation if it keeps interest rates too low; if many businesses' observations are correct, the Fed risks choking off the economic expansion by raising rates too high.
The economists who say unemployment is too low maintain that it will be months, or even years, before the proof that they are right rolls in. For the moment, however, the evidence is stacked against them. While some observers detect spotty increases in wages in particularly tight labor markets, those aren't yet working their way up to many of the country's biggest employers--or into the nationwide statistics.
'We aren't feeling pressure,' says Kelly Ritchie, vice president of human resources at Lands' End Inc., in Dodgeville, Wis. Last Christmas, the catalog retailer had no trouble hiring 2,200 additional people for peak-season help, without raising pay rates; neither did Sears, Roebuck & Co., which hired nearly 40,000 Christmas workers. MCI Communications Corp. has been hiring 10,000 to 15,000 people a year at about the same pay range for the past two years. 'We don't see any need to make any major changes,' a senior MCI official says.
Even as the U.S. unemployment rate fell to 5.4% at the end of last year, from 6.7% at the beginning, employee wage and benefit costs remained flat, as did the rate of rise in the consumer price index. 'We keep waiting for the other shoe to drop, and it never does,' says Donald Wood, chief of the division of employment cost trends at the Bureau of Labor Statistics. 'It's strange.'
So strange, in fact, that in the past few months it has prompted several economists--including a couple of the profession's most prominent defenders of the notion that unemployment had dropped too low--to lower their estimates of the natural rate. Perhaps, they now concede, their calculations were overly pessimistic.
'The danger zone for unemployment seems . . . to be lower than I had been previously estimating,' says Robert Gordon, a professor of economics at Northwestern University. As recently as last month, Prof. Gordon advised the Federal Reserve Board that the inflation trigger was an unemployment rate that was probably 6%, and possibly as high as 6.5%. 'I am the guy who sold 6% to the world,' he says. Today, he thinks that trigger point is probably closer to 5.5%--and could be as low as 5%.
By Prof. Gordon's earlier reckoning, the economy tripped the inflation switch as early as last March; according to his new calculations, trouble could still be a way off, and hundreds of thousands more people could go back to work before serious inflation rears its ugly head. 'I've just created 600,000 jobs,' he quips.
Of course the Federal Reserve Board and the bond market aren't ready to declare inflation buried just yet. Commodity prices are rising, and the effect is working its way up into the prices of final products. What's more, with the CPI growing at its second lowest rate in nearly three decades, 2.7% for 1994, almost everyone expects some pickup this year. The average of forecasts of 53 economists surveyed by Blue Chip Economic Indicators in Sedona, Ariz., is that inflation will pick up to a 3.3% annual rate by the end of this year. A further Fed tightening of short-term interest rates is widely expected next week.
The question, though, remains: Does the rise expected this year in the consumer price index represent simply a mild bouncing back from an unusually low bottom, or is it the first step on an inflationary escalator that will keep on rising until unemployment swells again?
To understand the roots of the debate, it helps to look at an arcane economic concept developed back in the late 1960s by Edmund Phelps, now a professor of economics at Columbia University, and by Milton Friedman, the Nobel Prize-winning economist. It is called the Non-Accelerating-Inflation Rate of Unemployment--NAIRU--or the 'natural' rate of unemployment.
What is the natural rate of unemployment?
With labor costs making up overall about 70% of business costs, the natural rate is an important concept to economists--including those at the Fed--because it indicates when wages are likely to rise as a result of the demand for labor outstripping supply.
Most economists have long agreed that some unemployment is inevitable because some people will always be between jobs or out of work because their skills don't immediately fit the jobs available. That transitional unemployment is the natural rate.
But before the work of Profs. Phelps and Friedman, economists thought that by speeding up economic growth they could engineer an even tradeoff between inflation and unemployment--say, a one-percentage-point increase in inflation, which would yield a one percentage point drop in the unemployment rate.
Prof. Phelps concluded instead that if unemployment falls below the natural rate, inflation won't stop rising until the jobless rate retreats. 'If the labor market stays over-tight, each year there will be another point added to the inflation rate,' says Prof. Phelps. 'It will go on rising, up and up and up higher and higher.'
What's more, once that inflation is embedded in the economy, it won't go away on its own, these theorists maintain. Instead, the theory holds that only a period of high unemployment will help. The rough economic rule of thumb: If unemployment stays one point below the natural rate for two years, it will cause a permanent one-point rise in the inflation rate-that only two years of unemployment one point above the natural rate will root out.
To business people's reports of lack of wage pressures so far, these economists reply: So what?
The economists say that history shows inflation does sometimes occur immediately after the natural rate has been breached, says Stuart Weiner, an economist at the Federal Reserve Bank of Kansas City. There also have been times, however, when it took nearly two years to become apparent, he adds.
Frederic S. Mishkin, executive vice president and director of research at the Federal Reserve Bank of New York, says businesspeople are indulging in wishful thinking. 'There really is no evidence that [they] can point to except to say `Gee, we haven't seen inflation yet,' and that's no evidence at all. People keep on making this mistake over and over again,' he says. Business counters: It is economists who repeat their own mistakes, because their calculations are looking at the world through a rear-view mirror. Economists are 'fighting a nuclear war with conventional weapons,' says Robert Cizik, chairman and chief executive of Cooper Industries Inc., a Houston manufacturer. 'My concern is that we are using data and statistics and rules of thumb that come from a different business environment than now exists.'
They describe the change in two words: productivity and competition.
Both, they say, wring out inflation and enable them to increase production and hire more people without raising wages, and without putting pressure on their own prices.
How is it that labor prices may not immediately adjust to changes in the labor market?
Over the past two years, Mr. Mead at Tenneco says the company increased output without increasing wages by moving some automotive production to under-used capacity in Europe. Moreover, by negotiating changes in union work rules, the company's packaging business has achieved 3% productivity gains, more than offsetting the 2.5% annual pay increases. Partly as a result, he figures the rates of price increases for all his company's products will be staying the same or declining this year.
Stephen S. Roach, an economist at Morgan Stanley, estimates that as a result of such changes, businesses' unit labor costs--that is, total compensation adjusted for productivity--rose by only 1% last year. He is forecasting an increase of 2% this year but says that is still very low by historical standards. 'Normally at this stage of the cycle, that number would be in the 5% to 6% zone. That tells you what an extraordinary job corporate America has done in holding the line in labor costs.'
It isn't only manufacturing, either.
In December last year, the services component of the consumer price index rose 2.9%, Mr. Roach notes. At the equivalent point in the last recovery, the number was 4.9%. He maintains that the service industry is in the throes of the same kind of cost-cutting that manufacturing began five years ago. That, he maintains, will keep on holding down wages and inflation longer than usual.
Southwest Airlines, for example, just negotiated a novel, 10-year contract that gives its 2,000 pilots shares in its company's stock but no cash pay increase for five years. The company says the contract helps keep its costs at least 20% below its competitors' and helps restrain price inflation in general.
None of these arguments impresses the high-NAIRU camp.
'Serious students of the issue of measuring the natural rate don't find [business's argument about productivity] convincing,' says Mr. Mishkin at the New York Fed.
Many economists do say that the natural rate has changed in the past, going from about 5.4% in the 1960s, to just above 7% in the 1970s, and declining to about 6.4% in the 1980s. They say these changes were related mainly to demographic shifts, mostly when less-employable groups began entering the work force. These shifts in the makeup of the labor force include the entry of more women, the big influx of young people in the 1960s and 1970s as the baby boom matured and, more recently, the larger number of nonwhite workers. As these groups, which traditionally have had higher unemployment rates, enter the work force, the natural rate rises; when they become absorbed in the work force, the natural rate declines again.
Economists themselves suggest other possibilities for why the natural rate may have dropped recently: Prof. Gordon at Northwestern says his original calculations were based on changes in the gross-national-product deflator, another measure of inflation, and not on the more widely watched consumer price index; moreover, since inflation has been so slow to appear, he is willing to entertain businesses' arguments that productivity gains and the weakness of labor unions have had an effect.
Prof. Phelps says he has lowered his own estimate of the natural rate which is still high--to 6% from 6.5%. He suggests that the per-person dollar value of a range of public-assistance programs has declined, giving some marginal workers more incentive to go to work. The fact that the minimum wage hasn't been raised in some time, too, he thinks could help lower the natural rate. Some economists think that a too-high minimum wage prevents employers from hiring more low-wage workers. A lower minimum wage, Prof. Phelps suggests, 'would be a barrier to entry into the labor force for fewer people.'
Meanwhile, economists don't even agree among themselves on how to read the few possible signs of wage inflation that are emerging. Manpower Inc., the big temporary-help agency in Milwaukee, had its first across-the-board wage increase in several years last year-averaging about 4%--and expects another this year. One group of economists sees that as a sign of incipient inflation, since wage increases typically begin at the lower end of the salary scale. The other group disagrees: Demand for temporary help is buffering the economy from even-larger wage increases, says Gail Fosler, chief economist at the Conference Board.
In addition, one group maintains that any sign of inflation turning up this year means that unemployment has dropped well below the natural rate. 'Natural-rate theory says that if you aren't at the natural rate, not only would you not expect to see inflation rising, but you would expect to see it declining,' says Mr. Weiner of the Kansas City Fed.
'That's completely wrong,' says Gordon Richards, chief economist for the National Association of Manufacturers. Inflation isn't affected just by wages, and can rise even if the economy hasn't yet passed full employment, he says.
As for Milton Friedman, the other father of natural-rate theory, he has completely disavowed the forecasting use to which his creation has been turned. 'I don't know what the natural rate is, neither do you, and neither does anyone else. I don't try to forecast short-term changes in the economy,' he says. 'The record of economists in doing that justifies only humility.'