Two components of economic growthproductivity and the supply of laborare growing faster than conventional economists acknowledge. The danger is that lowered expectations could become self-fulfilling.|
See "Why We Can Go Faster," by Barry Bluestone and Bennett Harrison
It has been amusing to watch the natural
rate of unemployment come down. Two years ago, the community of
respectable economists heldthough with exceptions including Robert
Eisner of Northwestern, Ray Fair at Yale, Harvard's James Medoff,
and myselfthat 6 percent unemployment was as low as the economy
could go without triggering inflation. This meant, in turn, that
sustainable economic growth could proceed only at the long-term
rate of labor force growth plus the average rate of improvement
of the productivity of labor in the recent past, for a growth
speed limit of, at the highest, 2.5 percent. Any at tempt to push
gross domestic product (GDP) growth any higher would be inflationary,
or so we were constantly told.
But since the end of 1995, real GDP
growth has averaged 3.6 percent annually. Employment growth and
labor force growth were both about double what was expected; productivity
growth was pretty much on target. Unemployment, meanwhile, has
declined to below 5 percent. And while consumer price inflation
rose slightly in 1996an increase due entirely to rising food
and energy prices rather than to any movement of wagesthe overall
rate of inflation remained negligibly low. Confronted with these
facts, the current respectable consensus is that the natural rate
of unemployment has fallen to 5.5 percent or 5 percent, or maybe
even lower. Those of us who think the very idea of a natural rate
should be junked have been encouraged as never before.
But what next? Natural rate devotees
remain cautious. For them, the metaphor of a labor market equilibrium,
where labor supply just balances labor demand, is too strong;
they cannot give it up. True, the equilibrium wasn't 6 percent:
We passed that point and disaster didn't happen. And it probably
wasn't 5.5 percent: We passed that point too, and again no disaster
happened. But it must be somewhere, they think, and we have only
5 percentage points left to go.
Yet the fact that the natural rate
turned out to be less than 6 percentand even less than 5.5 percentdoes
not make it more probable that the magic number will prove to
be 5 percent. Rather, it raises questions about the concept of
the natural rate and about the methods used to calculate it. Maybe
the natural rate always has been much lower than respected opinion
has thought. Or maybe the whole metaphorical notion of a natural
rate is misleading.
We don't know the answers to these
questions. The real issue, given our ignorance, is: What should
we do? Should we pursue falling unemployment and probe for a limit
that may or may not be there?
To natural raters, we are like a blind
person standing near a cliff by the sea. We may be perfectly safe
five feet back from the edge. We may discover by cautious experiment
that we can safely take one step forward. This lesson tempts us
to change our attitude toward risk, but prudence should hold us
backjust because we can take one step safely toward the edge
does not mean that we can safely take two more.
This metaphor accurately expresses
the natural raters' position on a policy for growth and employment.
It is a coherent metaphor, but does it illuminate our actual situation?
In my view, it does not. Maybe we need a new metaphor.
Are we really on a cliff by the sea,
poised perilously above the waves and the rocks? Or are we in
fact down by the beach, on a gentle slope of soft and agreeable
sand? What are the risks of another advanceinjury and death,
or a little wetting of the feet? And if we do get our feet wet,
what will it take to get them dry again?
Cliff or beach? This is an issue we
can investigate. The way to approach the question is to examine
the history of past forays toward the waves. History teaches clearly
on this point: Gradually falling unemployment has never resulted
in a rapid slide toward inflationary catastrophe. The process
is, at worst, extremely gradual. Estimates by Robert Gordon, a
pillar of mainstream thinking on the natural rate and a careful
student of the past, confirm this. In an article in the Journal
of Economic Perspectives earlier this year, Gordon gives a
scenario of inflation doublingto around 6 percentover eight
years, on the assumption that unemployment is kept 1 full percentage
point below its estimated equilibrium point. In other words, if
the natural rate is in fact 5 percent, then we could enjoy 4 percent
unemployment through 2005 without an intolerable increase in the
inflation rate. (By that time, of course, the federal budget will
have been in balance for more than three years and the Easter
Bunny will be President of the United States.)
It is also true that a sudden increase
in inflation could happen much soonernatural rate or no natural
rate. A tidal wave, originating in some seismic event in far-off
oil fields or elsewhere, could roll in. But in the case of a tidal
wave, being five feet back from the water's edge provides no margin
It therefore makes little difference,
from the standpoint of inflation dangers that matter most, whether
one pursues full employment or not. The inflation costs of lower
unemployment are small, tolerable, and easily reversed if necessaryand
that's using pessimistic assumptions. The dangers of an external
supply shock, though much greater, are not closely related to
the rate of unemployment and cannot be reduced by a slow-growth
policy. The lesson to draw is that there is no benefit in failing
to pursue full employment.
A second lesson is that the economy
is unpredictable in the short run. Those recent high rates of
labor force growth and employment growth were not widely predicted
and did not result from any policy. But they happened, and had
the effect of reconciling higher-than-predicted growth with low
rates of wage and price change. Can they continue? Not forever,
certainly. But whether they can continue for another year (or
three) is simply unknown. To slow the economy now on the assumption
that high growth rates cannot continue is to commit a damaging
act without justification.
Therefore, at a minimum, policy should
do nothing to slow economic growth. Let the economy grow. And
if growth slows, policymakers should react quickly by lowering
interest rates in an effort to keep progress going. There is certainly
no benefit from slower growth and rising unemployment, while the
inflationary costs of a stimulative policy in response to evidence
of a slowdown are speculative and small.
I happen to think that unemployment
can fall another point, to 4 percent, and stay there without disastrous
inflation. (Could we go further? Ask me when we get to 4 percent.)
I would be particularly confident of this if we had a sensible
balanced anti-inflation policy in placeone that did not rely
exclusively on raising interest rates and throwing people out
As we think about wading out on that metaphorical
beach, some other useful ideas come to mind. To deal with the
gentle waves at our feet, a pair of old boots might be helpful.
In the 1960s, these were known as "wage-price guideposts"
and they helped to keep inflation from accelerating while unemployment
fell to below 4 percent. Some new variation on this old-boot theme
might be helpful now, preferably one as self-enforcing as possible.
And as for the possibility of a tidal shock wave, well, for that
you need a boator even an ark. But that's another story.
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