It's Full Employment, Stupid

Newly released data on income and poverty suggest that the recent economic downturn hit lower-income families disproportionately. The latest Census Bureau report found that poverty began rising and median family income started falling in 2001, confirming what many of us have always known: The key to improved living standards for the bottom half was, and is, full employment.

After tumbling through the latter half of the 1990s, the unemployment rate hit a 30-year low of 4 percent in 2000. With the onset of recession, it reversed course and climbed to 4.8 percent in 2001.

Now, 4.8 percent doesn't sound that bad. Most economists used to think that you couldn't get below 6 percent unemployment without triggering dangerous inflation. But from the new data we learn that the 0.8 percent increment in unemployment led to higher poverty, less income for the typical middle-class family and a return to the 1980s and early 1990s pattern of highly unequal income growth.

In one sense, this reversal of economic fortune isn't entirely unexpected; that's what recessions do. But the new information stands in stark contrast to the impressive progress of the latter 1990s. During that boom, as we stress in our latest edition of The State of Working America, gains were broadly shared for the first time in decades.

The lesson is not just that booms are great and recessions are lousy. It's that broadly shared prosperity requires full employment. During the boom years of 1995-2000, everyone gained some but the most affluent gained more. Yet with a mild increase in unemployment in 2001, everyone lost except for the top fifth, much like in the bad old 1980s.

Those who lack historical context will just blame the temporary downturn. But the fact is that the economy of the latter half of the 1990s was truly unique. From the late 1970s through the mid-1990s, the increasing inequality and stagnant living standards that beset lower-income families seemed inexorable, a trend widely ascribed, by liberals and conservatives alike, to a general lack of skills in a high-tech, globalized economy. The numbers supported this view: The real family income of low-income families was stuck at about $22,000 in 1979, 1989 and 1995.

But in the late 1990s, this pattern changed. By 2000 low-income families were up to about $25,000, a 12 percent real increase in five years. Middle-income families likewise added far more real income in 1995-2000 than they did during the whole of the 1980s.

The source of this growth was near-full employment, with the increased bargaining power that tight labor markets always provide workers. Casting even further doubt on the notion that skills pure and simple are the key to income, the strong growth of this period provided the biggest boost to the worst off. Minority-family incomes grew by 16 percent for African-American families and a remarkable 25 percent for Hispanic families, about 5 percent per year in real terms from 1995 to 2000. White-family incomes grew at a slower rate -- 11 percent -- meaning that racial income gaps closed significantly during this period.

Black and Hispanic poverty fell 7 percentage points and 9 percentage points, respectively, signaling historic lows in both cases, compared with a 1 percentage point drop for whites. For young black children, poverty fell more than 16 percentage points, by far the best performance period since we've been tracking such data, implying that the gains over this period were particularly important to low-income working parents. Conservatives, of course, want to assign these gains to welfare reform, but reams of research show that while the policy pushed people into the labor market, it was growth (and not newly gained skills) that got them jobs.

Hold your fire, New Democrats. Nobody is saying that skills aren't important. One of the most reliable findings in labor economics is that more education equals higher earnings, and the payback has grown over time. But something else was going on: The economy grew more quickly during this period than it had in years, and the Federal Reserve let unemployment fall well below the rate that most economists warned would spur an inflation spiral. It's true that bubbly speculation and rogue accounting drove some of the growth, but that only casts doubt on some of the sources of growth; its impact, which is what matters, is without question.

For the first time since the 1960s, we tapped what Dean Baker and I (in our forthcoming book) call the 4/2 solution: 4 percent unemployment and 2 percent productivity growth.

For the bottom half of the workforce to get a piece of the action, two factors have to be in place. First, the economy has to expand faster than has been the norm during the past 30 years, and second, the labor market's got to be tight enough to ensure that those whose weak bargaining power had previously prevented them from receiving their fair share of the growth are now in a much better bargaining position. In the latter half of the 1990s, productivity growth (which in turn drives much of economic growth) climbed to about 2.5 percent per year, a change that appears to be sticking. And the labor market finally tightened up to the point where employers had to raise wages to keep or expand their workforce.

Our research shows that without productivity growth in the 2 percent neighborhood and unemployment around 4 percent, we can't expect much improvement in living standards for the bottom half. The poverty and income results for 2001 bear this out: Unemployment was 4.8 percent, productivity growth was 1.1 percent.

There is a real and terribly disconcerting lack of urgency about getting back to the full-employment conditions of the latter half of the 1990s. Remember, from the late 1970s to the mid-1990s, productivity growth was just 1.4 percent and unemployment averaged 6.9 percent. And note that the Congressional Budget Office still thinks full employment is 5.2 percent. In other words, unless we take action, we are unlikely to tap the 4/2 solution anytime soon.

There are at least two main reasons for the lack of urgency about returning to strong growth. First, national policy makers are focusing on the war with Iraq, which serves as a distraction. But it's the second reason that angers those of us who were so enthralled by the benefits of full employment for that brief patch of good years after so much stagnation. This is the ceaseless and sole emphasis on supply-side economics: the notion that while fast growth and low unemployment are desirable, the only way to get there is by cutting taxes if you're a Republican and promoting skills and training if you're a Democrat.

In this view, economic performance reflects supply -- either the supply of capital or the supply of human skills.

To go over to the other side -- you can call it the demand side, but it's really more than that -- you've got to be willing to mess with markets. You need to embrace the conviction that there are times when the invisible hand needs a solid nudge in the right direction.

One key policy player is the Federal Reserve, and Alan Greenspan and company did show their willingness to redefine low unemployment in the latter half of the 1990s. The Fed should push interest rates down further now, though it probably wouldn't help much. What's holding back the current economy is not the price of capital; our industrial capacity is not constrained, and there are certainly plenty of underutilized workers. Thus, the Fed finds itself in the uncharacteristic position of not being able to do much to stimulate growth.

What's lacking is what John Maynard Keynes called "animal spirits" among consumers and particularly investors. The former kept buying despite the recession, but with their confidence low and falling, their jobs less secure and their debts deeper than a few years ago, don't expect much of a bang from consumption. And until investors see more folks coming in the door to buy the products, there won't be many sparks from that sector, either.

When the private sector is failing to generate the growth needed to lower unemployment and tap the benefits therein, the federal government needs to step up to the plate and spend some money to make up the difference. If this means deficits -- as is the case now -- that's fine (in fact, you can't offset this spending by cutting elsewhere; that's not stimulative). This is just the time for it, and for those pikers who can't stomach deficit spending, a temporary jolt may be all that's needed.

The Bush administration occasionally pretends to see the need for fiscal stimulus, but its heart's not in it. The first installment of the tax cut did provide some lift, but it was too regressive -- tilted to the wealthy -- to either stave off the downturn or generate much growth thereafter. And in general, tax cuts are too leaky relative to spending programs; they can be saved (especially if they're tilted toward the rich) or spent on imports.

In an earlier TAP piece and more recently in Senate testimony, Economic Policy Institute President Larry Mishel made the case for federal spending based on a broad set of unmet needs, including improvements in our national infrastructure (with an emphasis on school renovation), extended unemployment insurance and fiscal relief to strapped states. In each case, the administration of these spending programs is either in place or easily managed. This brand of public spending is simply a better stimulus -- and also better distributed -- than Bush-style tax cuts. We've also stressed the importance of a lower dollar and higher minimum wage (see our Web site at for the relevant papers).

What these interventions all share is a willingness to intervene in the market system, alter prices and directly boost demand. But they don't have champions on Capitol Hill. Few Democrats are willing to invoke the need for new social spending. The current deficits are driven mainly by tax cuts and by the military buildup, and, as the current slow-growth recovery reminds us, they clearly haven't done the trick. Most Democrats are reluctant to give comfort to this brand of deficit, so they make the mistake of attacking deficit spending per se. The larger problem here is a general failure to acknowledge the limits of unfettered markets and to appreciate the vital importance of truly full employment.

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