T he Communist Manifesto exults over the "specter haunting Europe"--the growth of communism. Today, America's ability to grow in a socially equitable manner confronts a serious threat from another economic theory, one that shares with Marx's construct its devotees' loyalty in the face of strong contradictory evidence. This danger can be even more appropriately labeled a specter because, unlike Marx's hope that his newborn would grow rapidly, we are menaced by the revivification of a theory from a recent inglorious demise.
I refer to the return of the NAIRU. The concept known as the "nonaccelerating inflation rate of unemployment," or NAIRU, holds that there is a point below which unemployment cannot fall without triggering economy-destroying inflation. Well into the 1990s, the theory was widely supported by mainstream economists, whose consensus pegged the NAIRU threshold at roughly 6 percent. Should unemployment fall below that magic number, the financial establishment preached, unacceptable inflation would be set in motion--and thus the authorities, particularly the Federal Reserve system, had to be ready to slow down economic activity once unemployment dropped below the NAIRU.
But in the mid-1990s, a funny thing happened to the NAIRU: It shrank rapidly. And ultimately the shrinkage was so inexplicable that the idea became intellectually and politically insupportable. A little history is in order. When unemployment dropped to 5.5 percent, NAIRU-ites began to muster their arguments and call for slowing growth. Then, with no sign of inflation, the unemployment rate scaled down toward 5 percent. The NAIRU proponents' response was to revise their argument and concede that the NAIRU had now dropped to 5.5 percent. As unemployment hit 4.5 percent, the NAIRU was ratcheted down toward 5 percent, and by the time unemployment began to approach 4 percent, efforts by the advocates of the NAIRU to keep up with the good economic news began to founder. While a hardy few refused to give up on the concept and scrambled to revise the percentage, it became clear to most people that the NAIRU was not an economic rule but, rather, a de facto lagging indicator of the unemployment rate. To his credit, Fed Chairman Alan Greenspan never joined the NAIRU chorus, and he fought off some of the adherents' efforts to raise interest rates simply because unemployment dropped.
But while Chairman Greenspan deserves credit for resisting the attempt by NAIRU-ites both inside and outside the Federal Reserve to apply it and shut down economic growth at an early stage in the current run of prosperity, he has not been able to ignore them altogether. Greenspan is the most powerful member of the Federal Reserve system, but he does not have the ability completely to ignore other viewpoints--especially given the mystique that presumes theFederal Open Market Committee (FOMC) must always act unanimously, lest the common people get the notion that the level of interest rates is something about which people in a democratic society can legitimately debate.
Indeed, the concern that a 4 percent unemployment rate is an omen of inexorable inflation--even in the absence of any other indicators of such a phenomenon--lives on within the FOMC. Alarmingly, while not specifically named, it appears to have been a factor in the committee's recent outburst of aggressive inflation hawkishness.
The Fed's recent restrictive actions have two negative aspects. First, and most important in the near term, it is very possible that the FOMC has overshot its effort to slow the economy. Although the data are not yet conclusive, the signs of a greater slowdown than most people think desirable are disturbing. Indeed, the best arguments for asserting that the Fed has been guilty of excessive restraint over the past 18 months come from the financial community at large and the Fed itself.
To a troubling degree, fund managers, investors, and analysts have come to believe that the Fed's overreaction is as much of a danger as economic reality itself. When Chairman Greenspan finally acknowledged that the economy might be facing a much harder landing than he thought acceptable, the stock market had one of its best days in history. So if the news becomes bad enough for Greenspan to change his tone, the market regards this confirmation of bad news as good news because it augurs a reversal of the Fed's antigrowth posture. In other words, even many in the financial establishment now fear that the interest-rate tail is wagging the broader economic dog.
Second, we have an even more damning critique of the Fed's November insistence that inflation was a greater threat to the economy than a slowdown from the Fed itself. As I write this, word has come from economic Olympus that the Fed has finally caught up to the rest of the country in recognizing at its December FOMC meeting "that the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future."
That is, according to the Fed's official analysis, the economy swiveled in no more than six weeks from the brink of inflation to the edge of a slowdown. Two explanations are possible: Either the world's biggest economy can in fact turn on a dime, with a rapidity no one has heretofore believed possible, or the Fed was in error in November. In either case, it is now clear that the Fed was seriously wrong when it raised interest rates by 1.75 percent from June 1999 to May 2000. If the economy does slip into recession, the Fed's fear of the NAIRU specter will bear a large share of the responsibility.
And while the Fed has not formally resuscitated the NAIRU as the motive for this damaging overemphasis on restraint, recent statements from the Federal Open Market Committee are a form of NAIRU-speak. The FOMC's November 15 determination that "the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future" is explained by the Fed's dismay that "the utilization of the pool of available workers remains at an unusually high level." The statement does make reference to "the increase in energy prices," but it concedes--as the facts compel it to concede--that even this energy-price spike has been "having limited effect on core measures of prices to date." Thus, the Fed's justification for continuing to put inflationary fears at the center of its monetary policy is essentially the fact that unemployment remains low.
This analysis is further emphasized in the October FOMC minutes, released on November 15. Again the Fed concedes that price increases have been minimal: While "consumer prices edged up on balance over July and August," the panel says, "excluding the food and energy components, consumer price inflation remained moderate in both months." And while "core producer prices edged up over the July-August period," they "decelerated a little on a year-over-year basis." Even in the area of labor costs, presumably the place where the effects of the NAIRU would be seen, the worst the FOMC can say is that "the advance for the twelve months ended in August was slightly larger than that for the previous twelve-month period." Concern about slight increases hardly explains the significant interest-rate hikes the Fed engineered, and it is hardly a basis for continuing to argue as late as mid-November that inflation was our gravest danger.
The factor that accounts for this continued antigrowth bias is explicit in the October minutes, which report that "the members noted that decelerating demand and surging productivity seemed to have narrowed the gap between the growth rates of aggregate demand and potential supply, even though previous policy tightening actions had not yet exerted the full restraining effects." But the punch line smacks of an implicit NAIRU: "The members emphasized, however, that unusually taut labor markets could result in greater upward pressure on unit costs and prices, ... and they agreed that the ... risks remain weighted mainly in the direction of rising inflation" (emphasis added). So there was no significant indication of inflation as yet, and by the Fed's own rules of thumb the interest-rate increases it had engineered earlier in the year had yet to have their full deflationary economic effect. Yet the simple fact that unemployment was low led the shepherds of the nation's monetary system to focus on averting inflation--even in the face of indications that the economy was slowing significantly.
And the Federal Reserve is not the only place where the NAIRU specter lurks. In a December 5 op-ed column in The Washington Post, Robert Reischauer, a former director of the Congressional Budget Office under the Democrats, asserted "that the vast majority of economists welcome slower growth because they believe that the current 4 percent unemployment rate is incompatible with price stability." Given the economy's recent performance, this is an economists' special: the triumph of gloom, rather than hope, over experience.
For many of us, the notion that the central bank will slow growth simply because unemployment gets too low is disturbing because of the social cost it imposes. It is only when unemployment dropped significantly below 6 percent as we measure it that the 20-year trend of erosion in the relative incomes of people in the lower economic brackets began to turn around. Clearly, if unemployment is encouraged, it will be accompanied by a renewed increase in the unequal distribution of income.
For those in the financial community who are not motivated by equity concerns to oppose such a trend, another line of Alan Greenspan's thinking ought to dissuade them from welcoming it. Greenspan has noted, to his credit, that many Americans' resistance to further steps toward globalization and deregulation will increase if this course is accompanied by a weakening of their own economic position. Telling workers who lose their jobs that they are contributing to the greater good by participating in the Schumpeterian process of creative destruction does not work very well in mustering a national consensus in favor of the very economic policies the financial establishment advocates. The consequences of even an implicit revival of the notion that low unemployment is in and of itself a reason to cut back on growth will not simply be greater unemployment and lower incomes for working people. Making high levels of employment a cause for alarm will invite renewed resistance to a national economy that consists largely of removing both domestic and international restraints on capital--and that does so without paying attention to the negative impacts these policies can have on economic fairness. ¤
