Inflation or Unemployment?

Lane Kenworthy argues that the US needs to do more to seek "full employment", by which he means unemployment under 4%.  Under such a regime, he thinks, real wages for the bottom of the income distribution would rise, as employers were forced to compete for workers by spending more of their gross profits on wages.

But Kenworthy thinks that the independent fed is the enemy of this goal:

Can we do it? Pollin points to two historical precedents as grounds for optimism. The first is Sweden from 1960 to 1989. Sweden succeeded in keeping unemployment below 4% throughout those three decades by coupling employment-oriented monetary and fiscal policy with wage restraint. But Sweden's central bank at that time was subordinate to the government. Ours, the Federal Reserve, is independent. Since the late 1970s, independent central banks such as the Fed almost always have prioritized low inflation, rendering low unemployment difficult to achieve. If the Fed isn't on board, even a workable plan for full employment supported by the American public and our elected officials probably won't be enough.

What about Pollin's second precedent, the United States in the late 1990s? During those years the Fed, under Alan Greenspan, did keep interest rates low enough for the unemployment rate to drop below 4%. But Greenspan held rates low despite opposition from other Fed board members, who were concerned about potential inflationary consequences -- particularly given the internet-driven stock market bubble. Greenspan took this stance in part because his belief in the self-correcting nature of markets led him to worry less than others about the bubble. In light of the painful consequences of the 2000s real estate bubble, I doubt we'll see the Fed take that approach again for some time.

I have seen some variation of this argument on multiple progressive blogs recently.  I find it confusing, both because it contradicts everything I think I know about the history of monetary policy, and because I don't understand why you would define "full employment" as "less than 4%".


After all, 4% is essentially arbitrary--it is a nice round number, to be sure, but only because we happen to have ten fingers.  It's not really particularly likely that the ideal level of employment corresponds so neatly--and consistently!--to the arbitrary dictates of the decimal counting system.

More to the point, this rather begs the question of what the ideal is.  You could define "full employment" as a situation in which everyone who wants a job has one.  But on any level of economic organization above the size of a small village, this will not be true.  At any given time, there will be what economists call "frictional unemployment", which reflects the fact that it takes a little time to find a job after you've entered the labor force.  As long as companies are constantly creating and destroying jobs, the ideal level of unemployment is not zero.

To me, full employment is probably best defined as the situation where everyone's going to get a job in a relatively comfortable period of time--not instantly, but pretty briskly.  The time to find a job will vary with skill and income level (in my full employment world, we understand that a laid-off marketing executive is going to take longer to find another job than someone who works retail for $9 an hour, because it takes longer to find work that suits specialized skills).  

Over time, I'd say full employment will probably correspond pretty closely with what Milton Friedman and the monetarists called "the non-inflation accelerating rate of unemployment", or NAIRU.  NAIRU could be 4%, but it's not particularly likely to be--and it's even less likely to stay at 4%.  NAIRU changes along with changes in the economy and the labor force.  Equilibrium unemployment rates are very low when most men are unskilled labor who can pick up new jobs very easily--and need to, because they can never save up enough of a cash cushion to see them through an extended job search.  They will be higher when jobs are more specialized, when people are rich enough not to have to take whatever's offered, and when there are regulatory barriers to hiring and firing.

I take Kenworthy and co to be saying that we ought to be willing to tolerate a little more inflation in order to get lower unemployment--which also have the pleasant side effect of transferring wages to workers.  This was essentially what policy-makers thought in the late sixties.  They looked at the Phillips Curve, which promised a direct tradeoff between unemployment and inflation, and decided that a little inflation was worth lower unemployment.

I wouldn't necessarily disagree--if that simple relationship had held.  But as Kenworthy fails to mention, the reason that policymakers no longer rely on loose money to lower unemployment is that the relationship broke down in the 1970s.  

Arguments like Kenworthy's seem to me to assume that you can simply extrapolate short-term effects into long-term effects.  But of course the real world doesn't work that way.  In the short term, inflation boosts output because of imperfect information--if they understood how rapidly the purchasing power of their recent wage or profit boost was being eroded, people would simply discount accordingly, and exert exactly as much economic effort as before.  However, people don't have perfect information about the level of inflation, so when they get a slew of new orders, or a raise, they're willing to work harder because they don't understand that the purchasing power of their raise will be lower in a little while than it is now.

Over time, however, people learn from experience, and they do start discounting for inflation. Once inflationary expectations are established, unemployment creeps back to its old level--and now you've got inflation and unemployment.  

In order to keep unemployment low, you have to essentially out-inflate peoples' expectations.  In other words, I don't think you can get permanently lower unemployment by pushing inflation to 4%--you'd need to push it to 4%, and then ever-higher.  And even that will eventually fail, because people will start expecting that you'll out-inflate even their expecations--and then you've got hyperinflation.

It's true that a low level of inflation eases all sorts of problems, like "sticky wages" (the unwillingness of people to take nominal wage cuts, which forces employers to do layoffs instead when demand falls.)  But inflation is like cologne.  It's not true that if a splash is good, five splashes will be even better.

I'm not particularly stuck on a particular level of inflation--I'd be willing to listen to arguments that it ought to be 3%, or 4% (though I'd also argue back that this would cost the Fed some of its hard-won credibility as an inflation fighter, which should give us pause).  But whatever level of inflation we choose is ultimately not going to erase all the problems in the real economy, whether those problems are high unemployment or stagnant real wages.  Monetary policy is important.  But its power over the real economy is not unlimited.
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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