Class Conflict and the "Natural Rate of Unemployment"

Challenge, Nov, 1999 by Robert Pollin

There might well be a natural rate of unemployment below which inflation will accelerate. But this economist argues that the reasons may be different from those suggested by conventional theory.

EARLY last September, the world's financial press reported a familiar story: that the U.S. stock market had surged on reports that conditions for U.S. workers had turned less favorable. The lead headline in the Financial Times for September 3, 1998, was typical: "Inflation fears ease as U.S. jobs growth slows. Markets surge after chances of another rate rise are reduced."

At the time of this news report, the most up-to-date monthly figures reported unemployment in the United States at 4.2 percent and the rate for the first eight months of 1999 was also 4.2 percent. Most orthodox macroeconomists had long predicted that an unemployment rate this low would lead to virtually uncontrollable acceleration of inflation, and they had therefore argued that policymakers were obligated to maintain unemployment at a higher level, perhaps as high as 6 percent. However, the inflation rate for the first seven months of 1999 was 1.8 percent, a rate only slightly above the 1.6 percent figure for all of 1998, and otherwise lower than that for any twelve-month period over the past thirty-four years. What, then, are we to make of economists' ability to understand, much less predict, the performance of the economy?

The argument that low rates of unemployment would lead to accelerating inflation stems, of course, from the so-called "natural rate of unemployment theory," a term first advanced in 1968 by Milton Friedman (though Edmund Phelps was the independent co-originator of the theory in its modem form). The Friedman theory was subsequently developed by many macroeconomists under the term "non-accelerating inflation rate of unemployment," or NAIRU, a remarkably clumsy term for expressing the simple concept of a threshold unemployment rate below which the inflation rate begins to rise.

Based on this theory, Friedman and others have long argued that governments should never actively intervene in the economy to promote full employment or better jobs for workers, since it will be a futile exercise, whose end result will only be higher inflation. Over the past generation, this conclusion has had a far-reaching influence throughout the world. In the United States and Western Europe, it has provided a stamp of scientific respectability to a whole range of conservative policies, most clearly the Reaganite and Thatcherite programs in the United States and United Kingdom in the 1980s. But even into the 1990s, as the Democrats took power in the United States, the Labour Party won office in Britain, and Social Democrats won elections throughout Europe, governments have still been committed to stringent fiscal and monetary policies, whose primary goal has been to prevent inflation. In Western Europe this has produced an average unemployment rate of more than 10 percent from 1990 to 1998. In the United States, unemployment rates have fallen sharply in the 1990s, but, as an alternative symptom of stringent fiscal and monetary policies, real wages for U.S. workers have also declined dramatically over the past generation. As of 1998, the average real wage for nonsupervisory workers in the United States was 13.1 percent below its peak in 1973, even though average worker productivity had risen between 1973 and 1998 by 36 percent.

Why have governments in the United States and Europe remained committed to the idea of fiscal and monetary stringency, if the natural rate theory on which such policies are based appears so obviously wrong? The explanation is that the natural rate theory is not just about predicting a precise unemployment-rate figure below which inflation must inexorably accelerate, even though many mainstream economists have presented the natural rate theory in this way. At a deeper level, the natural rate theory is an expression of the idea that, in a capitalist economy, sustaining full employment at decent wages is a difficult proposition that depends on how the inherent conflicts between workers and capitalists are resolved. As such, the natural rate theory actually contains a legitimate foundation in truth amid a welter of sloppy and even silly predictions.

The "Natural Rate" Theory Is About Class Conflict

In his 1967 American Economic Association presidential address, in which he introduced the natural rate theory, Milton Friedman made clear that there was really nothing "natural" about the natural rate theory. Instead, Friedman emphasized that

by using the term "natural" rate of unemployment, I do not mean to suggest that it is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made. In the United States, for example, legal minimum wage rates ... and the strength of labor unions all make the natural rate of unemployment higher than it would otherwise be. (1968, p. 9)

In other words, according to Friedman, what he terms the "natural rate" is really a social phenomenon measuring the bargaining strength of working people, as indicated through their ability to organize effective unions and establish a livable minimum wage.