The Natural Rate of Unemployment

It's all about class conflict

by Robert Pollin

Dollars and Sense magazine, September/October 1998

In 1997, the official U.S. unemployment rate fell to a 27 year low of 4.9%. Most orthodox economists had long predicted that a rate this low would lead to uncontrollable inflation. So they argued that maintaining a higher unemployment rate-perhaps as high as 6%-was crucial for keeping the economy stable. But there is a hitch: last year the inflation rate was 2.3%, the lowest figure in a decade and the second lowest in 32 years. What then are we to make of these economists' theories, much less their policy proposals?

Nobel prize-winning economist Milton Friedman gets credit for originating the argument that low rates of unemployment would lead to accelerating inflation. His 1968 theory of the so-called "natural rate of unemployment" was subsequently developed by many mainstream economists 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 inflation begins to rise.

According to both Friedman and expositors of NAIRU, inflation should accelerate at low rates of unemployment because low unemployment gives workers excessive bargaining power. This allows the workers to demand higher wages. Capitalists then try to pass along these increased wage costs by raising prices on the products they sell. An inflationary spiral thus ensues as long as unemployment remains below its "natural rate."

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 and no improvement in job opportunities. Over the past generation, this conclusion has had far-reaching influence throughout the world. In the U.S. and Western Europe, it has provided a stamp of scientific respectability to a whole range of policies through which governments abandoned even modest commitments to full employment and workers' rights.

This emerged most sharply through 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 Labor Party won office in Britain, and Social Democrats won elections throughout Europe, governments remained committed to stringent fiscal and monetary policies, whose primary goal is to prevent inflation. In Western Europe this produced an average unemployment rate of over 10% from 1990-97. 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 also declined dramatically over the past generation. As of 1997, the average real wage for non-supervisory workers in the U.S. was 14% below its peak in 1973, even though average worker productivity rose between 1973 and 1997 by 34%.

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 is so obviously flawed? The explanation is that the natural rate theory is really 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 bound up with the inherent conflicts between workers and capitalists over jobs, wages, and working conditions. 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 theory. Friedman rather 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."

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

Friedman's perspective is supported in a widely-read 1997 paper by Robert Gordon of Northwestern University on what he terms the "time-varying NAIRU." What makes the NAIRU vary over time? Gordon explains that, since the early 1960s, "The two especially large changes in the NAIRU... are the increase between the early and late 1960s and the decrease in the 1990s. The late 1960s were a time of labor militancy, relatively strong unions, a relatively high minimum wage and a marked increase in labor's share in national income. The 1990s have been a time of labor peace, relatively weak unions, a relatively low minimum wage and a slight decline in labor's income share."

In short, class conflict is the specter haunting the analysis of the natural rate and NAIRU: this is the consistent message stretching from Milton Friedman in the 1960s to Robert Gordon in the 1990s.

Stated in this way, the "Natural Rate" idea does, ironically, bear a dose family resemblance to the ideas of two of the greatest economic thinkers of the left, Karl Marx and Michal Kalecki, on a parallel concept-the so-called "Reserve Army of Unemployed." In his justly famous Chapter 25 of Volume I of Capital, "The General Law of Capitalist Accumulation," Marx argued forcefully that unemployment serves an important function in capitalist economies. That is, when a capitalist economy is growing rapidly enough so that the reserve army of unemployed is depleted, workers will then utilize their increased bargaining power to raise wages. Profits are correspondingly squeezed as workers get a larger share of the country's total income. As a result, capitalists anticipate further \, declines in profitability and they therefore reduce their investment spending. This then leads ~_ to a fall in job creation, higher unemployment, and a replenishment of the reserve army. In other words, the reserve army of the unemployed is the instrument capitalists use to prevent significant wage increases and thereby maintain profitability.

Kalecki, a Polish economist of the Great Depression era, makes parallel though distinct arguments in his also justly famous essay, "The Political Aspects of Full Employment." Kalecki wrote in 1943, shortly after the 1930s Depression had ended and governments had begun planning a postwar world in which they would deploy aggressive policies to avoid another calamity of mass unemployment. Kalecki held, contrary to Marx, that full employment can be beneficial to the profitability of businesses. True, capitalists may get a smaller share of the total economic pie as workers gain bargaining power to win higher wages. But capitalists can still benefit because the size of the pie is growing far more rapidly, since more goods and services can be produced when everyone is working, as opposed to some significant share of workers being left idle.

But capitalists still won't support full employment, in Kalecki's view, because it will threaten their control over the workplace, the pace and direction of economic activity, and even political institutions. Kalecki thus concluded that full employment could be sustainable under capitalism, but only if these challenges to capitalists' social and political power could be contained. This is why he held that fascist social and political institutions, such as those that existed in Nazi Germany when he was writing, could well provide one "solution" to capitalism's unemployment problem, precisely because they were so brutal. Workers would have jobs, but they would never be permitted to exercise the political and economic power that would otherwise accrue to them in a full-employment economy.

Broadly speaking, Marx and Kalecki do then share a common conclusion with natural rate proponents, in that they would all agree that positive unemployment rates are the outgrowth of class conflict over the distribution of income and political power. Of course, Friedman and other mainstream economists reach this conclusion via analytic and political perspectives that are diametrically opposite to those of Marx and Kalecki. To put it in a nutshell, in the Friedmanite view mass unemployment results when workers demand more than they deserve, while for Marx and Kalecki, capitalists use the weapon of unemployment to prevent workers from getting their just due.

FROM NATURAL RATE TO EGALITARIAN POLICY

Once the analysis of unemployment in capitalist economies is properly understood within the framework of class conflict, several important issues in our contemporary economic situation become much more dear. Let me raise just a few:

1 Mainstream economists have long studied how workers' 1 wage demands cause inflation as unemployment falls. However, such wage demands never directly cause inflation, since inflation refers to a general rise in prices of goods and services sold in the market, not a rise in wages. Workers, by definition, do not have the power to raise prices. Capitalists raise prices on the products they sell. At low unemployment, inflation occurs when capitalists respond to workers' increasingly successful wage demands by raising prices so that they can maintain profitability. If workers were simply to receive a higher share of national income, then lower unemployment and higher wages need not cause inflation at all.

2 There is little mystery as to why, at present, the so-called "time-varying" NAIRU has diminished to a near vanishing point, with unemployment at a 25-yeas low while inflation remains dormant. The main explanation is the one stated by Robert Gordon-that workers' economic power has been eroding dramatically through the 1990s. Workers have been almost completely unable to win wage increases over the course of the economic expansion that by now is seven years old.

3 This experience over the past seven years, with unemployment falling but workers showing almost no income gains, demonstrates dramatically the crucial point that full employment can never stand alone as an adequate measure of workers' well-being. This was conveyed vividly to me when I was working in Bolivia in 1990 as part of an economic advising team led by [Prof] Keith Griffin of the University of California-Riverside. Professor Griffin asked me to examine employment policies.

I began by paying a visit to the economists at the Ministry of Planning. When I requested that we discuss the country's employment problems, they explained, to my surprise, that the country had no employment problems. When I suggested we consider the situation of the people begging, shining shoes, or hawking batteries and Chiclets in the street just below the window where we stood, their response was that these people were employed. And of course they were, in that they were actively trying to scratch out a living. It was clear that I had to specify the problem at hand far more precisely. Similarly, in the U.S. today, we have to be much more specific as to what workers should be getting in a fair economy: jobs, of course, but also living wages, benefits, reasonable job security, and a healthy work environment.

4 In our current low unemployment economy, should workers, at long last, succeed in winning higher wages and better benefits, some inflationary pressures are likely to emerge. But if inflation does not accelerate after wage increases are won, this would mean that businesses are not able to pass along their higher wage costs to their customers. Profits would therefore be squeezed. In any case, in response to either inflationary pressures or a squeeze in profitability, we should expect that many, if not most, segments of the business community will welcome a Federal Reserve policy that would slow the economy and raise the unemployment rate.

Does this mean that, as long as we live in a capitalist society, the control by capitalists over the reserve army of labor must remain the dominant force establishing the limits of workers' strivings for jobs, security, and living wages? The challenge for the progressive movement in the United States today is to think through a set of policy ideas through which full employment at living wages can be achieved and sustained.

Especially given the dismal trajectory of real wage decline over the past generation, workers should of course continue to push for wage increases. But it will also be crucial to advance these demands within a broader framework of proposals. One important component of a broader package would be policies through which labor and capital bargain openly over growth of wages and profits after full employment is achieved. Without such an open bargaining environment, workers, with reason, will push for higher wages once full employment is achieved, but capitalists will then respond by either raising prices or favoring high unemployment. Such open bargaining policies were conducted with considerable success in Sweden and other Nordic countries from the 1950s-1980s, and as a result, wages there continued to rise at full employment, while both accelerating inflation and a return to high unemployment were prevented.

Such policies obviously represent a form of class compromise. This is intrinsically neither good nor bad. The question is the terms under which the compromise is achieved. Wages have fallen dramatically over the past generation, so workers deserve substantial raises as a matter of simple fairness. But workers should also be willing to link their wage increases to improvements in productivity growth, i.e. the rate at which workers produce new goods and services. After all, if the average wage had just risen at exactly the rate of productivity growth since 1973 and not a penny more, the average hourly wage today for non-supervisory workers would be $19.07 rather than $12.24.

But linking wages to improvements in productivity then also raises the question of who controls the decisions that determine the rate of productivity growth. In fact, substantial productivity gains are attainable through operating a less hierarchical workplace and building strong democratic unions through which workers can defend their rights on the job. Less hierarchy and increased workplace democracy creates higher morale on the job, which in turn increases workers' effort and opportunities to be inventive, while decreasing turnover and absenteeism. The late David Gordon of the New School for Social Research was among the leading analysts demonstrating how economies could operate more productively through greater workplace democracy.

But improvements in productivity also result from both the public and private sector investing in new and better machines that workers put to use every day, with the additional benefit that it means more jobs for people who produce those machines. A pro-worker economic policy will therefore also have to be concerned with increasing investments to improve the stock of machines that workers have at their disposal on the job.

In proposing such a policy approach, have I forgotten the lesson that Marx and Kalecki taught us, that unemployment serves a purpose in capitalism? Given that this lesson has become part of the standard mode of thinking among [of] mainstream economists ranging from Milton Friedman to Robert Gordon, I would hope that I haven't let it slip from view. My point nevertheless is that through changing power relationships at the workplace and the decision-making process through which investment decisions get made, labor and the left can then also achieve a more egalitarian economy, one in which capitalists' power to brandish the weapon of unemployment is greatly circumscribed. If the labor movement and the left neglect issues of control over investment and the workplace, we will continue to live amid a Bolivian solution to the unemployment problem, where full employment is the by-product of workers' vulnerability, not their strength. ~

Resources: A longer version of this article appears as "The 'Reserve Army of Labor' and the 'Natural Rate of Unemployment': Can Marx, Kalecki, Friedman, and Wall Street All Be Wrong?," Robert Pollin, Review of Radical Political Economics, Fall 1998. Both articles derive from a paper originally presented as the David Gordon Memorial Lecture at the 1997 Summer Conference of the Union for Radical Political Economics. See also The Living Wage: Building A Fair Economy, Robert Pollin and Stephanie Luce, 1998; Fat and Mean, David Gordon, 1997; "Generating Affluence: Productivity Gains Require Worker Support," David Gordon, in Real World Macro, 15th Edition, 1998.

Robert Pollin teaches economics at the University of Massachusetts-Amherst and is Co-Director of its Political Economy Research Institute.

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