The Long FAQ on Liberalism
A Critique of the Chicago School of Economics:

MILTON FRIEDMAN AND THE NATURAL RATE OF UNEMPLOYMENT



Friedman is also famous for a second theory, this one containing much more merit. It's called the natural rate of unemployment. (1) To understand it, we should review the early Keynesian goal of reaching "full employment."

"Full employment" does not mean 100 percent employment. For various reasons, the unemployment rate cannot be reduced to zero, if only because people are always being fired, laid off or moving between jobs. But even granting that unemployment can never be completely eliminated, it still might be possible to ensure that anyone searching for a job can find one reasonably quickly. Economists call this happy state of affairs "full employment."

How can it be reached? Early Keynesians believed that they could achieve it by expanding the money supply. Of course they could not overdo it. Keynes himself knew of this danger when he wrote Tract on Monetary Reform in 1923. The central bank could expand the money supply right up to the point where full employment was reached; after that, any monetary expansion would result in inflation. The question was how much to expand.

An apparent answer emerged in 1959, when British economist A.W. Phillips discovered a relationship between wages and unemployment in British historical statistics. When unemployment was high, wages had fallen; when unemployment was low, wages had risen. A look at American statistics revealed the same tradeoff. Since wage changes are indicators of inflation, this discovery actually showed that a tradeoff existed between inflation and unemployment. Accepting more of one meant less of the other. When graphed, this tradeoff produced a nice, neat curve, which became known as the "Phillips Curve."

This discovery helped policy-makers determine how much to expand the money supply. Previously, no one really knew what constituted "full employment." Now they could make a judgment call. The curve showed them how far they could expand the economy without letting the cost of inflation outweigh the cost of unemployment. This seemed to be 3 or 4 percent inflation in return for 4 percent unemployment.

Over the next few decades, many public figures would call for the unemployment rate to be reduced to 4 percent; the 1978 Humphrey-Hawkins Act went so far as to put it into law. But economic events and advances in theory would overtake them. In 1968, Milton Friedman challenged the whole concept of the Phillips Curve, and his efforts would secure him lasting fame and the 1976 Nobel Prize. His argument went something like this:

Imagine an economy where the cost of everything doubles. You have to pay twice as much for your groceries, but you don't mind, because your paycheck is also twice as large. Economists call this the neutrality of money. If inflation worked this way, then it would be harmless. Of course, inflation does have other negative consequences, but they are minor compared to the terrible costs of widespread unemployment. (2) Hence the Keynesian policy of accepting high inflation in exchange for low unemployment.

But Friedman had a question: why is it that when the Fed expands the money supply by, say, 5 percent, all prices and wages everywhere do not go up by 5 percent as well? Why wouldn't the neutrality of money make this expansion meaningless? Friedman argued that it was because the public didn't know that they should raise their prices by 5 percent. That's because they were unaware of the expansion, or what it meant, or how large it was if they did. When the extra money was pumped into the economy, therefore, it was unwittingly translated into more economic activity, not higher prices.

However, if businessmen knew that a 5 percent increase was coming, it would be in their best interest just to raise their prices 5 percent. That way, they would make the same increased profits without having to work for them. Or, seen another way, if businessmen knew that inflation was going to be 5 percent every year, they would simply build those expectations into their normal price increases. But if everyone did this, then the Fed's monetary increases would become meaningless -- instead of resulting in more jobs, they would just create higher inflation. In other words, the neutrality of money would take over. To maintain the job creation effect, the Fed would have to surprise businessmen with a 10 percent increase the next year. But businessmen would eventually come to expect that as well -- requiring a 15 percent increase the next year, and so on, all the way to hyperinflation.

Friedman and others argued that as businessmen became wiser to the Fed's actions, the Fed would no longer have a tool to fight unemployment. And without this tool, unemployment would eventually start climbing as well, along with inflation, forming a twin monster that Paul Samuelson dubbed "stagflation." And indeed, from the late 60s all the way through the 70s, this is precisely what happened. Stagflation peaked on Jimmy Carter's watch, costing him his reelection for the presidency.

Friedman showed that monetary policy could not be used to achieve full employment. Unfortunately, inflation starts accelerating before full employment is reached. The best a nation can do is settle for the lowest level of unemployment that will not begin accelerating inflation. Friedman called this point the "natural rate of unemployment,".

Some controversy exists over what the natural rate is, because it depends partly on what markets expect inflation will be. But in the U.S. today, economists estimate it to be slightly less than 6 percent. Friedman is said to regret the term "natural rate of unemployment," since it implies that a certain amount of unemployment is acceptable. Therefore, most economists prefer to use the euphemism "NAIRU," which stands for Non-Accelerating Inflation Rate of Unemployment.

The natural rate of unemployment does not mean that Keynesianism is still not a useful tool for smoothing out the business cycle. Six percent is merely an average; in reality, unemployment can deviate substantially from 6 percent. Keynesian policies are therefore useful for stabilizing unemployment at this figure.

As one might expect, the natural rate of unemployment is not without controversy. Although most top-level economists -- on both the left and the right -- accept its validity, there are many economists who believe the NAIRU doesn't even exist. A few important dissidents include John Kenneth Galbraith and Robert Eisner, both past Presidents of the American Economics Association. A much more widespread controversy, though, is where to peg the natural rate. Nearly all economists agree that it is not a fixed figure, but that it can float. Galbraith, tongue firmly in cheek, writes: And this debate has a political cast as well: conservatives like a high NAIRU, liberals, a low one. When it's high, interest on bonds pay more, thanks to low inflation. Conservatives like that because most bond-holders are wealthy. Furthermore, when the unemployment rate is high, wages tend to fall, in accordance with the laws of supply and demand on the labor market. Exploiting labor, as they say, is profitable business. The current Fed chairman, Alan Greenspan, is a died-in-the-wool conservative and a self-described "inflation hawk," meaning that he is committed to a high NAIRU. Conversely, liberals prefer a low NAIRU because it raises workers' wages.

Friedman's discovery of the natural rate took the wind out of the Keynesians' sails concerning one of their most important goals. It raised the prestige of the Chicago School of Economics and turned it into a leading advocate of unfettered capitalism. But in the end he did not accomplish what he had set out to do: replace Keynesianism.

Robert Lucas would come much closer to achieving that.

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Endnotes:

1. Except where otherwise noted, this essay is primarily based on Paul Krugman, Peddling Prosperity (New York: W.W. Norton & Company, 1994), pp. 40-47.

2. Inflation is harmful because it transfers wealth from loaners to borrowers, makes financial planning difficult, alters investment decisions, erodes fixed incomes, devalues savings, leads to more barter transactions, and costs individuals more time and effort by keeping more of their money in interest-accruing bank accounts rather than on hand.

3. James K. Galbraith, "Well, Excuuuuse Me!" The International Economy, December, 1995.