Why 600,000 out of work is a magic number

Who would have expected it? A year ago we thought we were headed for a severe recession and this week we learn the rate of unemployment is down to 5.1 per cent. Do you realise that's just a fraction above what economists - and the Gillard government - regard as full employment?

Huh? If 5 per cent of the labour force - 600,000 people - is still looking for work, how on earth can economists say we're at full employment? Good question. Unfortunately, economists don't have a good answer.

This year's budget papers - which seem to have been overtaken by events already - say the unemployment rate is expected to fall to 5 per cent by the middle of next year and to 4.75 per cent by mid-2012, "around levels consistent with full employment".

Last month a senior Treasury officer, Dr David Gruen, told a Senate committee it was "a longstanding practice" to regard full employment as 5 per cent, although there was "a reasonable band of uncertainty around that number".

"With the best will in the world, we cannot really tell whether it is 5 per cent or anywhere in the range, say, from about 4.75 per cent to 5.25 per cent," he told

the committee.

I guess the first thing to understand is that, to an economist, "full employment" does not mean what you and I think it does. It does not mean everyone who wants a job has found one.

Rather, it refers to the lowest sustainable rate of unemployment. That is, the lowest rate to which unemployment can fall before shortages of labour lead to excessive wage increases and start pushing up inflation.

In the jargon, this is the "non-accelerating-inflation rate of unemployment" (NAIRU). So in an economist's mind the NAIRU is synonymous with full employment.

As Gruen implied, no one knows for certain where the NAIRU is, though we do know it can shift over time.

So, though economists do make calculations to estimate where it lies, you really have to discover where it is by real-world experience.

When the unemployment rate got down to 4 per cent in early 2008, most economists would have regarded that as clearly below the NAIRU. The private-sector wage index rose by 4.3 per cent over the following year - hardly a wage explosion, but clearly on the high side, particularly when the productivity of labour has been improving so slowly.

And the underlying rate of inflation has now been above the target range of 2 per cent to 3 per cent for more than three years. So I guess that does confirm that the NAIRU is nearer 5 per cent than 4 per cent.

Economists actually regard 5 per cent as good because, not that long ago, they believed the NAIRU was up somewhere between 7 per cent and 8 per cent. The rest of us, on the other hand, are shocked by the idea that economists could be satisfied with unemployment no lower than 5 per cent.

And oldies can remember the 1950s, '60s and early '70s when full employment (and the NAIRU) was regarded as an unemployment rate no higher than 2 per cent.

The 2 per cent was easily justified as "frictional unemployment". At any time, roughly 2 per cent of the labour force are unemployed simply because they are moving between jobs, and thus of no concern. In those days people were unemployed so briefly many did not bother to register for the dole.

But how do economists explain why the lowest point at which inflation pressure can be quiescent has shifted from 2 per cent to 5 per cent over the past 35 years or so? Well, the reason you can get inflationary wage pressure while still having 600,000 people looking for jobs is "structural mismatch": the remaining unemployed either don't have the skills employers are seeking or don't live in the parts of the country where those workers are being sought.

But that does not explain why structural mismatch is a much greater problem today than it was 40 years ago. So the truth is, economists can't offer a thorough explanation for why the full-employment rate has risen, as many of them will admit.

It is worth noting, however, that since the postwar Golden Age ended with the arrival of stagflation in the mid-1970s, NAIRUs have risen significantly in most developed economies.

And just because economists can prove it, that doesn't stop them having theories - rival theories, naturally.

Economists of a neo-classical disposition incline to the view that the full-employment rate is higher these days because a combination of increased interventions in the economy - minimum wage rates that are too high, unemployment benefits that are too generous and unfair dismissal laws - have stopped the labour market functioning as efficiently as it used to.

Limits on employers' freedom to dismiss unsatisfactory workers have made them more reluctant to hire those workers at the bottom of the barrel, it's argued.

Or, unduly high minimum wages effectively price unattractive workers out of a job, while generous unemployment benefits reduce the incentive for people to find work.

There may be other reasons why people don't try as hard to find work these days: because the stigma of being unemployed has declined, because dual-income households reduce the pressure on one partner to find work, which may be particularly true of married women.

But these arguments aren't terribly convincing. Relative to average income, our dole payments are very low.

And while it's true our minimum wage is quite high relative to average income, our NAIRU isn't that much higher than America's, even though its minimum wage is terribly low.

So economists of a more Keynesian disposition try to explain the higher full-employment rate more in terms of how the structure of the economy has

changed (as opposed to how governments have made prices more inflexible). When you get down to an unemployment rate of 5 per cent, most of those who have been unemployed for any length of time are unskilled, with a chequered work history. It may be that the kind of jobs suitable for such people no longer exist to the same extent they once did.

And there's a suspicion that where the NAIRU lies is affected by how rapidly you approach it. If unemployment falls rapidly, you may hit the NAIRU at a

higher level than if growth is more sedate and it takes a lot longer to get unemployment down.

Sorry, but all this is about the best explanation economists can offer. There is a lot economists do not know.