Lurking behind the employment white paper that Treasurer Jim Chalmers will release today is the ugly and ominous figure of NAIRU – the non-accelerating-inflation rate of unemployment. If the Albanese government can’t free itself and its econocrats from the grip of NAIRU, all its fine words about the joys of full employment won’t count for much.
The NAIRU is an idea whose time has passed. It made sense once, but not anymore. The story of how this conventional wisdom came to dominate the thinking of the rich world’s macroeconomists has been told by Queensland University’s Professor John Quiggin.
In the period after World War II, economists decided that the managers of the economy faced a simple choice between inflation and unemployment. Low unemployment came at the cost of high inflation, and vice versa.
This relationship was plotted on something called the Phillips curve, and the economic managers could choose which combination of inflation and unemployment they wanted.
It seemed to work well enough until the mid-1970s, when the developed economies found themselves with high unemployment and high inflation at the same time – “stagflation” – something the Phillips curve said couldn’t happen.
The economists turned to economist Milton Friedman, who’d been arguing that, if inflation persisted long enough, the expectations of workers and businesses would adjust. The inflation rate would become “baked in” as workers and suppliers increased their wages and prices by enough to compensate for inflation, whatever the unemployment rate.
So, after much debate, the economists moved to doing regular calculations of the NAIRU – the lowest rate to which unemployment could fall before shortages of labour pushed up wages and so caused price inflation to take off.
Since the early 1980s, the economic managers have tried to ensure the rate of unemployment stayed above the estimated NAIRU, so inflation would stay low. Should inflation start worsening, central bankers would jump on it quickly by whacking up interest rates.
Why? So that expectations about inflation would stay "anchored". Should they rise, the spiral of rising wages leading to rising prices would push up actual inflation. Then it would be the devil’s own job to get it back down.
If this sound familiar, it should. It’s what the Reserve Bank has been warning about for months.
Trouble is, the theory no longer fits the facts. Inflation has shot up, but because of supply disruptions, plus the pandemic-related budgetary stimulus, not excessive wage growth. And there’s been no sign of a worsening in inflation expectations.
Wages have risen in response to the higher cost of living, but have failed to rise by anything like the rise in prices. Why? Because, seemingly unnoticed by the econocrats, workers’ bargaining power against employers has declined hugely since the 1970s.
Meanwhile, the stimulus took us down to the lowest rate of unemployment in almost 50 years, where it’s stayed for more than a year. It’s well below estimates of the NAIRU, meaning wages should have taken off, but shortage-driven pay rises have been modest.
All of which suggest that the NAIRU is an artifact of a bygone age. As Quiggin says, the absence of a significant increase in wage growth is inconsistent with the NAIRU, which was built around the idea that inflation was driven by growth in wages, passed on as higher prices.
“As a general model of inflation and unemployment, it is woefully deficient,” Quiggin concludes.
Economists have fallen into the habit of using their calculations of an ever-changing NAIRU as their definition of full employment. But it’s now clear that, particularly in recent years, this has led us to accept a rate of unemployment higher than was needed to keep inflation low, thus tolerating a lot of misery for a lot of people.
So if today’s employment white paper is to be our road map back to continuing full employment – if our 3.5 per cent unemployment rate is to be more than a case of ships passing in the night – we must move on from the NAIRU.
A policy brief from the Australian Council of Social Service makes the case for new measures of full employment and for giving full employment equal status with the inflation target in the Reserve Bank’s policy objectives – as recommended by the Reserve Bank review.
The council quotes with approval new Reserve governor Michele Bullock’s definition that “full employment means that people who want a job can find one without having to search for too long”.
But it says another goal could be added, that “people who seek employment but have been excluded (including those unemployed long-term) have a fair chance of securing a job with the right help”.
And it argues that “since an unemployment rate of 3.5 per cent (and an underemployment rate of 6 per cent) has not triggered strong wages growth, this could be used as a full employment benchmark”.
One of the things wrong with the NAIRU was that it was a calculated measure, and it kept changing. As Quiggin notes, it tends to move in line with the actual rate of unemployment.
“When unemployment was high, estimates of NAIRU were high. As it fell, estimates of NAIRU fell, suggesting that how far unemployment could fall was determined by how far unemployment had fallen,” he says.
Which is why, to the extent that econocrats persist with their NAIRU estimates – or the government sets a more fixed target – the council is smart to suggest a test-and-see approach.
Rather than continuing to treat a fallible estimate as though it’s an electrified fence – to be avoided at all cost – you allow actual unemployment to go below the magic number, and see if wages take off. Only when they do, do you gently apply the brakes.
The council reminds us that it’s not enough to merely aspire to full employment, or even specify a number for it. It’s clear that, apart from the ups and downs of the business cycle, what keeps unemployment higher than it should be is long-term unemployment.
Committing to full employment should involve committing to give people who have “had to search too long” special help just as soon as their difficulties become apparent.
This would be a change from paying for-profit providers of government-funded “employment services” to punish them for their moral failings.
