There's Nothing `Natural' About 5% Unemployment

With unemployment edging down toward 5% nationally, we are finally seeing small increases in median household income. Inflation hawks are starting to worry. But suppose unemployment got really low--say 2% or 3%?

There are more than a dozen metropolitan areas where unemployment is currently below 2.5%--and they provide interesting laboratories. Places such as Madison, Wis., Sioux Falls, S.D., Lexington, Ky., Omaha and Lincoln, Neb., and Bismarck and Fargo, N.D., all have effectively full employment. And for the most part they don't have soaring wage or price inflation.

Contrary to the model of a "natural rate" of noninflationary unemployment, employers don't respond to tight labor markets by raising everyone's wages. Rather, as profit maximizers, they display great ingenuity in finding workers without increasing labor costs. The result, on balance, is good for society.

Very tight labor markets compel business to dip deeper into the labor pool: Hard-to-hire people become worth the trouble. Such markets also create a genuine rationale for school-to-work, apprenticeship, and mentoring programs as well as job fairs--because there are actual jobs at the other end.

According to labor economists, tight local labor markets do raise wages, but mainly at the bottom end. In places such as Des Moines and Omaha, where the unemployment rate is under 2.5%, the effective minimum wage is above $6 an hour. But this is exactly the medicine that the low end of the job market needs--a living wage.

DECENT JOBS. Massachusetts Institute of Technology economist Paul Osterman's study of Boston's hot labor market in the mid-1980s found dramatic reductions of poverty rates as tight labor markets enabled the poor to get decent jobs. Between 1980 and 1988, Boston poverty rates dropped from 10.6% to 5.6% for white families and from 29.1% to 13.1% for black families.

According to economist Timothy J. Bartik of the Upjohn Institute for Economic Research, tight labor markets are not necessarily inflationary because employers can fill vacancies by upgrading individual employees. For example, if Smith is promoted to fill a vacancy and gets a 20% raise, he is earning more, but in a different slot; the employer's overall wage costs have not changed.

To fill Smith's former job, the employer may hire Jones, from a school-to-work program or off the unemployment rolls. With 10% unemployment, Jones was not a plausible job candidate. But with a scarcity of workers, Jones looks attractive. Whether this hire is inflationary depends on how much it costs to train Jones; who pays for the training; and whether Jones will work productively enough to earn his wage.

In Omaha, business, government, and labor have taken a 2.4% unemployment rate as a challenge to maximize the community's human resources. There are job fairs, renewed recruitment efforts, and intensified school-to-work and welfare-to-work programs. Worker scarcity has also intensified business' interest in supporting early childhood education. In Madison, with 1.5% unemployment, Dane County Executive Richard J. Phelps and University of Wisconsin professor Joel Rogers have created a pilot program through the blue-ribbon Economic Summit Council to train workers and match skills with jobs.

TOLERABLE SIDE EFFECT. William J. Spring, vice-president of the Federal Reserve Bank of Boston, observes that the classic government rationale for manpower policies is to allow the economy to run near full employment without courting wage inflation. Enthusiasts of education and training should note the direction of cause and effect: High demand for workers makes it cost-effective to spend resources on education, training, and job matching. But a better-educated workforce in a slack economy will not create jobs.

General inflation does not break out in tight local labor markets because the prices of most consumer goods today are set globally, not locally. An exception is local housing prices, which may temporarily rise until new supply catches up with demand, but this is a tolerable side effect.

As business leaders of Lexington, Sioux Falls, Omaha, and Bismarck will tell you, tight labor markets may cause inconvenience, but it is the happy inconvenience of a booming economy that compels employers to find creative ways to treat people like valuable human resources. William Vickrey, the 1996 Nobelist who died just three days after receiving his prize, used to haunt conferences on the natural rate of unemployment declaring that the proper unemployment rate was 2%. Vickrey was right.

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