Why Not Target a 3% Unemployment Rate?

Women build Princess telephones in a factory assembly line in Indianapolis in 1961 Photograph by Dean Conger/National Geographic Stock

When will the job market revive and get back to something close to normal? Not any time soon. The consensus expectation for April’s job report is for nonfarm payrolls to rise by 140,000 and the unemployment rate to remain at 7.6 percent, according to a Bloomberg News survey. A safe bet is that the unemployment rate won’t breach 6.5 percent, one signal for it to start tightening monetary policy, until 2014, if not later.

Sad to say, the Fed considers 5.2 percent to 6 percent the economy’s long-run normal rate of unemployment. Achieving that rate would be a vast improvement over today. Still, once upon a time and not all that long ago, America’s elites strived for full employment, a catchphrase now relegated to economic history.

Full employment was once defined as somewhere between 1 percent and 2 percent, a figure that reflects the normal ebb and flow of the workforce as people leave jobs seeking better opportunities. In the U.S. a full-employment economy more realistically is closer to the 3 percent to 4 percent mark, a level reached only a handful of times during the past half-century, in the 1950s, the latter part of the 60s and during the heady years of the dot.com boom in the 90s.

Try this thought exercise: How do you think Wall Street money mavens, mainstream economists, institutional investors and other elites would react if the Fed said its unemployment rate target isn’t 6.5 percent. Nor is it 5.2 percent to 6 percent. It’s 3 percent to 4 percent. A catastrophic ambition, right?  A cottage industry of reports would come out predicting a coming hyperinflationary storm. The murmuring movement among conservative lawmakers and their think-tank allies to mandate that the Fed consider only price stability in its policymaking would gain momentum and go mainstream.

Big mistake. A 3 percent to 4 percent unemployment rate is a reasonable goal for policymakers to embrace. After all, a Main Street definition of a good economy is when a worker can walk into the boss’s office and demand a 5 percent to 10 percent raise—and get it. A bad economy is when the boss says, walk. The conventional wisdom that says such a low unemployment rate policy isn’t feasible because of inflation is wrong, deeply wrong.

The post-World War II public goal of full employment was a reaction to the trauma of the Great Depression. The ambition foundered on the double-digit inflation rates of the 1970s. Economists at the time became convinced the only way to keep inflation down was to tolerate higher rates of unemployment. Economists didn’t ever quite put it this way, but too much economic growth and too much employment was bad for the overall price level, and a reserve army of unemployed and underemployed workers is good for inflation.

Nevertheless, scholars now know that the trade-off between inflation and employment is theoretically mistaken and, in many cases, historically inaccurate. Throughout U.S. history, periods of rapid economic growth and technological innovation have often been times of declining inflation rates. Technological advances, productivity improvements, and open borders can hike growth prospects and still keep overall prices stable (the experience of the late 90s). “It is simply not logical (or correct) to argue that an increase in production will foster a general rise of prices. Concerns that faster total growth of output in the economy will cause a fall in the purchasing power of money—inflation—are simply wrong,” writes (pdf) Jerry Jordan, former president of the Federal Reserve Bank of Cleveland and a well-known monetarist. “Similarly, it is false to say that ‘too many people working’ or ‘too low unemployment’ can ‘cause inflation.’”

What counts is that the Fed maintains the credibility of its commitment to a target rate of 2 percent inflation. Seared by the experience of the 1970s, the Fed and the wide network of monetary mandarins in academia have developed a deeper understanding of its inflation-fighting toolkit. The result: the underlying trend toward subdued inflation over the past three decades.

At the same time, the human toll from long spells of unemployment is too high. When you’re unemployed, it’s hard to pay bills, but the damage runs much deeper. People lose purpose. Their health deteriorates. Families break apart. Laid-off workers can’t save for retirement and borrow too much to stay afloat. Work nourishes our sense of belonging to a much larger community. “How do we connect the disconnected?’ wonders Crystal Palmer, a lifelong public housing resident in Chicago and an employee at the Henry Horner public housing project. “That’s the key to success in this community and any other community.”

A robust job market is also the preferred solution to many of our most troubling social and political issues. Worried about the future cost of entitlements such as Social Security and Medicare? The funding pressures largely disappear if aging boomers labor into the traditional retirement years. What about poverty and inequality? Something of a consensus has emerged that antipoverty programs should focus on getting poor people to work.

“Prosperity has been key to the reduction of the number of people below the statistical poverty line from 40 million in 1961 to 25 million in 1968,” recalled the late economist Arthur Okun, chairman of the White House Council of Economic Advisers in the late 1960s. “It has meant jobs for those formerly at the back of the hiring line.” The unemployment rate in 1968 was 3.6 percent.

Monetary policy can’t do it alone, however. Fiscal policy needs to weigh in and, no, not with the discredited supply-side mantra of tax cuts. Economists have weighed in on tax credits, wage subsidies, training initiatives, and similar incentives to encourage employers to hire more workers, especially the less skilled.

Among the leading advocates for a fiscal focus on designing “a system of public low-wage employment subsidies as well as classical education subsidies in order to attract marginalized workers to the business sector, shrink their unemployment rates, and boost their pay” is Nobel laureate Edmund Phelps. In his 2006 Nobel Prize lecture, Phelps noted that “suitably designed employment subsidies would restore the bourgeois culture, revive the ethic of self-support, and increase prosperity in low-wage communities. That would boost a country’s dynamism, not weaken it, and also strengthen popular support for capitalist institutions.”

Now, that’s an ambition worth striving for as the U.S. slowly emerges from the worst labor market since the 1930s.

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