The Natural Rate of Unemployment
It's all about class conflict
by Robert Pollin
Dollars and Sense magazine, September/October
In 1997, the official U.S. unemployment rate fell to a 27
year low of 4.9%. Most orthodox economists had long predicted
that a rate this low would lead to uncontrollable inflation. So
they argued that maintaining a higher unemployment rate-perhaps
as high as 6%-was crucial for keeping the economy stable. But
there is a hitch: last year the inflation rate was 2.3%, the lowest
figure in a decade and the second lowest in 32 years. What then
are we to make of these economists' theories, much less their
Nobel prize-winning economist Milton Friedman gets credit
for originating the argument that low rates of unemployment would
lead to accelerating inflation. His 1968 theory of the so-called
"natural rate of unemployment" was subsequently developed
by many mainstream economists under the term "Non-Accelerating
Inflation Rate of Unemployment," or NAIRU, a remarkably clumsy
term for expressing the simple concept of a threshold unemployment
rate below which inflation begins to rise.
According to both Friedman and expositors of NAIRU, inflation
should accelerate at low rates of unemployment because low unemployment
gives workers excessive bargaining power. This allows the workers
to demand higher wages. Capitalists then try to pass along these
increased wage costs by raising prices on the products they sell.
An inflationary spiral thus ensues as long as unemployment remains
below its "natural rate."
Based on this theory, Friedman and others have long argued
that governments should never actively intervene in the economy
to promote full employment or better jobs for workers, since it
will be a futile exercise, whose end result will only be higher
inflation and no improvement in job opportunities. Over the past
generation, this conclusion has had far-reaching influence throughout
the world. In the U.S. and Western Europe, it has provided a stamp
of scientific respectability to a whole range of policies through
which governments abandoned even modest commitments to full employment
and workers' rights.
This emerged most sharply through the Reaganite and Thatcherite
programs in the United States and United Kingdom in the 1980s.
But even into the 1990s, as the Democrats took power in the United
States, the Labor Party won office in Britain, and Social Democrats
won elections throughout Europe, governments remained committed
to stringent fiscal and monetary policies, whose primary goal
is to prevent inflation. In Western Europe this produced an average
unemployment rate of over 10% from 1990-97. In the United States,
unemployment rates have fallen sharply in the 1990s, but as an
alternative symptom of stringent fiscal and monetary policies,
real wages for U.S. workers also declined dramatically over the
past generation. As of 1997, the average real wage for non-supervisory
workers in the U.S. was 14% below its peak in 1973, even though
average worker productivity rose between 1973 and 1997 by 34%.
Why have governments in the United States and Europe remained
committed to the idea of fiscal and monetary stringency, if the
natural rate theory on which such policies are based is so obviously
flawed? The explanation is that the natural rate theory is really
not just about predicting a precise unemployment rate figure below
which inflation must inexorably accelerate, even though many mainstream
economists have presented the natural rate theory in this way.
At a deeper level, the natural rate theory is bound up with the
inherent conflicts between workers and capitalists over jobs,
wages, and working conditions. As such, the natural rate theory
actually contains a legitimate foundation in truth amid a welter
of sloppy and even silly predictions.
THE "NATURAL RATE" THEORY IS ABOUT CLASS CONFLICT
In his 1967 American Economic Association presidential address
in which he introduced the natural rate theory, Milton Friedman
made clear that there was really nothing "natural" about
the theory. Friedman rather emphasized that: "by using the
term 'natural' rate of unemployment, I do not mean to suggest
that it is immutable and unchangeable. On the contrary, many of
the market characteristics that determine its level are man-made
and policy-made. In the United States, for example, legal minimum
wage rates. . . and the strength of labor unions all make the
natural rate of unemployment higher than it would otherwise be."
In other words, according to Friedman, what he terms ~ the
"natural rate" is really a social phenomenon measuring
the class strength of working people, as indicated by their ability
to organize effective unions and establish a livable minimum wage.
Friedman's perspective is supported in a widely-read 1997
paper by Robert Gordon of Northwestern University on what he terms
the "time-varying NAIRU." What makes the NAIRU vary
over time? Gordon explains that, since the early 1960s, "The
two especially large changes in the NAIRU... are the increase
between the early and late 1960s and the decrease in the 1990s.
The late 1960s were a time of labor militancy, relatively strong
unions, a relatively high minimum wage and a marked increase in
labor's share in national income. The 1990s have been a time of
labor peace, relatively weak unions, a relatively low minimum
wage and a slight decline in labor's income share."
In short, class conflict is the specter haunting the analysis
of the natural rate and NAIRU: this is the consistent message
stretching from Milton Friedman in the 1960s to Robert Gordon
in the 1990s.
Stated in this way, the "Natural Rate" idea does,
ironically, bear a dose family resemblance to the ideas of two
of the greatest economic thinkers of the left, Karl Marx and Michal
Kalecki, on a parallel concept-the so-called "Reserve Army
of Unemployed." In his justly famous Chapter 25 of Volume
I of Capital, "The General Law of Capitalist Accumulation,"
Marx argued forcefully that unemployment serves an important function
in capitalist economies. That is, when a capitalist economy is
growing rapidly enough so that the reserve army of unemployed
is depleted, workers will then utilize their increased bargaining
power to raise wages. Profits are correspondingly squeezed as
workers get a larger share of the country's total income. As a
result, capitalists anticipate further \, declines in profitability
and they therefore reduce their investment spending. This then
leads ~_ to a fall in job creation, higher unemployment, and a
replenishment of the reserve army. In other words, the reserve
army of the unemployed is the instrument capitalists use to prevent
significant wage increases and thereby maintain profitability.
Kalecki, a Polish economist of the Great Depression era, makes
parallel though distinct arguments in his also justly famous essay,
"The Political Aspects of Full Employment." Kalecki
wrote in 1943, shortly after the 1930s Depression had ended and
governments had begun planning a postwar world in which they would
deploy aggressive policies to avoid another calamity of mass unemployment.
Kalecki held, contrary to Marx, that full employment can be beneficial
to the profitability of businesses. True, capitalists may get
a smaller share of the total economic pie as workers gain bargaining
power to win higher wages. But capitalists can still benefit because
the size of the pie is growing far more rapidly, since more goods
and services can be produced when everyone is working, as opposed
to some significant share of workers being left idle.
But capitalists still won't support full employment, in Kalecki's
view, because it will threaten their control over the workplace,
the pace and direction of economic activity, and even political
institutions. Kalecki thus concluded that full employment could
be sustainable under capitalism, but only if these challenges
to capitalists' social and political power could be contained.
This is why he held that fascist social and political institutions,
such as those that existed in Nazi Germany when he was writing,
could well provide one "solution" to capitalism's unemployment
problem, precisely because they were so brutal. Workers would
have jobs, but they would never be permitted to exercise the political
and economic power that would otherwise accrue to them in a full-employment
Broadly speaking, Marx and Kalecki do then share a common
conclusion with natural rate proponents, in that they would all
agree that positive unemployment rates are the outgrowth of class
conflict over the distribution of income and political power.
Of course, Friedman and other mainstream economists reach this
conclusion via analytic and political perspectives that are diametrically
opposite to those of Marx and Kalecki. To put it in a nutshell,
in the Friedmanite view mass unemployment results when workers
demand more than they deserve, while for Marx and Kalecki, capitalists
use the weapon of unemployment to prevent workers from getting
their just due.
FROM NATURAL RATE TO EGALITARIAN POLICY
Once the analysis of unemployment in capitalist economies
is properly understood within the framework of class conflict,
several important issues in our contemporary economic situation
become much more dear. Let me raise just a few:
1 Mainstream economists have long studied how workers' 1 wage
demands cause inflation as unemployment falls. However, such wage
demands never directly cause inflation, since inflation refers
to a general rise in prices of goods and services sold in the
market, not a rise in wages. Workers, by definition, do not have
the power to raise prices. Capitalists raise prices on the products
they sell. At low unemployment, inflation occurs when capitalists
respond to workers' increasingly successful wage demands by raising
prices so that they can maintain profitability. If workers were
simply to receive a higher share of national income, then lower
unemployment and higher wages need not cause inflation at all.
2 There is little mystery as to why, at present, the so-called
"time-varying" NAIRU has diminished to a near vanishing
point, with unemployment at a 25-yeas low while inflation remains
dormant. The main explanation is the one stated by Robert Gordon-that
workers' economic power has been eroding dramatically through
the 1990s. Workers have been almost completely unable to win wage
increases over the course of the economic expansion that by now
is seven years old.
3 This experience over the past seven years, with unemployment
falling but workers showing almost no income gains, demonstrates
dramatically the crucial point that full employment can never
stand alone as an adequate measure of workers' well-being. This
was conveyed vividly to me when I was working in Bolivia in 1990
as part of an economic advising team led by [Prof] Keith Griffin
of the University of California-Riverside. Professor Griffin asked
me to examine employment policies.
I began by paying a visit to the economists at the Ministry
of Planning. When I requested that we discuss the country's employment
problems, they explained, to my surprise, that the country had
no employment problems. When I suggested we consider the situation
of the people begging, shining shoes, or hawking batteries and
Chiclets in the street just below the window where we stood, their
response was that these people were employed. And of course they
were, in that they were actively trying to scratch out a living.
It was clear that I had to specify the problem at hand far more
precisely. Similarly, in the U.S. today, we have to be much more
specific as to what workers should be getting in a fair economy:
jobs, of course, but also living wages, benefits, reasonable job
security, and a healthy work environment.
4 In our current low unemployment economy, should workers,
at long last, succeed in winning higher wages and better benefits,
some inflationary pressures are likely to emerge. But if inflation
does not accelerate after wage increases are won, this would mean
that businesses are not able to pass along their higher wage costs
to their customers. Profits would therefore be squeezed. In any
case, in response to either inflationary pressures or a squeeze
in profitability, we should expect that many, if not most, segments
of the business community will welcome a Federal Reserve policy
that would slow the economy and raise the unemployment rate.
Does this mean that, as long as we live in a capitalist society,
the control by capitalists over the reserve army of labor must
remain the dominant force establishing the limits of workers'
strivings for jobs, security, and living wages? The challenge
for the progressive movement in the United States today is to
think through a set of policy ideas through which full employment
at living wages can be achieved and sustained.
Especially given the dismal trajectory of real wage decline
over the past generation, workers should of course continue to
push for wage increases. But it will also be crucial to advance
these demands within a broader framework of proposals. One important
component of a broader package would be policies through which
labor and capital bargain openly over growth of wages and profits
after full employment is achieved. Without such an open bargaining
environment, workers, with reason, will push for higher wages
once full employment is achieved, but capitalists will then respond
by either raising prices or favoring high unemployment. Such open
bargaining policies were conducted with considerable success in
Sweden and other Nordic countries from the 1950s-1980s, and as
a result, wages there continued to rise at full employment, while
both accelerating inflation and a return to high unemployment
Such policies obviously represent a form of class compromise.
This is intrinsically neither good nor bad. The question is the
terms under which the compromise is achieved. Wages have fallen
dramatically over the past generation, so workers deserve substantial
raises as a matter of simple fairness. But workers should also
be willing to link their wage increases to improvements in productivity
growth, i.e. the rate at which workers produce new goods and services.
After all, if the average wage had just risen at exactly the rate
of productivity growth since 1973 and not a penny more, the average
hourly wage today for non-supervisory workers would be $19.07
rather than $12.24.
But linking wages to improvements in productivity then also
raises the question of who controls the decisions that determine
the rate of productivity growth. In fact, substantial productivity
gains are attainable through operating a less hierarchical workplace
and building strong democratic unions through which workers can
defend their rights on the job. Less hierarchy and increased workplace
democracy creates higher morale on the job, which in turn increases
workers' effort and opportunities to be inventive, while decreasing
turnover and absenteeism. The late David Gordon of the New School
for Social Research was among the leading analysts demonstrating
how economies could operate more productively through greater
But improvements in productivity also result from both the
public and private sector investing in new and better machines
that workers put to use every day, with the additional benefit
that it means more jobs for people who produce those machines.
A pro-worker economic policy will therefore also have to be concerned
with increasing investments to improve the stock of machines that
workers have at their disposal on the job.
In proposing such a policy approach, have I forgotten the
lesson that Marx and Kalecki taught us, that unemployment serves
a purpose in capitalism? Given that this lesson has become part
of the standard mode of thinking among [of] mainstream economists
ranging from Milton Friedman to Robert Gordon, I would hope that
I haven't let it slip from view. My point nevertheless is that
through changing power relationships at the workplace and the
decision-making process through which investment decisions get
made, labor and the left can then also achieve a more egalitarian
economy, one in which capitalists' power to brandish the weapon
of unemployment is greatly circumscribed. If the labor movement
and the left neglect issues of control over investment and the
workplace, we will continue to live amid a Bolivian solution to
the unemployment problem, where full employment is the by-product
of workers' vulnerability, not their strength. ~
Resources: A longer version of this article appears as "The
'Reserve Army of Labor' and the 'Natural Rate of Unemployment':
Can Marx, Kalecki, Friedman, and Wall Street All Be Wrong?,"
Robert Pollin, Review of Radical Political Economics, Fall 1998.
Both articles derive from a paper originally presented as the
David Gordon Memorial Lecture at the 1997 Summer Conference of
the Union for Radical Political Economics. See also The Living
Wage: Building A Fair Economy, Robert Pollin and Stephanie Luce,
1998; Fat and Mean, David Gordon, 1997; "Generating Affluence:
Productivity Gains Require Worker Support," David Gordon,
in Real World Macro, 15th Edition, 1998.
Robert Pollin teaches economics at the University of Massachusetts-Amherst
and is Co-Director of its Political Economy Research Institute.