There is one aspect of discussions of inflation in mainstream economics which is particularly crucial in government policy: the relationship between inflation and unemployment and the concept of the “non-accelerating inflation rate of unemployment (NAIRU).” It began life as the “natural rate of unemployment,” and its current form is an attempt to improve on its theoretical underpinnings or at least paper over the implication that there is anything “natural” about unemployment.

The nonaccelerating inflation rate of unemployment (or NAIRU) is that unemployment rate consistent with a constant inflation rate. At the NAIRU, upward and downward forces on price and wage inflation are in balance, so there is no tendency for inflation to change. The NAIRU is the lowest unemployment rate that can be sustained without upward pressure on inflation. [Samuelson/Nordhaus p.621]

This attempt to analyze the relationship between inflation and unemployment has it roots in a paper by A.W. Phillips in 1958 entitled “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Applying the theory of supply and demand to the labor market, Phillips analyzed data from almost a century of statistics on unemployment and wage rates in the U.K. to confirm an hypothesis “that the rate of change of money wage rates can be explained by the level of unemployment and the rate of change of unemployment, except in or immediately after those years in which there is a sufficiently rapid rise in import prices to offset the tendency for increasing productivity to reduce the cost of living.” He used mathematical techniques to derive a function which yielded a curve which fit the data as well as possible. His curve dealt with the rate of change of money wage rates, but other economists translated it into the “Phillips Curve” depicting a relationship between inflation and unemployment. Analyzing data for the U.S., Samuelson and Solow generated a curve which implied two things:

1. In order to have wages increase at no more than the 21/2 per cent per annum characteristic of our productivity growth, the American economy would seem on the basis of twentieth-century and postwar experience to have to undergo something like 5 to 6 per cent of the civilian labor force’s being unemployed. That much unemployment would appear to be the cost of price stability in the years immediately ahead.

2. In order to achieve the nonperfectionist’s goal of high enough output to give us no more than 3 per cent unemployment, the price index might have to rise by as much as 4 to 5 per cent per year. That much price rise would seem to be the necessary cost of high employment and production in the years immediately ahead.

The implications of this curve led to the concept of a “Natural Rate of Unemployment” and to idea that there was an inevitable tradeoff between inflation and unemployment. Further analysis indicated that there was not a single “natural” rate, but that for any given state of the economy a reduction in unemployment below a certain level would nonetheless result in some degree of inflation. The level of unemployment for a stable inflation rate is the NAIRU. The assumption seems to be that it is not possible to have stable prices without high unemployment or full employment without high inflation. The best compromise that can be hoped for is a relatively low and non-accelerating inflation rate with relatively low unemployment.

Samuelson and Nordhaus describe the Phillips Curve as “the major macroeconomics tool used to understand inflation.”

An important piece of inflation arithmetic underlies this curve. Say that labor productivity (output per worker) rises at a steady rate of 1 percent each year. Further, assume that firms set prices on the basis of average labor costs, so prices always change just as much as average labor costs per unit of output. If wages are rising at 4 percent, and productivity is rising at 1 percent, then average labor costs will rise at 3 percent. Consequently, prices will also rise at 3 percent.

Several things are striking about the Phillips Curve. First even though Phillips assumed that increasing productivity tends to lower the cost of living, his data never showed a decrease in the cost of living. He assumed this was because wages were always increasing and looked for a correlation between wages and unemployment. The textbook example does not elaborate on the assumptions involved in its “inflation arithmetic” If productivity is rising at a steady rate, either workers are always getting more proficient or capital expenditures are improving the equipment they use. Presumably some price increase would be required to compensate for the amortized capital expense. Assuming prices are set based simply on average labor costs seems to bias the calculation in a way that encourages one to place all the blame for inflation on wage demands rather than looking at the reason wages are rising at 4 percent.

Even though the data for the U.S. analyzed by Samuelson and Solow seemed to correspond to what Phillips had found in the U.K., subsequent data from the 70s was completely at odds with the theory. As every mutual fund prospectus is legally required to say, “Past performance is no guarantee of future results.”

Once it was realized that there was nothing “natural” about unemployment or the rate of change in unemployment, no one jumped to the conclusion that it might be possible somehow to achieve zero unemployment. The reason there is no place in mainstream economic theory for actual full employment seems just to be that both inflation and unemployment have always been a “fact of life” in industrialized market economies. There is also an assumption about the effect of widespread anticipation of continued inflation.

Why, you might ask, does inflation have such strong momentum? The answer is that most prices and wages are set with an eye to future economic conditions. When prices and wages are rising rapidly and are expected to continue doing so, businesses and workers tend to build the rapid rate of inflation into their price and wage decisions. High or low inflation expectations tend to be self-fulfilling prophecies.

Surely one of the primary goals of economic policy should be full employment. Why isn’t there an inalienable right to earn a living? Why is it OK if even 5% of the people who want to work cannot find jobs? Does that mean it is OK for 5% of the workforce and the families dependent on them to go without food, clothing and shelter? Article 23 of the Universal Declaration of Human Rights adopted by the UN General Assembly begins:

(1) Everyone has the right to work, to free choice of employment, to just and favourable conditions of work and to protection against unemployment.

Some unemployment may be inevitable with technological progress as older industries get displaced by newer ones, but surely providing new training to people who lose jobs due to “progress” should be a top priority on a par with any other investment. If the current economic system cannot produce full employment, then we need to keep looking for a better system. Is there really not enough work to go around, or is there just no access to the money to pay the wages involved in full employment? Even a superficial survey of the infrastructure in any community in the U.S. will surely reveal there is plenty of work to be done; so wouldn’t it be nice if Ann Pettifor is right, and there is always “enough money” for socially necessary projects?