By Roger E. A. Farmer
Confidence is slowly returning to the stock market and the S&P is back to the level it reached when President Obama took office in January. This is enough to prevent a further collapse in spending; the Obama stimulus package may even move us into positive territory for US gross domestic product growth. But these ‘green shoots of recovery’ are not enough to create the jobs needed to restore full employment in the US.
The economic history of the twentieth century is one of the struggle between classical and Keynesian ideas. Two events have transformed the history of economic thought since 1900. The first was the Great Depression of the 1930s. The second was the stagflation of the 1970s. We are now experiencing a third: the 2008 stock market crash and the ensuing Great Recession.
The economics of the 1920s was the economics of Adam Smith. Markets work well and the business cycle is self-stabilising. The economics of the 1950s was that of Keynes. Markets mess up sometimes and government must get in there and fix them. In the 1980s we had a resurgence of classical ideas with simpler content but harder mathematics.
Each of the two previous transformational events saw the death of a great idea. After the Great Depression it was the demise of Say’s law, the idea that supply creates its own demand. After stagflation in the 1970s, economists ditched the Philips curve; the idea that there is a stable exploitable trade-off between unemployment and inflation.
Which great idea will economists topple next? The next casualty of economic history will be the natural rate hypothesis. I make that case in two forthcoming books and in two recent NBER working papers.
What is the natural rate hypothesis and why is it important? It is the idea that unemployment has an inherent tendency to return to some special natural rate that is a property of the available technology for finding jobs. It is a fact of nature, a bit like the gravitational constant in celestial mechanics.
The natural rate hypothesis has been taught to every economist in every top economics department for the past 30 years. As part of the package they learn that the natural rate cannot be influenced by fiscal or monetary policy.
The fact that central bankers believe this theory is important because it will lead them to conclude that high unemployment after the Great Recession is inevitable. That is why the Obama administration is psychologically preparing the public for the possibility that we will see double digit unemployment. If the natural rate of unemployment goes up by 5 per cent, get used to it. Economists have a name for it: A jobless recovery.
But a jobless recovery is not inevitable. We do not need to accept the immense human misery that goes with permanent job losses. The natural rate of unemployment is not like the gravitational constant. It depends on the confidence of all of us and it can be influenced by policies that we can and should adopt.
Confidence matters because it reflects peoples’ beliefs about what their houses and their retirement portfolios will be worth. It is reflected in what they are willing to pay for these assets today, and that determines how much they are willing to spend on new cars, refrigerators and holidays in Spain.
When people collectively feel rich, we are rich. When our wealth goes up, we spend more on goods. This is not an illusion or the start of a new unsustainable bubble. It is a reality. When we spend more, firms hire more workers, unemployment falls, and the belief that we are collectively wealthier becomes a self-fulfilling prophecy.
How does this relate to the labour market? Finding a job doesn’t just happen. It uses resources. Jobs can be filled by many unemployed workers searching for a few vacancies, or by many vacancies searching for a few unemployed workers.
In the first scenario an economist would conclude that the natural rate of unemployment was high; in the second he would conclude that it was low. Both of these situations are different natural rates of unemployment. Which one we end up with depends on the confidence of you and me.
How does all of this relate to the coming jobless recovery? All signs are that the US economy will begin to grow again in the fourth quarter of this year. But unemployment is expected to remain high. If economists continue to believe in the natural rate hypothesis, they will conclude, as we emerge from the recession, that the natural rate of unemployment has increased. Central banks will raise interest rates to prevent inflation and face accusations by some of choking off the recovery.
In reality there is nothing natural about the natural rate. What economists see as the natural rate of unemployment is driven by the beliefs of stock market participants. If confidence is high, wealth will be high and employment will be high. If confidence is low, wealth will be low and employment will be low. Either situation is consistent with any level of GDP growth and any rate of inflation.
A stock market rally is not enough. The market must rally to the point where wealth enables households and firms to purchase the goods that will maintain full employment. If this does not occur, and I think this is likely, we are heading for a jobless recovery.
Is there an alternative? I believe so and I have made the case elsewhere by providing a new theory that goes beyond Keynesian and classical economics. But the alternative does not involve business as usual. As I argued in the Economists Forum, central banks must act to sustain the wealth of the private sector by making sure that it is high enough and stable enough, not just to sustain positive growth, but also to provide jobs for all.
© Roger E. A. Farmer: professor and chair of the economics department, University of California Los Angeles
Prof Farmer is author of two books on the current crisis forthcoming with Oxford University Press. How the Economy Works and How to Fix it When it Doesn’t: Confidence, Crashes and Self-Fulfilling Prophecies, written for laypersons and academics; and, Expectations, Employment and Prices
