Friedman and Full Employment Theory

other. When graphed, this tradeoff produced a nice, neat curve, which became known as the "Phillips Curve."This discovery helped policy-makers determine how much to expand the money supply. Previously, no one really knew what constituted "full employment." Now they could make a judgment call. The curve showed them how far they could expand the economy without letting the cost of inflation outweigh the cost of unemployment. This seemed to be 3 or 4 percent inflation in return for 4 percent unemployment.Over the next few decades, many public figures would call for the unemployment rate to be reduced to 4 percent; the 1978 Humphrey-Hawkins Act went so far as to put it into law. But economic events and advances in theory would overtake them. In 1968, Milton Friedman challenged the whole concept of the Phillips Curve, and his efforts would secure him lasting fame and the 1976 Nobel Prize. His argument went something like this:Imagine an economy where the cost of everything doubles. You have to pay twice as much for your groceries, but you don't mind, because your paycheck is also twice as large. Economists call this the neutrality of money. If inflation worked this way, then it would be harmless. Of course, inflation does have other negative consequences, but they are minor compared to the terrible costs of widespread unemployment. (2) Hence the Keynesian policy of accepting high inflation in exchange for low unemployment.But Friedman had a question: why is it that when the Fed expands the money supply by, say, 5 percent, all prices and wages everywhere do not go up by 5 percent as well? Why wouldn't the neutrality of money make this expansion meaningless? Friedman argued that it was because the public didn't know that they should raise their prices by 5 percent. That's because they were unaware of the expansion, or what it meant, or how large it was if they did. When the extra money was pumped into the economy, therefore, it was unwittingly translated into more economic activity, not higher prices.However, if businessmen knew that a 5 percent increase was coming, it would be in their best interest just to raise their prices 5 percent. That way, they would make the same increased profits without having to work for them. Or, seen another way, if businessmen knew that inflation was going to be 5 percent every year, they would simply build those expectations into their normal price increases. But if everyone did this, then the Fed's monetary increases would become meaningless -- instead of resulting in more jobs, they would just create higher inflation. In other words, the neutrality of money would take over. To maintain the job creation effect, the Fed would have to surprise businessmen with a 10 percent increase the next year. But businessmen would eventually come to expect that as well -- requiring a 15 percent increase the next year, and so on, all the way to hyperinflation.Friedman and others argued that as businessmen became wiser to the Fed's actions, the Fed would no longer have a tool to fight unemployment. And without this tool, unemployment would eventually start climbing as well, along with inflation, forming a twin monster that Paul Samuelson dubbed "stagflation." And indeed, from the late 60s all the way through the 70s, this is precisely what happened. Stagflation peaked on Jimmy Carter's watch, costing him his reelection for the presidency.Friedman showed that monetary policy could not be used to achieve full employment. Unfortunately, inflation starts accelerating before full employment is reached. The best a nation can do is settle for the lowest level of unemployment that will not begin accelerating inflation. Friedman called this point the "natural rate of unemployment,". Some controversy exists over what the natural rate is, because it depends partly on what markets expect inflation will be. But in the U.S. today, economists estimate it to be slightly less than 6 percent. Friedman is said to regret the term "natural rate of unemployment," since it implies that a certain amount of unemployment is acceptable. Therefore, most economists prefer to use the euphemism "NAIRU," which stands for Non-Accelerating Inflation Rate of Unemployment.The natural rate of unemployment does not mean that Keynesianism is still not a useful tool for smoothing out the business cycle. Six percent is merely an average; in reality, unemployment can deviate substantially from 6 percent. Keynesian policies are therefore useful for stabilizing unemployment at this figure.As one might expect, the natural rate of unemployment is not without controversy. Although most top-level economists -- on both the left and the right -- accept its validity, there are many economists who believe the NAIRU doesn't even exist. A few important dissidents include John Kenneth Galbraith and Robert Eisner, both past Presidents of the American Economics Association. A much more widespread controversy, though, is where to peg the natural rate. Nearly all economists agree that it is not a fixed figure, but that it can float. Galbraith, tongue firmly in cheek, writes: "That 5.5 to 6 percent consensus is easily explained: it's where the actual unemployment rate is. And that is usually been true: the estimated NAIRU tracks actual unemployment. When unemployment goes up, conservative economists raise their NAIRU. When it falls, they predict inflation, and if inflation doesn't happen they cut their estimated NAIRU. There is a long and not-very-reputable literature of such estimates -- you can look it up. In fact, this little corner of the professional record is embarrassing." (3) And this debate has a political cast as well: conservatives like a high NAIRU, liberals, a low one. When it's high, interest on bonds pay more, thanks to low inflation. Conservatives like that because most bond-holders are wealthy. Furthermore, when the unemployment rate is high, wages tend to fall, in accordance with the laws of supply and demand on the labor market. Exploiting labor, as they say, is profitable business. The current Fed chairman, Alan Greenspan, is a died-in-the-wool conservative and a self-described "inflation hawk," meaning that he is committed to a high NAIRU. Conversely, liberals prefer a low NAIRU because it raises workers' wages.Friedman's discovery of the natural rate took the wind out of the Keynesians' sails concerning one of their most important goals. It raised the prestige of the Chicago School of Economics and turned it into a leading advocate of unfettered capitalism. But in the end he did not accomplish what he had set out to do: replace Keynesianism.Robert Lucas would come much closer to achieving that.