The GFC changed us as a generation – adventures in labour market slack

Alphachat (great podcast btw) had a recent episode on Labor market slack that raised some intriguing questions. The central question is how to define slack, what is the right metric. The end result was that slack means different things to different people – but there is one thread that I’d like to explore more.

Let’s start with the concept of NAIRU (non-accelerating inflation rate of unemployment). Wikipedia defines it as “NAIRU refers to a level of unemployment below which inflation rises”. Central Bank Monetary policy is always and forever worried about inflation. The expected cycle is that as unemployment falls, wages will rise as supply of workers is constrained – less supply, more depends, prices i.e wages have to rise. When wages rise, input costs for producers rise which they will pass on the end consumers. Thus the general price level of the economy will rise hence leading to inflation.

So, when does this cycle kick in, at what level of unemployment rate? Does it only kick in at zero unemployment? Is such a thing possible? A common hypothesis is that there is a “Natural rate” of unemployment, we can never achieve zero unemployment – as there are people between jobs, people on disability benefits, children, retirees, stay at home moms and discouraged workers (tried looking for a job didn’t get any – now just don’t want to look anymore). At any given point in time, the entire population of a country cannot all have a job.  With this context, NAIRU can also be thought of as the natural rate of unemployment that exists in the economy – as we can never be at zero unemployment.

Imagine now a scenario that the NAIRU estimate is 5% and the unemployment rate starts trending down to about 4% – does the wage increase happen automatically? Ie does inflationary effect kick in immediately? Well no – and here is where labour market slack comes in. As the labour market gets tight, discouraged workers or workers in transition start getting pulled into the workforce with the same wage level as other workers, in effect wages don’t rise quickly until this slack is exhausted. A good analogy is when you pull on a rope that has slack, it doesn’t immediately pull taut until the slack is exhausted.

Now comes the interesting part, most long-run estimates of NAIRU for the united states before the financial crisis were about 5%. The current US unemployment rate is at 4.1% (was as low as 3.7% last year) – a historic low. Since the GFC we have seen extraordinary central bank quantitative easing and an increase in the money supply – which historically has been the central cause for inflation. Milton’s Friedman’s said it best –  “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output

So with a massive increase in money supply and historic low unemployment, where is the inflation? This is a conundrum.

One explanation is that there is still large labour market slack in the economy so the NAIRU is actually much lower than 5%. Unemployment can still go lower till we get real wage increases that drive inflation. I have a different thought – I believe that this is purely psychological. While we can feel and relate to a lot of the real effects of the GFC, destruction of wealth, loss of income, houses etc – the effect it has taken on our mental psyche as a society is still being discovered.

The GFC was such a life-altering event for an entire generation that we are now shit scared of that happening again. We are shit scared of losing our primary source of income. As labor, we have seen our bargaining power chipped away bit by bit over the years and we now know that we have no bargaining power. The realization that we are at the total mercy of an employer and have no social security net has hit home.

Guess what, nobody is going to be clamouring for higher wages, you are just happy to have a job. It’s not about slack, it’s about labour giving up.

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