Let's celebrate a quiet revolution: The return of "full employment." In the 1960s and 1970s, politicians and economists clamored for it, defining full employment as an unemployment rate of 4 percent. They were repeatedly disappointed, because whenever joblessness dipped so low, inflation accelerated. Now look. Low unemployment and inflation coexist. The jobless rate has been below 5 percent since mid-1997, but inflation remains tame. In 1998 the consumer price index rose a mere 1.6 percent.
Probably not one economist in a hundred would have predicted this five years ago. The reason is that most economists subscribe to a theory called the "natural rate" of unemployment. It holds that, below a certain unemployment rate, the job market becomes so tight that wages and inflation inevitably surge. Employers can get needed workers only by offering big pay increases that, in turn, are passed along in higher prices. In the early 1990s, most economists put the natural rate of unemployment at about 6 percent. Optimists went down to 5.5 percent or a bit lower.
It now seems that even the optimists were too pessimistic -- with wondrous results. The old natural rate seemed to preclude a job boom from ever reaching the poorest and least-skilled workers. This is less true now, which is one cause of the early success of welfare reform. Many single mothers have found jobs. Consider: The U.S. labor force is now 139 million people strong. The difference between a 6 percent and 4.5 percent unemployment rate amounts to an extra 2.1 million jobs. What happened?
The standard explanation goes like this. Corporate "downsizing" has so terrified workers that they've become meek in pushing for higher wages and, if their demands are rejected, have gone elsewhere. Meanwhile, computer technology raised productivity -- overall efficiency -- and enabled companies to absorb modest increases in labor costs without raising prices. Good fortune also helped: Cheap imports cut inflation; subsiding health spending held down employers' insurance costs.
All this is true (since 1995, for example, the annual rate of productivity growth has doubled, from about one percent to 2 percent). But it is not the whole truth. Despite the phraseology, the "natural" rate isn't natural. It varies from country to country -- or over time in the same country. The reason is that it depends on government policies, business practices and worker attitudes. For instance, generous unemployment benefits (as in Europe, for instance) tend to raise the natural rate. The jobless don't energetically look for work; labor scarcities develop sooner.
What's occurred in the United States is that companies have refashioned pay practices to cushion the conflict between rising wages and higher prices. "There's been a tremendous shift from base salaries [across-the-board increases] to variable pay," says David Hofrichter of the Hay Group, a consulting firm. Companies can customize pay increases to minimize both cost and turnover. Workers who seem less valuable (or who complain less) get less. The more valuable -- and possibly flighty -- get more.
Combined with greater insecurity, this may temper overall wage pressures. Other changes also contribute. In a study, economists Lawrence Katz of Harvard and Alan Krueger of Princeton argue that the natural rate has fallen by about a percentage point since the mid-1980s for three reasons:
Older workers: Since the late 1970s, the share of the labor force under 25 has shrunk from about 25 percent to 16 percent. Older workers change jobs less often. This reduces their bargaining power. It also cuts unemployment. In 1998 workers between 20 and 24 had a jobless rate of 7.9 percent; the rate for those between 45 and 54 was 2.7 percent. The effect on the natural rate: a minus 0.4 percentage points.
Temporary-help agencies: In 1998 they filled about 2 percent of all jobs, up from 0.5 percent in the early 1980s. As a result, many unemployed workers get jobs quicker; they don't have to wait for a permanent opening. And companies can attract new workers without resorting to across-the-board wage increases to all workers. The effect: up to minus 0.4 percentage points.
The prison population: Since 1980 it's quadrupled from 316,000 to 1.3 million in 1998. About 90 percent are men. Before prison, they had abnormally high jobless rates. Removing them from the labor force trims reported unemployment, simply as a matter of arithmetic. The effect: a minus 0.2 percentage points.
None of this is exact. Note that Katz and Krueger don't say what the new natural rate is -- just that it's about a percentage point lower than the old. Presumably, that means between 4.5 and 5 percent. Estimating the natural rate involves much guesswork, and today's jobless rate (4.2 percent in May) may fall below it. By some informal reports, labor scarcities are now pushing up wages. Last week Federal Reserve Chairman Alan Greenspan hinted the Fed might soon raise interest rates to preempt a wage-price spiral.
The business cycle, of course, endures. The present boom will one day give way to a slump. Joblessness will rise. But today's "full employment" still offers lasting lessons and benefits. Indeed, it resolves an old debate. In the 1960s and 1970s, it was said that government could -- through low interest rates, easy money, budget deficits -- engineer full employment. These policies produced perverse results. After an initial drop in unemployment, both joblessness and inflation rose. By promising full employment, government inspired the very inflationary behavior that made full employment unattainable.
Just the opposite has happened in the 1990s. The Fed has concentrated on containing inflation. Hardly anyone talked about full employment. But the silence improved the odds of its realization. The determination to hold prices in check forced companies and workers to change their behavior in ways that made it easier to expand employment without causing inflationary bottlenecks. Even with business cycles, this elevates everyone's lifetime job prospects.