Without Risking Inflation?
Thirty-eighth Annual Meeting
[Via Satellite from Washington, D.C.]
Thank you, David Berson, for that introduction. And congratulations to you and to the National Association of Business Economists on the great success of your conference this week. By all accounts, it has been highly productive and informative.
I will focus my remarks today on the theme of this conference: "Living Standards and the U.S. Economy." In particular, I'd like to address a set of questions that are on many peoples' minds these days, and which have a direct bearing on this theme: Is the current low unemployment rate, below 5.5 percent of our workforce, sustainable? Can it be lower? Does the long-awaited increase in wages now being enjoyed by production and non-supervisory workers -- a 3.6 percent nominal increase from August of l995 to August of l996 -- threaten inflation?
Let me say at the outset that my purpose in addressing these questions is not to suggest what the Federal Reserve Board will or should do in two weeks' time, or at any point in the future. This Administration does not comment on the policies of the Federal Reserve Board. I am speaking solely as Secretary of Labor whose statutory responsibility is to "foster, promote and develop" the capacities of the American workforce and to enhance "opportunities for profitable employment." And I am talking about the current relationship as I see it between employment, wages, and inflation.
It is indeed a good time to be Secretary of Labor. Ten-and-a-half million new jobs have been added to the economy since 1993, and there is substantial evidence that these are good jobs, with average wages higher than the average wages of the jobs that were already here. Unemployment is at its lowest rate in seven years. The 15-year decline in hourly earnings has finally been arrested, and recent data suggest that wages are beginning to turn upward. The economy is growing rapidly, and consumer confidence is at a six-year high.
And still no sign of accelerating inflation.
Until recently, it was something of an article of faith among economists and researchers that the so-called "natural" rate of unemployment or NAIRU -- the rate under which unemployment could not fall without causing inflation to accelerate -- was 6 percent. Six percent is almost 8 million people.
For 24 consecutive months now, the rate of unemployment has remained under six percent, while the rate of inflation has remained below three percent. The so-called "misery index," which combines the inflation and unemployment rates, is almost at a thirty-year low. I believe it is fair to conclude that the "natural" rate of unemployment has fallen well below 6 percent. I believe that, over the long term, it can fall further.
Why has this happened? The assumptions lying behind the 6 percent figure derive from the l980s, when inflation appeared to accelerate below that rate of unemployment. But the economy of the l990s has a very different structure from the economy of the l980s.
First, price competition in most industries is far more intense than it was in the l980s. This is due in part to the combined effects of wider deregulation and of a broader segment of the American economy exposed to international competition. But it is also due to technological advances which have permitted large numbers of small and medium-sized firms to enter markets that heretofore had been well-guarded by larger and more established businesses.
You can see the effects in almost every industry: Banking, insurance, telecommunications, apparel, entertainment, appliances, transportation. Entry barriers are falling, product cycles are shortening, large firms are scrambling to maintain market share. The old economies of scale which gave larger companies an inherent advantage and allowed them some degree of discretion in setting prices are being undermined by computer technologies which give smaller companies the ability to target specific market niches.
This is a revolutionary change. It means that producers are far more reluctant to raise prices even in the face of rising costs. And they are far more aggressive in holding costs down.
A second structural change which distinguishes this economy from that of the l980s is also due to technology: The "knowledge" content of goods and services continues to climb as a percentage of total cost, relative to materials and energy. More and more value is added through design, styling, manufacturing-engineering, process-engineering, advertising, marketing, servicing, selling, consulting and advising. As a result of this continuing shift in the value-added composition of goods and services, increases in the prices of materials or energy pose less of an inflationary threat than before.
There is a third important way in which today's economy is different from the economy of the l980s. For the first time in recent memory, the growth of employer health care costs is actually falling. Prodded by the same intense competitive forces I mentioned before, employers are switching away from fee-for-service arrangements and into managed care. They are also shifting more of the costs of health care to their employees, in the form of higher deductibles, co-payments, and premiums. Or they are reducing the availability of employer-provided health care altogether. The net effect is that while wages and salaries rose 3.2 percent in the second quarter of 1996, overall employer compensation costs rose only 2.9 percent just in line with inflation.
Given these three structural changes, accompanied by yesterday's slight upward revision in productivity growth, unit labor costs are still rising roughly in line with inflation. Yesterday we learned that they rose 2.9 percent between the second quarter of l995 and this year's second quarter. The Producer Price Index rose only 2.6 percent, and the Consumer Price Index rose only 3 percent for the year ending in July.
These structural changes in the American economy suggest why we can sustain a lower level of unemployment than we had previously assumed, without risking accelerating inflation. How low can unemployment go? We simply don't know. In fact, researchers are beginning to question whether we can even measure with any precision what the rate might be. So how do we balance our concerns about containing inflation with the desire to reduce unemployment? Should we err on the side of reducing unemployment a bit too much to contain inflation, or on the side of preventing inflation by forcing out of jobs more people than are necessary to contain it?
In looking at this tradeoff, it is important to remember that we have committed ourselves as a nation to moving more than 4 million welfare-recipients off of the welfare rolls and into work. These people are likely to be at the end of any job queue. It seems to me that in making decisions about how vigorously we wage war on inflation we should fully consider those who are most likely to be the war's first casualties.
At the least, we should demand a high burden of proof from those who argue that zero inflation is an appropriate policy goal. New research from George Akerlof, William Dickens, and George Perry of the Brookings Institution suggests that the unemployment rate would be as much as 2.6 percentage points higher if inflation were brought down to zero. That would mean three million more Americans than today who were unemployed because they became unwitting draftees into the fight against inflation. Let us agree that the casualties on this scale are not worth the war.
Moreover, whatever the "natural" rate of unemployment is, we need not assume that nothing can be done to lower it further. Remember that even now, when labor markets are tight and many employers are having trouble finding the employees they need, millions of Americans who want to work still cannot find jobs. These millions of prospective workers are simply unable to respond to the demand. Why? Because they lack education and skills, or they have the wrong skills, or they do not know what's required, or they reside in the wrong place, or they are assumed to be too old. These millions of unemployed are walled off from a job market that is heating up -- a job market that would be less prone to overheat if more of these people were ready to join it.
The best way to lower the "natural" rate of unemployment -- whatever it is -- is to ease the transition of these prospective workers into the workforce. This has been a central goal of this administration's workforce agenda. For example, one of the most difficult transitions is from school to work, for the majority of young Americans who don't earn four-year college degrees. School-to-work apprenticeships -- there are now almost a half million -- provide pathways toward careers as laboratory assistants, sales and service technicians, manufacturing specialists, and other types of technical work that's in ever greater demand.
Another perilous transition is from a job in an industry whose market is shrinking to a new job requiring higher or different skills. In the old economy of large and stable industries, job security was the rule; in the new economy it's the exception. How to smooth the inevitable job changes? We are in the process of converting the unemployment insurance system (designed to provide temporary income during cyclical layoffs until the old jobs returned when the economy picked up) into a re-employment system, getting people the information and skills they need to quickly shift from old work to new. And the President wants to go further -- consolidating all job-training programs and providing anyone who loses a job with a voucher to get new skills at a local community college or technical institute.
Another virtue of a better-educated and better-trained workforce, of course, is that it is capable of generating a higher rate of productivity -- which permits faster growth and higher wages without risking accelerating inflation.
There should be no doubt about the relationship between higher skills and higher productivity. Economists Lisa Lynch and Sandra Black recently found that raising the average educational level of a company's workers by one year boosts business productivity about 10 percent. Another recent study found that companies that introduced formal employee training programs experienced a 19 percent larger rise in productivity than firms which did not train their workers.
With these returns, you would expect that businesses would be investing substantial sums upgrading the skills of their employees. They are, but according to the American Society for Training and Development, business spending on employee training has not kept pace with the increase in the size of the workforce. Adjusted for inflation, and on a per-employee basis, workers are receiving less employer-provided training today than they were a dozen years ago. This may account, at least to some extent, for this economy's paradoxically low productivity gains despite all the new capital investments and restructurings of recent years -- a gain of only .8 from the second quarter of l995 to the second quarter of l996. A knowledge-based economy requires a workforce capable of utilizing knowledge.
One catch may be that companies can't capture all these productivity gains for their shareholders. To this extent, some targeted incentives may be appropriate. The President has signed into law a continuation of the exclusion from taxable income of employer-provided educational assistance under Section 127 of the IRS Code. He has called for a new small business tax credit for 10 percent of the amounts paid for employee education and training. And he is proposing a new Welfare-to-Jobs tax credit providing a 50 percent credit on the first $10,000 of wages for long-term welfare recipients, up to two years. Employer-provided training would be treated as wages for the purpose of this credit. These tax incentives notwithstanding, I believe it is in the interest of American businesses to invest to a far greater extent in their employees. Firms that unlock the full potential of their workforces are reaping handsome rewards.
Will the lure of higher paychecks induce individuals to invest in their own skills? To some extent, of course it does. Record numbers of high school graduates are continuing their educations, and community colleges are brimming with adult students. But for too many families the costs of higher education are prohibitive.
This is why the President has proposed making the 13th and 14th years of education as universal to all Americans as the first 12 are today. He would do that by giving families a refundable tax credit of $1,500 for each of the first two years of full-time, post-secondary enrollment -- equalling tuition at an average community college. The credit would also be available for students who study at least half-time, and it could be used for job training and re-training. Families also could receive tax deductions of up to $10,000 a year to help them offset college tuition costs.
Let me summarize. It is true, of course, that we must guard against reigniting inflation. The real question is how low can unemployment go, and how high can wages rise, before we risk that danger. I have argued that for a variety of reasons the structure of this economy may permit a much lower level of unemployment without posing such risk than was the case even a decade ago. I have further suggested that in determining what that level is, and what risk is acceptable, we should bear in mind that the people who are most likely to be unemployed are the most vulnerable members of our society -- including, especially, those who will no longer collect welfare checks. Moreover, whatever the level, it is possible to reduce it further by helping more people who want jobs become qualified to get them. Finally, a key to higher rates of productivity -- and thus more jobs and higher wages without inflation -- is a better-educated and skilled workforce.
Thank you for giving me an opportunity to speak with you this afternoon.