What is the Unemployment Rate, and What Does it Mean?

In a previous posting I mentioned that there were 3 major indices regarding the overall stare of the nation's economy: the Consumer Price Index, the Unemployment Index, and the Gross National Product. In today's posting, we will take a look at the Unemployment Index and what it actually means.

Unemployment is usually defined as when an otherwise qualified individual is without regular employment, actively seeking employment, and is willing to accept an offer of employment. Economists recognize several causes, or types, of unemployment even though these causes (types) often overlap in the labor force at any given time. Using this definition, the Unemployment Rate is defined as the total number of unemployed potential workers divided by the total number of workers (both employed and unemployed) in the labor pool.

The first type of unemployment that all economists will agree to exist is that of frictional unemployment.

Frictional unemployment is unemployment occurring from workers that are changing jobs, searching for new ones, or is the result of a new entry into the labor pool (e.g. graduating students) and re-entrants into the labor pool (e.g. former homemakers). Seasonal employment (such as that in the agricultural industry) is included in frictional unemployment.

Another type of unemployment is structural unemployment, which occurs when there is a mismatch of qualified workers (with the necessary skills) to fill the number of available jobs. An example of structural unemployment can be found in the early 1990s, when the computer industry had more jobs available than it had qualified applicants to fill those jobs. As a general rule, when there are fewer qualified workers available in a given industry the pay scale for qualified workers will rise.

Cyclical unemployment gets its name from the theory of the business cycle, Business cycle theory states that, in the long term, business activity will tend to expand (grow) and contract (decrease) in response to any number of factors such as demand for goods and services or the availability of credit. When conditions are favorable, businesses will expand and need more workers but, during periods of unfavorable conditions, businesses will cut costs by hiring (or retaining) fewer employees. Cyclical unemployment is said to be caused by a mismatch of a lower number of jobs available to the higher number of workers available in the labor pool.

Finally, there is something called the natural unemployment rate.

The natural unemployment rate is a concept arising from the assumption that, based on the above-described types of unemployment that are themselves unavoidable, there will always be a certain percentage of the available labor force that is unemployed at a given time. Economists agree on the concept of natural unemployment, but disagree on what percentage of the labor pool will be naturally unemployed. On this point, depending on which economist you talk to, the natural unemployment is usually stated as being somewhere between 2.5 and 6% (with most estimates falling in the vicinity of 5%). The significance of this number will be explained in a moment. But first, let's take a quick look at a little history.

The federal government's attempts to guarantee full employment began shortly after World War II with the passage of the Full Employment Act of 1946. Under this act, the government was charged (given responsibility for and not, unfortunately, charged as in a criminal case) with developing plans to assure that unemployment would not recur to the same levels that had been present in the just-resolved Great Depression.

Despite its name, the Full Employment Act was not a guarantee that everyone that was otherwise qualified and able to work would have a job but rather that the federal government would strive to stabilize the economy to prevent wild fluctuations in the demand for labor. The primary tool to be used in this stabilization would be the advice provided by the newly-formed Council of Economic Advisors, or CEA.

The CEA is composed of 3 economists (1 chairman and 2 members) whose duty is to advise the President on economic matters such as the best national economic policy that will prevent another Great Depression or, failing that, to make the periodic economic recessions as mild as possible. To its credit, the CEA did a reasonably good job of moderating the economy until Lyndon Johnson tried to simultaneously fund his War on Poverty and the Vietnamese War out of the same federal budget. For those readers that are too young to remember this screw-up of truly monumental proportions, I will give a brief summary.

All economic Hell broke loose when Johnson, faced with the choice between "guns or butter," decided on both options. Like his hero, Franklin Roosevelt, Johnson spent money like there was no tomorrow and thus brought on the period of American economic history known as the "Great Inflation (ca 1965 - ca 1984)." It was during this period that Congress, faced with rising unemployment and rising inflation, reacted in its usual manner: it passed another law, the Full Employment and Balanced Growth Act of 1978. Needless to say, this Act accomplished absolutely nothing except to hasten Jimmy Carter's departure from the White House.

Now, everyone (including the 535 distinguished economists that moonlight as members of Congress) would agree that the more people that have jobs the better off everyone will be because everyone will be working, spending money (which will boost the economy), and paying taxes (so members of Congress will have plenty of tax money with which to buy votes). If unemployment rose too high, the cure (ala Franklin Roosevelt and John Maynard Keynes, who I will properly denounce in a later posting) was that the federal government should spend money to "create" more jobs. Then someone came along and rocked the lifeboat.

In 1958 an obscure economist named Alban Phillips published a paper, "The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957," in an equally obscure academic journal called Economica. In that paper Phillips found an inverse relationship between wages and unemployment in the British economy over the period that he examined. Soon, other economists found similar patterns in other countries. Then, in 1960 two American economists (Paul Samuelson and Robert Solow), took Phillips' work to the next level and found an explicit the link between inflation and unemployment: the lower the rate of unemployment, the faster the rate of inflation increased, and vice-versa. To paraphrase Buzz Aldrin, "Washington, you have a problem."

Needless to say these findings, once they "trickled down" to the real world from the halls of academia, were not very popular with members of the United States Congress. This is because, as noted earlier, those distinguished ladies and gentlemen felt that more government money was the solution to any problem. Then, amid much Congressional wailing and gnashing of taxpayer subsidized teeth and other dental work, someone took a closer look at what had become known as the "Phillips Curve."

The Phillips Curve is nothing more than a graphical representation of the relationship between employment and inflation and, as we learned earlier, the lower the rate of unemployment the higher the rate of inflation. But, there is point before which the rate of inflation rises much more slowly than afterwards. Care to take a guess where that pint is?

The graph at the upper left is the Phillips Curve, where the unemployment rate increases along the x-axis (increases as you move to the right along the horizontal line) and inflation increases along the y-axis (increases as you move up the vertical line). Notice that inflation increases rapidly near a certain unemployment rate. That point is the natural unemployment rate! As the Phillips Curve demonstrates, as more and more people become employed their earnings will tend to push inflation higher; but inflation really "takes off" once you get closer and closer to the natural unemployment rate.

The importance of this demonstration is the fact that "full employment" is that, first of all, full employment is a myth. Secondly, it shows that if you want to avoid inflation you must tolerate some unemployment in excess of the natural rate of unemployment!

So far we have seen that an increase of less than 1% in the Consumer Price Index is considered to be zero inflation. This posting has shown that there is a real natural unemployment level that should be subtracted from the reported level of unemployment in order to get a more realistic idea of actual unemployment in the economy.

In an upcoming posting, we'll take a look at the third economic indicator: the Real Gross Domestic Product.