One explanation of inflation is now so widely held among the economics profession, is so bitter in its implications, and is so disastrous in its consequences for millions of men and women throughout the world that it demands special treatment. It first attracted general attention in 1967 when it was called, perhaps daring listeners to be shocked, the natural rate of unemployment. Later it was given a more descriptive name: the non-accelerating inflation rate of unemployment. Even this gobbledegook expression is too strong for many economists, who use instead the acronym "NAIRU" and thus hide their meaning from their readers and perhaps even from themselves.

Journalistic reports of the thoughts of mainstream economists may lead the unwary to imagine that when they talk about 5 or 6 or 7 percent of the work force being unemployable, they mean that all those millions are too irresponsible, too little educated, too stupid, too malicious, too sick, or too pregnant to participate in the modern economy. What they mean, however, is not exactly that.

Instead, they insist that there is a rate of unemployment that cannot be reduced without indefinitely accelerating the rate of inflation, Exactly what the effective rate of unemployment is, and how or, indeed, if it may be determined, are far from clear.

There are almost as many versions of the natural-rate theory as there are theorizers. Some versions are close to Marx's metaphor of the industrial reserve army of the unemployed, whose existence warns those with jobs that they can be replaced if they agitate for higher wages. Some versions amalgamate natural-rate theory with productivity theory (thus compounding fallacies). Some versions turn on an elaborate pas de quatre among real wages and nominal wages, and real prices and nominal prices. Some versions require that inflation be not anticipated, although there surely has not been a time, at least since World War II, when inflation was not anticipated by the financial community and especially by the Federal Reserve Board. There is even a far- out version, and international conferences have been convened to consider it, that pretends to connect NAIRU with hysteresis, a phenomenon characteristic of ferrous metals in an electromagnetic field. (God, Einstein said, does not play dice, but evidently some economists do.)

The story would be ludicrous were not policies based on this formless theory pursued by central banks all over the world and acquiesced in by bemused legislatures, with the results that tens of millions of men and women are denied employment, and economic growth is deliberately stunted. These millions of men and women may be highly skilled and highly virtuous in every way, but we must not employ them, or disastrous inflation will ensue, and we shall no longer be free to choose among moderately priced commodities. Although sadly many commentators find it easy to slip into complaining about the "underclass", the fault is not in the unemployed. On the contrary, the unemployed are absolutely necessary to the operation of the system. They should be honored for making it all possible.

All the chatter about ending welfare as we know it, about job training, about workfare instead of welfare, about enterprise zones and the like- all that talk, and there seems to be no end to it, is cruelly deceptive. In many cases, it is deliberately deceptive. As fast as Congress puts welfare recipients to work, the Federal Reserve Board, ruled by whichever version of the natural rate of unemployment is then fashionable, will see to it that the economy is sufficiently slowed down for an equal number of present jobholders to be fired.

ii.

The natural rate theory is certainly preposterous, certainly callous, certainly nasty. It is also fallacious.

We may begin by inquiring why the percentage of the work force without jobs should be thought to be the principal determinant of the price level. How can being unemployed qualify one to affect the prices of commodities made by people who are employed? Why are those who are employed disqualified? And why do only the officially unemployed make a difference? There are several million people the Bureau of Labor Statistics used to count and perhaps 120 million they've never counted. Why don't these people have an effect on prices?

The minority of theorists who fancy Marx's industrial reserve army can show how at least some costs are held down. For those who eschew Marx, the argument is somewhat less straightforward.

Those who consider price inflation to be cost-push may take "unemployment" as a crude inverse surrogate for what does have an influence on prices- the unit cost of labor (or the aggregate value of output divided by the aggregate compensation of employees). And those who consider price inflation to be demand pull may take "unemployment" as a crude inverse surrogate for aggregate demand. In neither case is the surrogate an improvement over what it stands for: Statistics are not easier to come by or more reliable, calculations are not simpler or more precise, nor are conclusions more revelatory.

More important, the cost of labor (or unemployment as its surrogate) radically underspecifies what is involved. In today's American economy, compensation of employees comes to roughly 60 percent of gross domestic product, leaving 40 percent of costs unaccounted for. In addition, "compensation of employees" is hardly homogeneous but includes, together with the salaries and perks of several hundred thousand men and women who severally take home between a quarter of a million and half a billion dollars annually, the wages of some ten million men and women (7.4 percent of all workers) who, despite working full time, do not earn enough to lift themselves and their families out of poverty. In between is the famous middle class. These classes have markedly different effects on the price level, and the price level has markedly different effects on them.

Besides labor, the classic, factors of economic production are land and capital, to which must be added, in the capitalist system, entrepreneurship and government. The corresponding costs of these factors are rent, interest, profit, and taxes. (Actual profit, to repeat yet again, is a residual that does not affect price because it can be determined only after the product is sold. Planned profit, however, is a factor in price setting.)

Instead of only two variables in the natural-rate equation (the rate of unemployment and the price level), we now have eight (the aggregate takings of the working rich, the aggregate salaries of the working middle class, the aggregate wages of the working poor, together with aggregate rents, interest, planned profits, taxes-and the price level).

The costs that form a floor under the price level thus consist of no fewer than seven factors. Price inflation can, in principle, continue in the face of a decrease in any one- or any six- of these costs.

In the present context, the natural-rate theory will be refuted if price inflation continues in the face of an increase in unemployment. In such a situation it will be evident that something other than the rate of unemployment is responsible for the inflation.

In fact, the Consumer Price Index has retreated only once since 1951, and then minimally, from 26.9 to 26.8. In that year (1955), unemployment fell from 5.4 percent to 4.3 percent whereas, according to the natural-rate theory, it should have risen. (Also in 1955, interest payments as a percentage of national income fell from 5.2 percent to 4.7 percent- contradicting the conventional notion that rising interest rates go with falling prices.)

In the other forty-odd years in question, while the CPI has continued to climb, the rate of unemployment has had eight peaks and valleys. If the natural-rate theory were valid, the price level should have fallen- perhaps with a lag- as unemployment scaled each of these peaks. The price level did not fall, laggardly or not.

iii.

There is no denying, however, that something has been driving the price inflation of our time. Of the seven factor costs we have mentioned, three can be quickly eliminated-rent (which has fallen as a percentage of GDP since the early 1960s), planned profit (because actual profit, which is at least a guide for planning, has fallen as a percentage of GDP since the late 1960s), and taxes (because the corporate income tax has fallen from 23.4 percent of federal income in 1960 to 9.7 percent in 1990. 1

Two costs that have fallen less dramatically should also be counted out: the salaries of the working middle class (because the average hourly private-sector cost of wages and benefits, when adjusted for inflation, has fallen more than 10 percent since 1979), and the wages of the working poor (because the minimum wage, despite the 1991 increase, has not kept up with inflation, and the bottom quintile of wage distribution has likewise fallen more than 10 percent since 1979). 2

Two of our cost factors are left. As we have previously noted, interest as a percentage of national income has increased from 4.6 percent in 1951 to over 20 percent today. Because business executives perservere with their plans and expect to make profits despite this rapid escalation, economists have tended to concentrate on the psychology of executive expectations. The truly economic effects are there, nevertheless. Explicit interest costs must be paid to satisfy lenders, and implicit interest or opportunity costs must be earned to attract investors of capital. Prices must be high enough to cover these interest costs, or a business fails. The price level is intimately involved and must push upward with the interest rate.

For the takings of the working rich, we have professional sports as handy models of the certainly not mysterious way high salaries and perks are translated into high prices at the ticket window.

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1. Robert S. McIntyre, "Inequality and the Federal Budget Deficit" (Washington: Citizens for Tax Justice, 1991), p. 12.

2. Lawrence Michel and Jared Bernstein, "The State of Working America", 1944-95. Economic Policy Institute Series (Armonk, N.Y.: Sharpe. 1994), pp. 114, 121.

That only two of seven factor costs account for current price inflation indicates a vast distortion of the price system. These two have been increasing while the other five have been stagnating or falling. The distortion has been magnified and is continuing. In the mid-1990s, it was widely contended that the then current price inflation of less than

3 percent was insignificant. It would have been insignificant if the inflation had been uniform, but a 3 percent distortion, continuously compounded, quickly becomes a serious matter.

iv.

So far we have been discussing the factors as though they were impersonal, but economic factors are not impersonal any more than the market is impersonal. Things are owned and traded by persons.

Of first importance is the fact that the recipients of the gains of the "winning" factors were already prosperous. Interest recipients must already have had money to lend and now will have more, while excessively paid executives in all likelihood already bad good incomes and now also will have more money than they need for daily living.

Both classes of winners are now in a position to engage in speculation, with consequences for the economy we have seen in Chapter 8. They will be more likely to engage in speculation to the extent that the "losing" factors are being hurt by the disruption of the price system. And the factors where productive investments might have been made are indeed being hurt. Weak corporate profits, both before and after taxes, do not entice investors in the producing economy. The same is true of rents, where speculation has always been endemic. It takes extraordinarily vibrant animal spirits to launch a really new enterprise today.

The hurts of the remaining factors- the salaries of the middle class, the wages of the poor, and taxes- account for much of the sluggishness of the producing economy. These factors are important elements of the demand side, without which the supply side has no purpose.

The distortion of the price system- the inflation of our time-not only has impeded the growth of the economy, but has grossly benefited two comparatively small classes of citizens (rentiers and highly paid executives), and has seriously disadvantaged all the rest.

V.

The actual inflation would seem to have been caused by the Federal Reserve Board's dogged attempts to control anticipated inflation by manipulating the interest rate. The theory behind these attempts is directed at both demand-pull and cost-push inflation.

Demand-pull inflation is supposed to result from overexpansion of the money supply resulting from excessive borrowing, which gives consumers too much money with which to chase goods.

As we have seen in Chapter 4, most commodities can now be indefinitely reproduced, are therefore seldom rare, and consequently do not rise in price simply because demand for them grows. Labor, however, cannot be indefinitely reproduced. When demand for certain commodities causes shortages of the specialized labor necessary to produce them, not only will the prices of the affected commodities rise, but the wages of specialized labor will rise, thus increasing aggregate demand and pulling prices still higher. The conventional solution is to discourage borrowing by raising the interest rate.

This solution has the beauty of being also effective against cost-push inflation, and even more directly effective. In the cost-push scenario, excessive borrowing finances excessive production, which escalates the demand for labor. Labor is then empowered to demand higher wages, thus increasing production costs and pushing both wholesale and retail prices higher.

Vi.

Now it would seem that raising the interest rate is both the cause of price inflation and its theoretical cure. "Here's a pretty mess," as Ko-Ko sings in The Mikado.

When we were searching for the cause of inflation, we found it necessary to narrow the specificity of our terms and hence to increase the number of terms. The same tactic will be adopted here as we consider the proposed cure. Instead of being satisfied with the effect of high interest rates on demand in general or on labor as the largest factor of production, let us examine the effects of a rise in interest rates on five classes of prominent actors in the drama, as follows:

If the interest rate rises, the direct effect, other things being equal, on (1) holders of bonds and other income-earning assets is a fall in asset prices; on (2) bankers, speculators, and people with large cash incomes, access to investment bargains; on (3) entrepreneurs, an increased cost of doing business (especially if cognizance is taken of opportunity cost), requiring increased prices, and resulting in lower sales; on (4) workers, rising unemployment and constraints on wage scales; on (5) consumers, higher prices and higher borrowing costs.

The five classes are obviously neither mutually exclusive nor together exhaustive. Almost everyone belongs to the last class and at least one other, and it is not uncommon for people to be classifiable under all five headings.

The summary analysis shows that an increase in interest rates is not even-handed in its consequences for economic agents. Three points are worth emphasizing. First, while it is common to lump investors in the ongoing economy (the first class) with speculators (the second class), they actually have opposing interests. Second and most important, while current anti-inflation policy is directed primarily at the fourth class of agents, and while it may be said to work there roughly as intended (although not as might be desired), its side effects are disadvantageous for every class except the second, which has generally benefited, and continues to benefit, enormously. Third, the effects on classes three and five include upward pressures on the price level.

In short, the price system is not a monolith; and when it is treated monolithically, as it is by current policy, its diversity is accentuated, and its disruptions exaggerated.

Over the past quarter century, the Federal Reserve Board's deliberate disruptions of the American economy have increased the polarization of society by transferring wealth and income from the capitalist system's relatively many borrowers to its relatively few lenders, from its workers in the producing economy to bankers, speculators, and rentiers. This transfer is the more malign in that, as we have seen in Chapter 3, borrowers are systematically the more active and creative element in the economy.

That this transfer is not trivial can be shown by an everyday example of the effects of the Reserve Board's increases of the interest rate between January 1994 and March 1995. The payments on a $100,000 mortgage undertaken after the rate increases were about $110 a month greater than if the mortgage bad been undertaken before the rate hikes. The mortgagor bad done nothing to deserve this considerable loss of wealth, (about $1,300 a year, or $39,000 over the life of a thirty-year mortgage), and the mortgagee (presumably a bank) had done nothing to deserve this added income. The transfer was an incidental consequence of the Federal Reserve's misguided assault on inflation as it knew it. Similar transfers occurred with all home mortgages and with all automobiles, appliances, furniture, and vacations bought on time. The cost, especially to the middle class, was of orders of magnitude greater than the benefit expected from the tax cut then talked about, while the tax cut itself was rendered more expensive by the increased interest to be paid on government bonds.

Nor was this all. All commercial loans and mortgages were affected in the same way. Borrowers in the producing economy were required to pay vast extra sums to lenders in the speculating economy.

Worst of all, these gratuitous transfers generally aggravated the polarization of society.

Vii.

It must be recognized that the price system is indeed a system. The natural-rate theorists are correct to this extent: Our shameful rates of unemployment and poverty are of a piece with the prices both of commodities and of the factors of production. It will be impossible to improve the rates of unemployment and poverty without modifying commodity and factor prices.

In the speech in which he named the natural rate of unemployment, Milton Friedman made the point in a back-banded way: "At any moment of time, there is some level of unemployment which has the property that it is consistent with equilibrium in the structure of real wage rates. At that level of unemployment, real wages are tending on the average to rise at a I normal' secular rate, i.e., at a rate that can be indefinitely maintained so long as capital formation, technological improvements, etc., remain on their long-term trends." 3

Granting Friedman's large and untestable assumption, we see that it can be read in at least two ways. His way undoubtedly requires the rate of unemployment to accomodate itself to the other "long-term trends." But there is nothing in the scenario be presents to us that denies the possibility of a very low rate of unemployment to which the other long-term trends accommodate themselves. And if the interest rate is subsumed under the heading "capital formation," we have a good idea bow at least that trend must be shifted.

3. Milton Friedman, "The Role of Monetary Policy," American Economic Review 78 (March 1968): 8.

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