April Freeman Banner 2014


Unemployment: What Is It?


Unemployment has regained center stage now that the debt crisis has receded from that position, at least for a time. Unless things change dramatically over the next year unemployment will be the number one issue in the forthcoming presidential election. Hardly any proposal will escape being labeled “job-killing” or “job-creating” or both.

To begin with some basics, what is work and what is a job? For economists, work is any activity that we would not perform without tangible compensation, usually money. In our work lives almost all of us are also motivated by nonmonetary considerations, and to the extent we diverge from the most remunerative activity available to us, we are blending work and leisure. A retired person who takes up college lecturing may do the work primarily for the satisfaction it brings. If his salary were withdrawn and he continued to teach, he would be enjoying leisure.

The goal of all economic activity is consumption, which to economists means not just mundane goods like faster cars but also “noble” ends like cathedrals. Jobs are therefore not ends in themselves, as much as public discussion would suggest otherwise. They are means to acquire income to be used for consumption and saving, in addition to personal satisfaction, learning opportunities, or socializing.

A person who lacks a job is unemployed if he or she wants work, has suitable skills, and has realistic expectations about compensation. These are vague terms; they make unemployment a murky concept. That goes double for underemployment, though both remain very real phenomena.

What is it about unemployment that makes it so problematic? Why can’t markets cure labor surpluses with lower wages as coffee surpluses are cured by lower coffee prices? Is government interference to blame, or is there something about free markets that allows unemployment to persist?

Both. Let’s look first at natural unemployment, which is unemployment not caused by government policies. Economists Milton Friedman and Edmund Phelps brought this concept to the fore during the 1960s even though, like most modern economic concepts, it had been recognized in various guises long before they wrote of it.

Labor markets, even when unhampered by government interference, are different from other markets. Nonmonetary considerations do not arise in other markets as much as in labor markets. Not just salary, but working conditions, job satisfaction, and advancement opportunities matter to most job seekers, often greatly.

A certain number of unemployed people are holdouts, people who might find some sort of job fairly quickly but are holding out for a higher salary, more job satisfaction, convenient location, and so on. Lumping all holdouts together is problematic. Some may harbor unrealistic expectations. Some feel constrained by their spouses’ wishes. Some have ample savings and can afford to hold out more stubbornly than others.

Some holdouts are reluctant to relocate. Moving is usually expensive and often emotionally distressful, especially to children. The current lingering housing crisis makes moving especially unattractive to some. People who are not only unemployed but also “underwater” in their mortgages—and particularly those who have simply stopped making payments, knowing that their lenders may not get around to their case for months or even years—are strongly inclined to stay put rather than accept distant job offers.


Efficiency Wages

Another form of natural unemployment is a bit subtle but very real. It goes by the name “efficiency wages,” based on the fact that recruitment and training costs are quite significant for most firms. Employers want their new hires to stick around so that these costs can be amortized over a reasonably long and productive term of employment. To motivate valuable new and old employees to stay, firms tend to offer compensation somewhat higher than the going rate for workers in any particular category. If the going rate is the wage that balances supply and demand for a particular labor category and if most offers are somewhat above this rate—efficiency wages—the result must necessarily be some unemployment. No one exemplified this theory better than Henry Ford and his outlandishly high $5-per-day wage beginning in 1914. According to one report, the policy eliminated complaints and reduced absenteeism by 75 percent. Total labor costs actually fell. There was a long waiting list for Ford jobs, but those men had other opportunities in the growing Detroit economy.


Government-Caused Unemployment

Government policies contribute to unemployment above and beyond natural unemployment. The most notorious of these policies are minimum wage laws. These laws make it illegal, effectively, for low-skilled workers to accept employment. Anyone who cannot generate $8 worth of production per hour cannot expect to be paid more than $8. Such unfortunate people might be productive at $6 per hour but are forbidden to accept employment at this rate and are instead condemned to joblessness and all its attendant miseries. This burden falls most heavily on black teenagers, whose unemployment rate (based on those seeking work and excluding those who are in school) is well over 40 percent. The benefits accrue mainly to slightly higher-skilled workers, who have climbed onto the metaphorical ladder leading to better jobs and who are shielded from competition from those excluded by minimum-wage laws.

Unemployment insurance softens the impact of joblessness and reduces the incentives to find a job. Recipients are supposed to show that they are actively seeking work, but this rule is easily sidestepped. There is nothing wrong with unemployment insurance per se. The problem is that the government forces all workers to buy this insurance whether it suits them or not. (Though nominally paid by employers, in fact the burden falls partly on workers and partly on employers.) Some workers might prefer to take that portion of their compensation in cash, but that choice is forbidden. Private carriers that might offer this insurance would, like all insurance providers, take steps to minimize adverse selection (the tendency for riskier workers to buy insurance) and moral hazard (the incentive for those covered to take risks that could get them fired).

Labor unions, as voluntary associations bargaining freely with employers, are unobjectionable. They did a lot of good in the past when working conditions in many places were pretty bad. But now they are granted special privileges by law—basically the privilege to engage in violent or coercive activities. The result is often wage agreements that are above market-clearing levels. Those left out are of course unemployed.

While labor unions can boost their members’ compensation at the expense of non-union workers, higher wages generally and higher living standards are due mainly to increased productivity, which in turn depends on high levels of capital investment. People are more willing to save and invest when they have confidence in the future, and that confidence comes from respect for property rights.


The Pain of Unemployment

Because unemployment, natural or government-caused, is such a personal matter, its impact is highly subjective, extending far behind lost wages.

A teenager looking for work may not be his family’s main source of income, but finding a job could be crucial to his life path. In my day teenagers could earn money delivering papers, mowing lawns, raking leaves, and shoveling snow. The work was unregulated and the income untaxed. Were we exploited? Hardly. We learned to take pride in our work, save for the future, and in contrast to our allowances, savor the special significance of money that we had earned.

A family breadwinner who loses his job and remains unemployed for an extended period of time will surely become discouraged, a term that only begins to describe the psychological devastation that can ensue. Men especially begin to see themselves as failures not just as breadwinners, but as husbands and fathers and more generally. Marital problems often arise. Children pick up on the distress and at certain ages wonder if they are to blame. Domestic violence and suicides are not uncommon. But losing a job may be no big deal for the senior citizen who works mainly for pleasure.

If anguish could be measured we would probably say that one year’s unemployment is more than twice as painful as six months’. As time goes by the jobless not only lose hope, but also suffer erosion of their work skills and attitude. Their former colleagues and clients tend to forget about them. Some without work turn to alcohol or worse in their despair.

Overqualification is a problem for many job-seekers. Employers are reluctant to hire people who are qualified to do better-paying work simply because those workers are likely to leave once they get a more lucrative offer. So some people simply “forget” to list that master’s degree on their résumé.


Unemployment and Macroeconomic Policy

Returning to Friedman and Phelps, the phrase they actually used was the natural rate of unemployment, the rate that would prevail when the economy is operating at full potential. Economies can operate below potential, as ours is presently, and they can sometimes operate above potential. Correspondingly we can have unemployment above the natural rate or, rarely, below. In the latter situation, we might see seniors lured out of retirement or young people lured into jobs before they finish school. But this situation is not our focus here.

Friedman was known for his opposition to Keynesian policies and his championship of free-market ideas. But that one word rate hints at the fact that Friedman fits squarely into the Keynesian macroeconomic project. Friedman viewed economics as an empirical science, not fundamentally different from physics, in direct opposition to the Austrian approach. He and Phelps spawned a cottage industry of searchers for the natural rate. Without that one word his work might not have received the broad attention that it did.

Some economists define the natural rate as an average rate (technically, a moving ten-year average). By this definition the actual rate must always lie above the natural rate at some times and below at other times. But this is simplistic. There is nothing “natural” about a moving average. Natural unemployment lies in the intentions and expectations of the people involved and is not so easily measured.

While the natural rate may be difficult to quantify and the highly subjective effects of unemployment cannot be measured, what about the amount of unemployment? Can it be measured? The Bureau of Labor Statistics (BLS) has that responsibility, and the numbers it announces get more attention nowadays than any others, with the possible exception of GDP growth figures. How does the BLS arrive at its numbers?


BLS Categories

To begin with, it must decide who is in the labor force and who is not. Among those who don’t hold jobs, infants, jail inmates, and people in nursing homes aren’t expected to work and shouldn’t be called unemployed. They are simply excluded from the labor force. Beyond that it starts to get fuzzy. Should that senior person who works mainly for nonmonetary reasons really be counted in the labor force? What about discouraged workers? A discouraged worker is one who wants work and has looked during the past 12 months, but not during the past four weeks. Do the statisticians really know who has looked and who hasn’t, and whether the reason was discouragement or something else?

Because of these and other ambiguities the BLS estimates unemployment in six different ways. U-3 gets the most attention. It is the number of unemployed divided by the size of the labor force. That number was 9.1 percent at press time. The next most widely followed version is U-6, which adds “marginally attached” workers—those who are out of the labor force but want work and have looked within the previous 12 months. It also adds those with part-time jobs who would like full-time work (again, how do they know?). This figure was a whopping 16.2 percent.

So which is the real unemployment figure, U-3 or U-6? There is no right figure, and the emphasis on U-3 is not some sort of conspiracy to hide the “real” situation. The figures are what they are, and it’s a mistake to read too much into them.

The biggest problem with unemployment statistics is not their fuzziness but, like GDP, the implications they carry: the idea that the government can and should proactively attempt to manage the unemployment rate. Such has been the presumption for at least 65 years.

Since 1948 the Federal Reserve System has operated under a dual mandate: maximize employment and stabilize prices. This is a direct reflection of the dominant macroeconomic theory of the time, which assumes the authorities could reduce unemployment by adding a little inflation, or vice versa. The theory seemed to work for awhile but fell apart in the 1970s, when the term “stagflation” appeared. We had the worst of both worlds for a time, and Friedman was ready with an explanation: Inflation could only temporarily boost unemployment—until such time as expectations caught up to reality. The Fed, as we all know, has injected massive amounts of reserves into the banking system with no discernible effect on growth or unemployment. So much for the dual mandate. More about this and other current conditions in part two, which will appear next month.


November 2011



Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.

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