The Economy

Dec. 21, 2004
Foreign workers key to U.S. labor supply

Many years ago, macroeconomists thought they had all the answers. The economy was growing at an average rate of 5%, with the inflation rate well below 2%. The budget was balanced, while the stock market had surged sixfold over a decade and a half. Surely, it was reasoned, the superior performance of the economy in the first half of the 1960s could continue indefinitely. Today fewer and fewer messianic voices are heard. The standard argument for substantially slower growth in the months and years ahead is twofold. First, the high-tech bubble is in the process of bursting. Second, the economy is about to experience severe labor shortages. That will lead either to sharply higher inflation or slower growth in output simply because there are not enough people available to perform the necessary tasks. The Fed, if it wants, has the power to cause a recession no matter what else is happening. But why would it want to terminate the current boom? When former Fed Chairman Paul Volcker boosted the federal funds rate to 18% the inflation rate had been 13% and the U.S. economy was running the danger of turning into another banana republic. That hardly applies these days. Yet the curve theory of British economist A.W. Phillips -- which states that there must be some tradeoff between inflation and unemployment -- is still prominently mentioned in spite of the fact that inflation has not budged over the last five years. The issue is not so much whether such a tradeoff ever existed, but whether the Fed thinks it still exists, and hence will continue to tighten in order to offset the inflation that it claims would otherwise occur. Economists Milton Friedman and Ned Phelps accurately predicted the demise of the Phillips curve in the late 1960s, well before it actually happened. Recently, however, Phelps argued that the so-called NAIRU, the nonaccelerating inflationary rate of unemployment, is still with us and must be factored into macroeconomic analysis. That rate, according to Phelps, has fallen from 6% to 3.5% over the last decade, an impressive accomplishment. However, if Phelps is correct and the actual unemployment rate continues to decline, the economy will soon find itself back in the penalty box, with both wages and prices accelerating. It is widely believed that sort of analysis influences Fed policy decisions. Yet I think the labor supply is far more elastic than is indicated by the standard analysis. Thus, even if the economy does continue to grow at above-average rates, as I am convinced it will, labor markets will not tighten further, and wage gains will not accelerate. Unfortunately, the measured statistics are of very little use here. Over the last five years employment as measured by the household survey has grown an average of 1.6% per year, while measured by the payroll survey it has grown 2.4% per year. What factors account for such a large discrepancy? One answer has surfaced in line with the Census 2000 forms. As someone who has long crusaded for more accurate government data, I can hardly applaud those who refuse to supply the requisite information. Nonetheless, it is easy enough to sympathize with the dilemma of illegal aliens: They have good reason to assume that if the government finds out about them, it will deport them or jail them. The supply of foreign workers is of increasing importance not only because of full employment domestically but also because of the mammoth amount of underutilized labor in the rest of the world waiting for the opportunity to work in the U.S. As long as domestic labor remains scarce, a larger proportion of total employment will consist of undocumented aliens who show up in the workforce but not in the Bureau of Labor Statistics data. If the proportion of undocumented workers continues to rise and the unemployment rate does not fall further, then after a while the Fed can relax its guard and permit the recovery to continue unhampered by overly tight monetary policy. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill.

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