Rodney Dickens shows why targeting 4% unemployment is misguided and would backfire. He says it is political nonsense

By Rodney Dickens*

Recent New Zealand experience tells us why targeting a 4% unemployment rate is misguided, which points to such a target being motivated by "politics" rather than sound judgement. 

We only have to look at Reserve Bank Governor Alan Bollard's misguided go-for-growth experiment in the 2000s to see why.

When National leader Dr Don Brash was languishing in the opinion polls after taking over as leader in October 2003 he delivered the infamous Orewa Rotary speech in January 2004 that focused on "the dangerous drift towards racial separatism in New Zealand, and the development of the now entrenched Treaty grievance industry".

The speech achieved the desired result of boosting his and National's standings in the polls, although he peaked too early for the September 2005 Election.

I believe Labour Leader David Cunliffe's pledge to get the unemployment rate down to 4% should be viewed even more cynically.

If pursued it would ensure we either get hit with high interest rates and a recession or return to the bad old days of the 1970s of double digit inflation that had lots of undesirable consequences.

Unfortunately, we seem to be drifting back to the bad old days of political parties promising things even they should know aren't realistic in the hope of fooling some people come Election Day.

There is more than one route to a lower unemployment rate

The unemployment rate can be an emotive issue so let's look at it from an analytical perspective.

There are a range of factors that contribute to people being unemployed, including:

• What economists call "frictional" unemployment; at least that was what is was called when I studied economics. This relates to people who lose jobs or resign for a range of good or unavoidable reasons and so find themselves temporarily unemployed while they look for a new job.

• There are people who live in parts of the country where industries have declined and jobs have been lost, but for various reasons, including the social welfare safety net, they remain where they are rather than move to places where there are jobs.

• There are people who for various reasons beyond their control struggle to get or retain jobs.

• Some people work in seasonal jobs and so are unemployed for parts of the year.

• There are people who declare they are looking for work when they aren't really because they have access to other sources of income or support (i.e. this includes the infamous "dole bludgers").

• There are periods when monetary policy is battling inflation or the government is battling to get down a massive fiscal deficit and to achieve the goals there is a recession and a temporary or cyclical period of above average unemployment.

If Labour's plan was to address some of the avoidable reasons for a higher unemployment rate all would be great (e.g. encouraging a more mobile workforce; addressing reasons why people struggle to get or hold jobs; weeding out genuine "dole bludgers").

But Labour's plan is largely just old-school-Keynesianism (i.e. boost demand in the economy to boost employment), albeit dressed up with some interesting industry initiatives that should stand or fall on their own merit rather than be linked to a dubious target for the unemployment rate. 

Based on the media coverage, Cunliffe's plan is to: "drive jobs growth through a combination of policies including more government buying of Kiwi-value wood products to boost forestry jobs, and create jobs in the construction sector via its 'KiwiBuild' plan to build 100,000 affordable homes over 10 years."

What we should have learnt from Governor Bollard's go-for-growth experiment

The unemployment rate is inseparably linked to the inflation rate and while economists struggle to quantify the rate there is a rate or range of rates that is consistent with the Reserve Bank's target of keeping inflation low on average over the medium-term.

I have estimated that the "equilibrium" or "inflationary-neutral" unemployment rate in New Zealand is in the vicinity of 5.5-5.8%.

This may seem high to some, but it is a natural by-product of the reasons I have listed above for people being unemployed.

If Labour were to fix some of the solvable reasons for people being unemployed the equilibrium unemployment rate would be lower.

But getting unemployment down by boosting demand would result in a self-defeating wage-price spiral (described below in the context of the role the unemployment rate plays in the wage-salary bargaining process), much higher interest rates and eventually a recession that drives the unemployment rate back up.

Even if the unemployment rate is initially reduced by well-founded industry initiatives the result will be a destructive wage-price spiral, which is why the industry initiatives should be focused on as separate issues rather than being tainted by the link to a nonsense target.

We only have to look at what happened as a result of Governor Bollard's go-for-growth experiment in the 2000s to see that pushing the unemployment rate below the equilibrium rate using things that boost demand rather than solving the solvable causes of unemployment is foolhardy and will end up in a recession.

This assumes the Reserve Bank is allowed to do its job, but if it becomes a casualty of the 4% unemployment rate target the result will be a return to the destructive wage-price spiral of the 1970s and first half of the 1980s that not so many people can remember but is not a desirable future.

A good starting point is to consider the unemployment rate as an indicator of bargaining power between employees and employers.

If low interest rates, as was the case in the 2000s, or initiatives to boost spending in the economy, which is the Labour plan, drive stronger economic growth it will flow through to stronger employment growth and a fall in the unemployment rate.

This is Economics 101 and it will work in the real world, although it is only part one of the multi-part story that will be set in motion by the stimulus to spending.

Stage one of the story is confirmed by the adjacent chart.

The blue line shows annual GDP growth, left scale, while the thick black line shows the annual percentage point change in the unemployment rate, right scale. When economic growth accelerates the unemployment rate almost always falls, while in the odd occasion the relationship isn't maintained it could as much as anything be because of the at times large sampling errors in the unemployment rate data the Reserve Bank commented on in a Monetary Policy Statement last year.

Equally, when economic growth slows significantly the unemployment rate generally increases.

For the mathematically minded the chart includes a correlation that at -0.81 is pretty high in the context of the maximum possible negative correlation being -1.0 (i.e. it is a bit like getting an 81% mark in an exam).

The best fit is with GDP growth leading changes in the unemployment rate by one quarter.

So we can be pretty confident that Labour's plan to boost spending by a range of industry initiatives would be successful in driving the unemployment rate down.

So based on the first stage of the journey, Cunliffe's plan gets the thumbs-up.

The resulting fall in the unemployment rate would give more bargaining power to employees vs. employers and would result in larger pay increases (see the adjacent chart).

The thick black line in the chart shows a productivity-adjusted measure of annual labour cost inflation calculated by Statistics New Zealand, left scale. It measures labour cost increases that can't be justified by productivity growth and in that sense are purely inflationary, but more on this later because it is too early to spoil David's plan. The blue line is the unemployment rate, right scale.

The chart shows a strong inverse relationship between the two, as reflected in the correlation of -0.86.

The best fit is with the unemployment rate advanced or shifted into the future by three quarters.

The chart above shows that a natural consequence of getting the unemployment rate down would be higher labour cost inflation approximately three quarters later. Employees would understandably take advantage of the increased bargaining power.

From the perspective of a Labour Government, stage two of the journey most likely gets the thumbs-up (i.e. a shift in income from employers to employees).

But the journey doesn't end there because pay increases that aren't justified by productivity growth set in motion equally understandable responses from employers that will end in a self-defeating wage price spiral.

The experience in the 2000s when Governor Bollard's go-for-growth experiment drove the unemployment rate down below 4% and resulted in productivity-adjusted labour cost inflation heading above 3% is instructive (see the bottom chart on page 3).

As I have covered in earlier Ravings, this was a misguided experiment that would inevitable end in tears.

Reflecting how misguided it was, after delivering the first OCR hike in January 2004 the Reserve Bank in March 2004 forecast that the unemployment rate would magically increase and that labour cost inflation would subsequently fall (green and blue lines, respectively, in the left chart below).

The Reserve Bank also predicted sideways movement in the 90-day bank bill yield (green line, right chart), with these predictions being proxies for OCR forecasts.

The first lesson from the monetary policy experiment in the 2000s is that the Reserve Bank's forecasts can be motivated by wishful thinking more than sound analysis.

But the lesson that is relevant to David Cunliffe's plan is that the inevitable consequence of driving the unemployment rate down to 4% using policies that stimulate demand in the economy will be higher labour cost inflation, high price inflation and lots of OCR hikes that ultimately result in a recession and a rebound in the unemployment rate.

In the case of Governor Bollard's experiment in the 2000s the result was 13 0.25% OCR hikes over a three year period, a recession that started before the financial crisis arrived and an unemployment rate back above 6%.

So if we set aside the politically-charged connotations associated with the unemployment rate and look at it as a by-product of a range of factors that mean a sensible or sustainable rate is well above 4%, we should conclude that the Labour Leader's plan is either foolhardy or purely politically motivated.

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*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.