Conservative economists worry that a backlash against the incorrect assumptions that led to a belief in a very high natural rate will now convince policymakers that they can ignore the concept of a natural rate altogether. There is a natural rate, they argue. It's just not as high as we thought.
In fact, the nation's jobless rate--at 5.2% in September--is probably close to the natural rate now.
Economists now acknowledge that their estimates of the natural rate were so far off because they were fighting the last war. They based their analysis of the relationship between inflation and employment on historical trends--ignoring the fact that the U.S. economy was undergoing a remarkable transformation just as they were compiling their 30-year-old data.
Maybe those Fed economists haven't gotten out much. Maybe they haven't had to look for a job for a while. But they still should have recognized that the economy of 1996 looks nothing like the economy of 1966. Have they heard about Intel, Netscape and Microsoft? Starbucks and Home Depot? Fidelity and Vanguard? The Stealth fighter and cellular phones? Japan's decline and China's rise? BMW's car factory in the American South?
"What has been embarrassing is that precisely as this wave of research in the early 1990s was generating natural rate estimates around 6.4%, based mainly on the record of the three prior decades, the natural rate apparently was falling, and fast," observed a sheepish Edmund S. Phelps, an economist at Columbia University, in a recent op-ed piece in the Wall Street Journal.
That brings us back to my pet peeve. Economists exhibited enormous professional hubris when they tried to divine a precise "natural rate" for all time. They forgot that the economy doesn't stand still for their laboratory experiments.
Let's hope the economics profession will learn from its mistake, accept the fact that the "natural rate" is organic and flexible, and use that knowledge to propose more creative fiscal and monetary policies for the future. They need to think about how natural rate theory works in the real world of the late 1990s.
And they can start with the debate over welfare reform: How can the economy absorb the new low-wage job-seekers who will enter the labor force once they are thrown off assistance by this year's welfare reform legislation?
The welfare bill establishes a lifetime limit of five years for welfare payments to any family and will require most adults to work within two years of receiving aid. But if the economy is already running close to full capacity, will the Federal Reserve accommodate these new job-seekers? Will the central bank ease up on interest rate policy in order to find room in the economy for these former welfare recipients?
Now that economists have acknowledged their earlier mistakes on the natural rate, maybe they will be brave enough to argue for further flexibility on monetary policy as well.