392 | Kevil D. Hoover are in both groups—is where we find the stories of people skimping on food to afford their medications, The murnber fof people in both groups is actually lower than 2 percent because of the numerous patient assistance programs of fered by pharmaceutical companies. For all the talk of Tower drug prices, what people really want is lower risk through good insurance Ingurance lowers an individual's isk and, consequently, increases the demand for pharmaceuticals. By spending someone else's money for a good chunk of every phat ‘maceutical purchase individuals become less price sens tive. A two hundred-dollar prescription fora new medicine is forty times as expensive as a fivedollar generic but its copay may be only three times the generic’s copay. The ‘marginal cos to patients of choosing the expensive prod: uct is reduced, both in absolute and relative terms, and patients ate thus more likely to purchase the expensive rug and make purchases they otherwise would have skipped. The data show that those with insurance com sume 40-100 percent move than those without insurance Drugs account for a small percentage of overall health: care spending, Infact, branded pharmaceuticals are about 7 percent and generics 5 percent of total U. Costs.” The tremendous costs involved with ilnesses— even if they ate not directly measured—are the economic and human costs ofthe diseases themselves, not the drugs. s. health-care ‘About the Author Charles L, Hooper is president of Objective Insights, a come pany that consults for pharmaceutical an biotech companies He isa visting fellow with the Hoover Institution. Further Reading Bast, Joseph L., Richard C. Rue, and Stuart A. Wesbury J Why We Spend Too Much on Heath Care and What We Con Do Atout It. Chicago: Heartland Institute, 995 DiMasi, Joseph A., Ronald W. Hansen, and flenty G. Gre Dowski, “The Price of Innovation: New Estimates of Drug Developenent Cost Jounal of Health Economies 22, no. 2 (2003): 151-385, Higgs, Robes, ed, Hazardous to Our Health? FDA Regultion of Heal Care Products. Oakland, Calif: independent ust inte, 1995. Hilts, Philip J. Protecting Amorca's Heath: The FDA, Busines, ‘aud One Hundred Yes of Reputation, New York: Alfred A. Knopf, 2005. Klein, Daniel B., and Alesander Tabarrok, FDA Reviewor. ‘Oakland, Calif: Independent Institute, Online at utp// swovveldarevieworgy. 1p. The Centers for Medicare and Medicaid Services (CMS) January 8, 2004 Mille, Henry 1. To America’s Health: A Proposal to Reform the Food and Drug Administration, Stanford, Calf: Hoover In- stitution Press, 2000. Kevin D. Hoover “The Phillips curve represents the relationship between the rate of inflation and the unemployment rate, Although he had precursors, A. W. H. Phillips's study of wage inflation and unemployment in the United Kingdom from 186 to 1957 isa milestone in the development of macrocconom- ics, Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when ‘unemployment was low, wages rose rapidly Philips conjectured that the lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must taise wages to atiract scarce labor. At higher rates of unemployment, the pressure abated. Phillips's curve" represented the average relationship between ut employment and wage behavior over the business cycle, It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time. Economists soon estimated Philips curves for most de veloped economies. Most related general price infation, rather than wage inflation, to unemployment. OF course, the prices a company chaxges are closely connected to the wages it pays, Figure x shows atypical Phillips curve fitted to data for the United States from r96rto 1969. The dose fit between the estimated curve and the data encouraged ‘many economists, following the lead of Paul Samuelson and Robert Solow, to treat the Phillips curve as a sort of ‘menu of policy options. For exarnple, with an tnemploy- rent rate of G percent, the government might stimulate the economy to lower unemployment to 5 percent, Figure 1 indicates that the cost, in terms of higher inflation, would be a litle more than half a percentage point. But if the government initially faced lower rates of unemployment, the costs would be considerably higher: a reduction in un- eanployment from 5 to 4 percent would imply more than twice as big an increase inthe rate of fnflation—about one and a quarter percentage points. ‘Atthe height ofthe Phillips curve's popularity asa guide to policy, Edmund Phelps and Milton Friedman indepen dently challenged its theoretical underpinnings. They 2 gued that well-informed, rational employers and workers would pay attention only to real wages—the inflaton adjusted purchasing power of money wages. In their view, zeal wages would adjust to make the supply oflabor equal | source: Henderson, D.R., ‘The Concise Ene iclopedia of Economics, Viberty Fund , usa.+1969 1968 Phillips Curve | ‘ UNEMPLOYMENT RATE (PERCENTAGE) “Figure 1 The Phillips Curve, 1961-1969 Stun urea of Labor Statstis Noe: nfation based on the Consumer Price Indes. to the demand for labor, and the unemployment rate » would then stand at a level uniquely associated with that real wage—the “natural rate” of unemployment. oth Friedman and Phelps argued thatthe government «ould not permanently trade higher inflation for lowee un: ‘employment, Imagine that unemployment is atthe natural rate, The real wage is constant: workers who expect a given tate of price inflation insist that their wages increase atthe same rate to prevent the erosion oftheir purchasing power, Now, imagine that the government uses expansionary monetary or fiscal policy in an attempt to lower unem: ployment below its natural rate. The resulting increase in demand encourages firms to raise their prices faster than workers had anticipated, With higher revenues, firms are willing to employ more workers at the old wage rates and ‘even to raise those rates somewhat. Fora short time, work- x8 suffer from what economists call money illusion: they see that their money wages have risen and willingly supply tore labor. Thus, the tunemployment rate fill They do not realize right away that their purchasing power has fallen because prices have risen more rapidly than they expected. But, over time, as workers come to anticipate higher rates of price inflation, they supply less labor and insist om increases in wages that keep up with infation, The real wage is restored to its old level, and the unem: ployment rate retums to the natural rate. But the price inflation and wage inflation brought on by expansionary policies continue at the new, higher rates Friedman's and Phelps's analyses provide a distinction between the “shorteun" and “long run” Phillips curves. So Jong as the average rate of inflation remains fairly con: stant, as it di in the 1960s, inflation and unemployment will be inversely related, But ifthe average rate of inflation changes, as it will when policymakers persistently try to push unemployment below the natural rate, after a period of adjustment, unemployment will return to the natucal rate. That is, once workers’ expectations of price inflation Ihave had time to adjust, the natural rate of unemployment is compatible with any rate of inflation. The long.eun Phil lips curve could be shown on Figure x as a vertical line above the natural rate. The orignal curve would then apply only to bref, transitional periods and would shift with any persistent change in the average rate of inflation. These long-run and short-run relations can be combined in a si: ple “expectations-augmented” Phillips curve, The more ‘quickly workers’ expectations of price inflation adapt to changes in the actual rate of inflation, the more quickly ‘unemployment will return to the natural rate, and the less successful the government will bein reducing unemploy- ‘ment through monetary and fiscal polices. a)394 | Kevin D. Hoover “The 1970s provided striking confirmation of Friedman's and Phelps's fundamental point. Contrary to the original Phillips curve, when the average inflation rate rose from about 245 percent in the 1960s to about 7 percent in the 19708, the unemployment rate not only did not fall, it ac- tually rose from about 4 percent to above 6 percent. Most economists now accept a central tenet of both Friedman's and Phelps's analyses: there is some rate of unemployment that, if maintained, would be compatible with a stable rate of inflation. Many, howeves, call this the “nonaccelerating inflation rate of unemployment” (NAIRU} because, unlike the term “natural rate,” NAIRU does not suggest that an unemployment rate is socially optimal, un changing, or impervious to policy. ‘A policymaker might wish to place a value on NAIRU. ‘To obtain a simple estimate, Figure 2 plots changes in the rate of inflation (i. the acceleration of prices) against the ‘unemployment rate from 1976 to 2002. The expectations: augmented Phillips curve is the straight line that best fits the points on the geaph (the regeession line), It summa- rizes the rough inverse relationship, According to the re gression line, NAIRU (ie, the rate of unemployment for ‘whieh the change in the rate of inflaton is zero) is about 6 percent. The slope of the Phillips curve indicates the speed of price adjustment. Imagine that the economy is at CHANGE IN THE INFLATION ware (P% -404 = 35 45 5 35 NAIRU with an inflation rate of 3 pescent and that the government would like to reduce the inflation rate to er. Figure 2 suggests that contracionary monetary and fiseal policies that drove the aveeage sate of unemployment up to about 7 percent {.., one point above NAIRU) would be associated with a reduction in inflation of about one per centage point per year. Thus, i the government's policies caused the unemployment rate to stay at about 7 percent, the percent inflation rate would, on average, be reduced cone point each yeat—falling to zero in about three years. Using similar, but more refined, methods, the Congres: sional Budget Office estimated (Figure 3) that NAIRU was about 5.3 percent in r950, thatit rose steadily until peaking {in 1978 at about 6.3 percent, and that it then fell steadily to about 52 by the end of the century. Clearly, NATRU is, not constant. Itvaries with changes in so-called ral factors affecting the supply of and demand for labor such as dem- graphics, technology, union power, the smuctre of taxa- tion, and relative prices (eg. ol prices). NAIRU should not vary with monetary and fiscal policies, which affect aggregate demanel without altering these real factor. ‘The expectations-augmented Phillips curve isa funda ‘mental element of almost every macroeconomic forecast ing model now used by government and business I is accepted by most otherwise diverse schools of macrocco: UNEMPLOYMENT (PERCENTAGE) Figure 2 The Expectations Augmented Phillips Curve, 1976-2002 Source: Bureau of Labor Statistics. Note: Infation based onthe Consume Price Index.Phillips Curve | ig45 1990 1955 1960 1965 1970 1975 1980 1685 1990 1995 2000, Figure 3 Nonaccelerating Inflation Rate of Unemployment ‘Source: Congressional Budget Ofc, nomic thought. Early new classical theories assumed that prices adjusted freely and that expectations were formed rationally that is, without systematic error. These assump: tions imply thatthe Phillips cueve in Figure 2 should be very steep and that deviations from NAIRU should be shottlived (see NeW CLASSICAL MACROECONOMICS and, RATIONAL BxPECTATIONS}. While sticking to the rational- ‘expectations hypothesis, even new classical economists now concede that wages and prices are somewhat sticky. Wage and price inertia, resulting in real wages and other relative prices away from their market-clearing levels, ex: plain the large Auctuations in uneraployment atound NAIRU and slow speed of convergence back to NAIRU. Some “new Keynesian” and some free-market econo tists hold that, at best, there is only a weak tendency for an economy to return to NAIRU. They argue that there is 1 natural rate of unemployment to which the actual rate tends to return, Instead, when actual unemployment rises and remains high for some time, NATRU also rises. The dependence of NAIRU on actual unemployment is known as the hysteresis hypothesis. One explanation for hysere sis ina heavily unionized economy is that unions direclly represent the interests only of those who are currently em ployed, Unionization, by keeping wages high, undermines the ability of those outside the union to compete for em- ployment. Afler prolonged layofls, employed union work ers may seck the benefits of higher wages for themselves rather than moderating their wage demands to promote the rehiring of unemployed workers. According to thehys- teresis hypothesis, once unemployment becomes hhigh— as it did in Europe in the recessions of the r97os—it is relatively impervious to monetary and fiscal stimuli, even in the short run, ‘The unemployment rate in France in 1968 was 18 percent, and in West Germany, 15 percent, In contrast, since 1983, both French and West German ‘unemployment rates have fluctuated between 7 and 11 per cent. In 2003, the French rate stood at 8.8 percent and the German rate at 8.4 percent. The hysteresis hypothests ap pears to be more relevant to Europe, where unionization is higher and where labor laws create numerous barriers to hiring and firing, than itis to the United States, with its considerably more fexible labor markets. The unem- ployment rate in the United States was 3.4 percent in 1968 U.S. unemployment peaked in the early 1980s at 10.8 per- cent and fell back substantially, so that by 2000 it again stood below 4 percent. Modern macroeconomic models often employ another version of the Phillips curve in which the output gap Te places the unemployment rate asthe measure of aggregate demand relative to aggregate supply. The output gap isthe difference between the actual level of GDP and the poten- tial (or sustainable) level of aggregate output expressed as a percentage of potential. This formulation explains why, at the end of the 1990s boom when unemployment rates were well below estimates of NAIRU, prices did not ac- celetate. The reasoning is as follows, Potential output de- pends not only on labor inputs, but also on plant and equipment and other capital inputs. At the end of the boom, after nearly a decade of rapid investment, firms found thernselves with too much capital. The excess ci- ong,pacity raised potential output, widening the output gapand reducing the pressure on prices. Many articles in the conservative business press criticize the Phillips curve because they believe it both implies that growth causes inflation and repudiates the theory that ex cess growth of money is inflation’s true cause. But it does no such thing. One can believe in the Phillips curve and still understand that increased growth, all other things equal, wll yeduce inflation. The misplaced criticism of the Phillips curve is ironic since Milton Friedman, one of the coinventors of its expectationsaugmented version, is also the foremost defencer ofthe view that "inflation is always, and everywhere, # monetary phenomenon." The Phillips curve was hailed in the 1960s as providing ‘an account of the inflation process hitherto missing from the conventional macroeconomic. model. After four de: ceades, the Phillips curve, as transformed by the natural- rate hypothesis into its expectations-augmented version, remains the Key to relating unemployment (of capital as well as labor} to inflation in anainstream macroeconomic analysis About the Author Kevin D, Hoover ie peofestor in the departments of econom: ics and ghilosophy at Duke University, He is past president of the History of Economies Society, past chairman of the Inter national Network for Economic Method, and editor of the [Journal of Bconomite Methodology. Further Reading Cross, Rod, ed. Unemployment, Hysteresis, and the Natural Rate Hypothesis. Onford: Blackwell, 1988, Friedman, Milton. “The Role of Monetary Policy." American Fonomle Review 58, no. (1968): 17. Incas, Robert E. Jr “Heonometeie Testing ofthe Natueal Rate Hypothesis In Ono Eckstein, ed., The Beonometres of Price Determination, Washington, D.C: Federal Reserve Syeterm, 1972. Phelps, Bdmmund 8, “Phillips Curves, Expectations of tnflation snd Optimal Employment over Time.” Economica, n 34 no. 3 1967) 254-281. Phillips, A. W. H. “The Relation Between Unemployment and the Rate of Change of Mouey Wage Rates in the United Kingdom, 1861-1957." Foonomica, ns., 25, no 2. (t958): 283-299. Sarnuelson, Paul A., and Robert M. Solow. “Analyticn) Aspects of Anthinflation Policy.” American Economic Review 50, no, 2 {1960}: 177-194, Shefirn, Steven M. Rational Expectations, ad ed. Cambridge: Cambridge University Press, 1996. ‘Symposium: “the Natural Rate of Unemployment.” Journal of Beonomic Perspectives 11, no. (1997): 3-108, Politic Richard L. Stroup “The fact of scarcity, which exists everywhere, guarantees that people will compete for resources. Markets are one ‘way to organize and channel this competition. Politics is another. People use both markets and politics to get re- sources allocated to the ends they favor. Even in a democ racy, however, political activity is startlingly different from voluntary exchange in markets. People can accomplish many things in polities that they could not accomplish in the private sector. Some of these are vital tothe brosder community's welfare, such as con tol of health-threatening air pollation from myriad sources affecting millions of individuals or the provision of national defense. Other public-sector actions, such as subsidies to farmers and restrictions on the mumber of taxicabs ina city, provide narrow benefits that fall far short of their costs, 1n democratic politics, rules typically give a majority co- alition power over the entire society, These rules replace the rule of willing consent and voluntary exchange that: exists in the marketplace. In politics, people's goals are similar to the goals they have as consumers, producers, and resource suppliers in the private sector, but people ‘participate instead as voters, politicians, bureaucrats, and lobbyists In the political system, as in the marketplace, people ae sometimes (but not always) selfish. Inall cases, they are narrow: how much they know and how much they = cate about other people's goals is necessarily limited: ‘An advocate of the homeless working in the political arena typically lobbies for a shift of funding (reflecting ‘ove of real resources) ftom other missions to help poor people who lack housing, The views of such a-persony While admirable, are nanrow. He or she prefers that government (and other givers) allocate more resouitces't meet his or her goals, even though it means fever 1 sources for the goals of others. Silay, a dedicated pro: fessional, such as the director ofthe National Park Service however unselfish, pushes strongly for shifting gover: ‘ment funds away from other uses and toward expand and improving the national park system, His or b orty is to get more resources allocated to parks, even goals espoused by others, such as helping the poor, AES cssarily suffer. Passionate demands for funding! an fot legislative favors inevitably at the expense of ote ple's goats) come from every dieection. Political rules determine how these competing: #7 mands, which far exceed the government's ability pt, vide them, will be arbitrated, The rules of the poltiaag502 | Lawrence H, Summers oflaw, postcommunist countries followed three starkly dif ferent policy paths. Radical reformers really wanted de- mocracies and dynamic market economies. At the other end of the spectrum, a few autocrats desired litle but the consolidation of their power. Inthe middle, countries pur sued policies imposed by dominant elites who wanted to make themselves wealthy on transitional market distor: tions. Not surprisingly, the correlation between democracy, marketization, and privatization has been very strong. Since 1999, economic development has taken another tum, By cutting government spending and introducing low or even fat tx rates, the former Soviet countries have excelled, with an average growth of 6 percent per yeat for five yetis aid alinost balanced budgets, The early success fal yeformers in Central Europe have stopped ata medio: exe. growth fate of 3 percent per. yeai, with large budget defiit, current account deficits, and. unemployment. ‘Thee public éxpenditures have stayed at 2 West European zshare of GDP. These cotmtries have become, as Hungar- jan economist Jénios: Kornaisput it, social welfare states “*premiatiuely.! with extessive taxes and social transfersim- pedinig economic growth (Kerns 1992, p. 15). The picture of sugcess appears to be partially reversed. Yet, the post Soviet countries are lapsing into more authoritarian sys tems, while EastCentral Europe remains democatic. Much of Bast-Central Europe acceded to the European Union in 2004} and this appears to have stimulated de- rmocracy rather than economic grow. ‘Transition economics have brought a few new insights to economics. How to launch the transition mattered so muuch not because the workers or the people objected, but, it turns out, because the elite were the strong interest f20up that had to be molified. Because much output un- der socialism was of so litle value, whether real output declined during the transition is stil in dispute, Priatiza tion and enterprise restructuring have been the most pio- neering areas, and the final verdict on their success is not yetio, Corruption is widespread, but this tends to happen in all countries where government officials have a lnege amount of discretionary power (see Cornursion), not just in transition economies. Macroeconomic stabilization and Iieralization hardly offered anything very unexpected, apart from technicalities such as barter. As time passes, the peculiavties of transition economies wane. About the Author ‘Anders Aslund isa senior fellow atthe Peterson Institute for International Economics and was previously director ofthe Russian and Eurasian Progeatn at the Carnegie Endowment 2. Beton, Latvia, Lithuania, Poland, the Czech Republic, Sto vakia, Hungary, and Slovenia, for International Peace in Washington, D.C, He has been a senior economic advier tothe governments of Russia and Ubsaine, and tothe president of the Kyrgyz Republic. Funher Reading lund, Anders. Building Capitation: The Transformation ofthe Former Soviet Blo. New York: Cambridge University Pess, Berg, Andrew, Edvardo Borensntein, Ratna Schay, end Je rons Zettelmeyer. “The Evolution of Outpt in Tanstion Economies: Explaining the Dillerences” IMF Working Pa- pet no. 73. International Monetary Fund, Washington, DC, 1999 Boycko, Maxi, Andrel Shleifer, and Robest W. Vishny. Priv fining Ruste. Cambridge: MIT Pres, 1995. uropean Bank for Reconstruction and Development {EBRD}. “Tiasion Report 2003. Landon: EBRD, 2003, Fischer, Staley and Alan Gelb “The Peoces of Socialist ‘nomic Transformation. Journal of Beonomie Perspectives 5, no. 4 1991 9F-105, Hellman, Joel S. "Winners Take All The Plies of Patil Re: foren in Postcoranaunit Tanstions.* World Polis 50 (998) 205-234 Kornat, nos, The Socialist Syst: The Pla Economy of CConsnuoi, Princeton: Puincton Univeraty Pres, 1992, “The Postocialst Transition and the State: Rellec- \ioos inthe Light of Hungarian Fisal Problems" Ameri can Beonomic Review 8, no. 2 (1993) 2 Lipton, David, and Jefftey D. Sachs. “Crating a Market in Eastern Burope: The Case of Poland.” Brookings Popers on Economie Activity 20, m0. (2990). 75-147. Milanovie, Branko, Income, Inguoity and Poverty During the ‘Train fom Planned to Market Haonor. Washington, D.C: Would Bank, 1998. Murrell, Peter “Evolutionary and Radicel Approaches to Heo?” = nomic Rforen.” Eeonomics of Planning 25 1992) 79-95: Roland, Gérard, Wanstion and Bronomics: ole, Markets, and Eis, Cambridge: MIT Fress, 2000. Sachs, Jeffrey D, and Wing Thye Woo. “Reform in China and Russia” Eooromi Policy no. 18 (1994): 11-14. Shleifer, Andrei, and Robert W. Vishny. The Grabbing Mond. Government Pathologes and Their Cares. Cambridge: Hae ard University Pres, 1998 : Stig, Joseph Norton, 2003, Unemployment ans than unemployment statistics. Reports that une ployment rates axe dropping make us happy; reports to tier cotty cake us arson. But jst whet do employent figures tell us? Are they reliable measures? What fluences joblessness? Ww Is Unemployment ‘Defined and Measured? ich month, the federal govermnent’s Burcaw of Labor istics randomly surveys sisty thousand individuals brourd the nation. IF respondents say they are both out of work and seeking employment, they are counted as une smployed members ofthe labor force. Jobless respondents {who have chosen not to continue tooking for work are con- dered out ofthe labor force and therefore are not counted unemployed, Almost half ofall unemployment spells »end because people leave the labor force. Ironically, those ‘who drop out of the labor force—because they axe dis " couraged, have household responsibilities, or are sick~ ‘actually make unemployment rates look better; the un- “employment rate includes only people within the labor “force who are out of work. Not all unemployment isthe same, Unemployment can © belong term or short term. It can be frictional, meaning “someone is between jobs; or it may be structural, as when someone's skills are no longer demanded because of a ‘change in technology or an industry downturn. “Is Unemployment a Big Problem? Some say there are reasons to think that unemployment in the United States is not a big problem. In June 2005, for example, 335 percent of all unemployed people were under the age of twentyfour, and presumably few of them were the main soutce of income for their families. One out of six ofthe unemployed are teenagers. Moreover, the average duration of a spell of unemployment is short. Ia June 2005 it was 16.3 weeks. And the median spell of unemployment is even shorter. In June 2005 it was 7.0 weeks, meaning that half of all spells last 7.0 weeks or less. On the basis of numbers like the above, many econo: mists have thought that uneraployrnent is nota very lange problem. A few weeks of unemployment seems to thera like just enough time for people to move from one job to another, Yet these numbers, though accurate, are mislead- ing, Much ofthe reason why unemployment spells appear short js that many workers drop out of the labor force at least temporarily because they cannot find attractive jobs. Oen two short spelis of unemployment mean. long spell of joblessness because the person was unemployed for a short time, withdrew from the labor force, and then reen- tered the labor force. ‘And even if most unemployment spells are short, most weeks of unemployment are experienced by people who are out of work for a long time. To see why, consider the Unemployment | following example. Suppose that each week, twenty spells of unemployment lasting 1 week begin, and only one be gins thet lasts 20 weeks. Then the average duration of a completed spell of unemployment would be only 1.05 weeks. But half ofall unemployment (half of the total of 40 weeks that the bventy-one people are ont of work) ‘would be accounted for by spels lasting 20 weeks. Something like this example applies in the real world In June 2005, for example, 42.9 percent of the unem- ployed had been unemployed for less than five weeks, but 16.9 percent had been unernployed fr sx oF more months What Causes Long-Term Unemployment? To fully understand unemployment, we must consider the causes of recorded long-term unemployment. Fmmpicical evidence shows that two causes are welfare payments and unermployment insurance. These government assistance programs contribute to longeterm unemployment in two Tis, goverment ansistance increaves the mets of unemployment by prompting people who are not working to claim that they are looking for work even when they are not. The workcregisteation requirement for welfare recip- ents, for exaraple, compels people who otherwise would not be considered part ofthe labor force to register as if they were a part of it. This requirement effectively in creases the measure of unemployed inthe labor force even though these people are better described as nonem- ployed—that is, not actively looking for work. Ina study using state data on registrants in Aid to Fam- ilies with Dependent Children and food stamp programs, ry colleague Kim Clark and I found that the work-regis+ tration requirement actually increased measured tinem ployment by about 0.5 to 0.8 percentage points. If this same telationship holds in 2005, this requirement in creases the measure of unemployment by 750.000 to 1.8 million people. Without the condition that they look for work, many of these people would not be counted as un- employed. Similarly, unemployment insurance increases the measure of unemployment by inducing people to say that they are job hunting in order to collect benefits. ‘The second way government assistance programs cone tribute to long-term unemployment is by providing an in- centive, and the means, not to work. Bach unemployed person has a “reservation wage"—the minimum wage he or she insists on getting before accepting a job. Unem ployment insurance and other social assistance programs rease that reservation wage, causing an unemployed person to remain unemployed longer. Consider, for example, an unemployed person who is accustomed to making $15.00 an hour. On unemployment insurance this person receives about $5 percent of normal 503504 | Lawrence H. Summers earnings, of $8.25 per lost work hour. If that person is in 215 percent federal tax bracket and 2 3 percent state tax bracket, he or she pays $1.49 in taxes per hou not worked and nets $6.76 per hour after taxes as compensation for not working. If that person took a job that paid $15.00 per hour, overtments would take 28 percent for income taxes and 7.65 percent for Social Security taxes, netting him or her $71.15 perhour of work. Comparing the two payments, this person may decide that an hour of leisure is worth more than the extra $4.39 the job would pay. If so, this means that the unemployment insurance raises the per- son's reservation wage to above $15.00 per hour Unemployment, therefore, may not be as costly forthe jobless person’ as previously. imagined. But as Harvard ecoiioanist Martin Feldsiei pointed out in the 19705, the Gals of unteanploymient taxpayers are very grat indeed. “Take the example above of the individual who could work for $15.00. an hour or colleet tinemployment insurance of ‘per hour The coat of wsiemiployment to this nen» loyed person was only $4.39 per hour, the difference be- en the net income from working and the net income “pom not working. And ss compensation for this coat, the ‘unemployed jietson gained leisure, whose value could well be above $4.39 per hour. But other taxpayers as a group ald $8.25 in unemployment benefits for every hour the person was unemployed, and got back in taxes only $1.49) on this benefit. Moreover, they gave up $3.85 in lost tax and Social Security revenue that this person would have paid per hour employed at a $15.00 wage. Net loss to other taxpayers: $10.61 ($8.25 ~ $1.49 + $3.85) per hout, Mul: tiply this by millions of peopl collecting unemployment, each missing hundreds of hours of work, and you get a cost to taxpayers in the billions. ‘Unemployment insurance also extends the time a per- son stays off the job, Clark and I estimated that the ens tence of unemployment insurance almost doubles the number of unemployment spells lasting more than three ‘months. If unemployment insurance were eliminated, the ‘unemployment rate would drop by more than halfa per- centage point. which means that the number of unem ployed people would fall by about 750,000. This is all the more significant in light of the fat that less than half of ‘the unemployed receive insurance benefits, largely be cause many bave not worked enough to qualify ‘Another cause of long-term unemployment is union zation. High union wages that exceed the competitive mar- Ket rate are likely to cause job losses in the unionized sec- tor ofthe economy, Also, those who lose high-wage union jobs are often reluctant to accept alternative lov-wage em- ployment. Between 1970 and 1985, for example, a state ‘with a 20 percent unionization rate, approximately the av erage for the fifty states and the District of Columbia, ex perienced an unemployment rate that was 12 percentage points higher than that ofa hypothetical state that had no ‘unions. To put this in perspective, 2 percentage points is about Go percent ofthe increase in normal unemployment between 1970 and 1985 ‘There is no question that some long-term unemptoy ment is caused by government intervention and unions thatinterfere with the supply ofabor. tts, however, great mistake {made by some conservative economists toate butte most unemployment to government interventions in ‘the economy or to any lack of desire to work on the part of the unemployed. Unemployment was 2 serious eco: nomic ptoblem in the late nineteenth and caely twentieth, centuries prior tothe welfare state and widespread union: ization, Unemployment then, a8 now, was closely linked to general macroeconomic conditions. The GResr DxPRes: stox, when tunemployment in the United States reached 25 percent, isthe classic example of the damage that col lapses in ceedit can do, Since then, most economists have agreed that cyclical fluctuations in tmemployment aré ‘caused by changes in the demand for labor, not by changes in workers’ desiees to work, and that unemployment in recessions is involuntary, Even leaving aside cyclical fluctuations, 2 large patt of ‘unemployment is due to demand factors rather than sup: ply. High unemployment in New England in the early 19908, for example, was duc to declines in computer ad other industries in which New England specialized, High ‘unemployment in northern California in the eatly 20065 was caused by the dot-com bust. The process of adjust: tment following shocks is Jong and painful, and recent re: search suggests that even temporary declines in demand ‘can have permanent effects on unemployment, as workers who lose jobs are unable to sell their labor due to aloes of skills ot for other reasons. Therefore, most econotiniss = who study unemployment support an active governtiten role in training and retraining workers and in maint stable demand for labor. “The Natural Rate of Unemployment Long before Milton Friedman and Edmund Phelps ad: vanced the notion of the natural rate of unemployiitent (Qhe lowest rate of unemployroent tolerable without pst ‘ng up infation), policymakers had contented themselves, with striving for low, not zero, unemployment, ust wha constitutes an acceptably low level of unemplaymeat I been redefined over the decades, In the eatly 19608 48 unemployment rate of 4 percent was both desirable ari achievable. Over time, the unemployment rate drified UP= ward and, for the most pat, has hovered around 7 percent)Lately it has fallen tos percent. I suspect that some of the = seduction in the apparent natural rate of unemployment Jiu secent years has to do with xeduced transitional unem: ‘ployment, both because fewer people are between jobs and because they are between jobs for shorter periods."Union jower has been eroded by domestic regulatory action and ~ jnaction, as well by international competition. More ‘generally international competition has restrained wage Increases in highwage industries. Another factor making ‘employment lower is 2 decline inthe fraction of the un- fmployed who are supported by unemployment insurance © About the Author Lawrence H. Summers is Charles W. Eliot University Profes 01 at Harvard University. He was previously the president of “ Haraed University. Before that, he was secretary ofthe US. ‘Treasury Further Reading "Feldstein, Manin, “The Beonomice ofthe New Unempoy. men Public Interest 3 (Pall 1973: 3-42 ‘Why Is Productivity Growing Faster?” NBER Work- ing Paper no, gs3o. National Buea of BeonomicRe- seauch, Cambridge, Mase, 200) Fiedan, Mion. “The Role of Monetary Polcy* American “eontne Review 58 (March 1968} 1-17. Holl, Robert. "Employment Fhacations and Wage Rigi” ‘Brookings Papers on eononte Aci 1 t9Bo}! 91. Summers, Lavence H, Understanding Unemplayment, Cmm- ‘widge: MIT Press, 1990. "Why Is the Unemployment Rate So Very High Neat ull Brployment?™ Broobings Popes on Economic Activity 2 {0986): 399-38 Summers Lawrence H,, a Kim B, Clark. "Labor Market Dy- ‘namics and Unemployment: A Reconsideration.” Boolings apes on Beanie Adit (979): 3-60. Unintended Consequences Rob Norton The aw of unintended consequences, often cited but rarely defined, is that actions of people—and especially of gov crnment—always have effects that are unanticipated or un intended. Economists and other social scientists have heeded its power for centuries; for just as Jong, politicians suid popular opinion have largely ignored it The concept of unintended consequences is ane ofthe building blocks of economics. Adam Smith's “invisible hand," the most famous metaphor in socal science, is an Grample of a postive unintended consequence, Smith Unintended Consequences { maintained that each individual, seeking only his own gain, “is led by an invisible hand to promote an end which ‘was no patt of his intention," that end being the public interest, “Itis not from the benevolence of the butcher, or the baker, that we expect our dinner,” Smith wrote, “but from regard to their ov self interest.” Most often, however, the law of unintended conse. quences illuminates the perverce unanticipated effects of legislation and regulation, In 1692 the English philoso. pher John Locke, a forerunner of modem economists, urged the defeat of parliamentary bill designed to cut the maximum permissible rate of interest from 6 percent to 4 percent. Locke argued that instead of benefiting borrow: rs, as intended, it would hurt them, People would find ‘ways to circumvent the law, with the costs of cireumven- tion borne by borrowers. To the extent the law was obeyed, Locke concluded, the chief results would be less available credit and a redistribution of income avvay from “widows, orphans and all those who have their estates ia money.” Im the first half of the nineteenth century, the farnous French economic journalist Frédéric Bastiat often distin guished in his writing between the “seen” and the “un- seen.” The scen were the obvious visible consequences of an action or policy. The unseen were the less obvious, and often unintended, consequences. In his famous essay “What Is Seen and What Is Not Seen,” Bastiat wrote: “There is only one difference between a bad economist and a good one: the bad economist confines hiraself to the visible effect; the good economist takes into account Doth the effect that can be seen and those effects that must be foreseen. Bastiat applied his analysis toa wide range of issues, in- cluding trade barriers, taxes, and government spending “The fist and most complete analysis of the concept of unintended consequences was done in 1936 by the Amet- ican sociologist Robert K. Merton, tn an influential aticle titled “The Unantieipated Consequences of Purposive So dal Action,” Merton identified five sources of unantici pated consequences, The frst twoand the most perva- sive-—were “ignorance” and "error" Merton labeled the third source the “imperious imme: diacy of interest” By that he was referring to instances in ‘which someone wants the intended consequence ofan 3¢- tion so much that he purposefilly chooset to ignore any unintended effects. (That type of wif jgnorance is very different from true ignorance.) The Food and Drug Admin: istration, for example, creates enormously destructive ut 1. Online a hip: /worwecontih.org/ibrary/Bastit basset hl 505