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Not just a number: Defining full employment

Is 5.5% unemployment really so great? It depends on your notion of full employment. Image sourced from

Political discussion over the current government’s economic record centres on Australia’s unemployment rate of 5.5%. As some commentators have noted, this is better than the average of the last three decades for Australia.

Nonetheless a reasonable person might well ask how 5% of the labour force being unemployed could be viewed in any way as acceptable, regardless of the average over a significant period of time.

The answer lies in the long-running influence of some conventional economic propositions on the way we look at unemployment and how these propositions inform discussion about what full employment means.

I would add also that none of these propositions are beyond question. I believe they should be held up for scrutiny.

Exactly what is full employment?

More than anything else in the last hundred years, explanations of unemployment in capitalist economies and the related notion of full-employment have been at the heart of debate in macroeconomics.

In particular, for the economics profession the question at the centre of macroeconomic debate has always been whether there exists a spontaneous market mechanism which could be relied on to push a capitalist economy towards full-employment.

To understand this debate, one must define “full-employment”.

I myself would prefer an old-fashioned starting point: full-employment means the absence of involuntary unemployment and thus a situation where all those wishing to work at the ruling set of real wage rates can find employment.

Defining unemployment this way would reasonably imply the absence of what traditionally would be called “structural unemployment”; that is, people are unemployed because of a mis-match of the skills they possess and those required by the available jobs.=

This one might class this as a type of involuntary unemployment and is generated obviously as the economy goes through structural change, with certain sectors declining and others emerging and expanding.

To the extent that skilled workers are channelled into unskilled or semi-skilled occupations as a result, this displaces less skilled workers and also represents an underemployment of skilled workers.

Economists would also typically note that this notion of full-employment is not synonymous with the absence of all unemployment. Rather it would allow for people voluntarily unemployed between jobs – sometimes referred to as frictional unemployment.

But here the line between voluntary and involuntary unemployment becomes somewhat blurred. Frictional unemployment itself may reflect a move by people out of jobs in which they are underemployed in search of positions more suitable to their skills and experience.

So, a desirable position for society – which I would call “full employment” - is the absence of unemployment that is due to an insufficient number of jobs relative to jobseekers, including the absence of structural unemployment and underemployment.

It is stating the obvious then that full employment defined in this way requires having sufficient number of jobs - generated by economic activity - and a set of job opportunities which are commensurate with the skills that the jobless have or are capable of attaining – via retraining and through education.

Two grand but incompatible theories

And ensuring an economic climate consistent with this goal is where the controversy in the history – both past and contemporary – of macroeconomic discussion begins.

It is not an exaggeration to say that on this matter, the history of economic thought sees two grand though fundamentally incompatible traditions.

The first and by far the most dominant throughout the 20th century and up to the present day posits that the long-run growth path of the competitive economy will align itself with what’s required for full-employment (as I’ve defined it).

The proviso is that there is sufficient flexibility in the working of markets – for products and resources, but particularly labour and financial markets.

From this view it follows that a persistent departure from full employment reflects at its heart a lack of such flexibility.

More often than not, the finger will be pointed squarely at the labour market – insufficient flexibility in real wages, including relative wage inflexibility which leads in this view to unemployment in specific segments of the labour market.

“Natural” rate of unemployment and full employment

Since the mid-1970s a related idea (in fact the flipside of the idea above) has been coupled by policy-makers and most commentators with an emphasis on market flexibility. This is the notion that there will be a certain rate of unemployment beyond which macroeconomic policy attempting to lower it further would lead to accelerating inflation.

Moreover, at this rate of unemployment policy-makers would not be able to trade-off higher inflation for lower unemployment for any length of time.

This – euphemistically called the “natural” rate of unemployment – has become since the 1970’s the modern analogue of full employment.

One should understand however that this “modern” view of full employment derives from the same theoretical foundation as that which emphasises that the economy would in a world of freely operating markets converge on a position of full-employment.

What this relatively modern view added was that governments would be ill-advised to seek to reduce unemployment beyond the natural rate for fear of exacerbating inflation.

The idea of a non-accelerating inflation rate of unemployment towards which unfettered markets would steer the economy, has informed most discussion about what defines full employment and resulting macro policy for over four decades.

In essence, the hegemony of this view in academic and policy circles manifests itself in the primacy of inflation as a target of central banks - and forms part of the centerpiece which is seen to justify the problematic idea of an independent central bank.

However, the 20th century is rich with an undercurrent of dissent from this view about unemployment the supposedly self-correcting virtues of capitalist economies.

Rather than starting from the standard economic perspective of seeking to explain why there is unemployment, it begins with the following question: why should one expect capitalist economies left to themselves to generate full employment?

The most famous dissenter in this regard was Keynes, but plenty of others have followed, all with the same message: conventional economics has failed to produce a coherent basis for the belief in a spontaneous market mechanism pushing a capitalist economy towards full employment.

These critcs maintain that those arguments which have been forthcoming from orthodox economics throughout the 20th century are questionable on both theoretical and empirical levels.

In this view, orthodoxy has failed to appreciate particularly how fragile and ultimately incoherent is the theoretical foundation on which conventional arguments about the self -correcting nature of unemployment have been erected.

A corollary of this type of criticism is that government can influence in a positive way and permanent way through its monetary and fiscal policies the long-run growth path of the economy and its proximity to full-employment.

Proximity to some sort of inflation barrier – as if the consequences of inflation were comparable to the social consequences of unemployment – is not an excuse for a macro-policy retreat. Rather it’s a call for greater imagination in policy; God forbid that someone might call out for an incomes policy!

There is nothing natural in the sense of inevitable about full employment in competitive capitalist economies; nor is unemployment something impervious to a coherent macroeconomic policy.

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