Forget inflation – what hurts the most is unemployment

Unemployment and inflation are major targets of macroeconomic policy, presumably because policymakers believe a higher level of either adversely affects welfare. The macroeconomist Arthur Okun developed a measure known as the "misery index" – the sum of the unemployment rate and the inflation rate – intended to capture how increasing values of unemployment and inflation reduced national welfare. The measure conveys some information on how the economy is performing. However, it also implicitly assigns equal weights to inflation and unemployment rates.

Presently the misery index for the UK is slightly above 10, which contrasts with 28 for Greece and 29 for Spain, 13 for France, 7 for Germany, 9 for the Netherlands and 15 for Italy. In this calculation it is assumed that both a higher rate of unemployment and higher inflation create both economic and social costs for a country. A combination of rising inflation and more people out of work implies deterioration in economic performance and a rise in the misery index. But there is disagreement on the relative cost of unemployment and inflation. Standard macroeconomic models typically find small costs associated with unemployment such that the welfare gains from price stability are significantly greater than those from stabilising output and therefore unemployment. These findings contrast with concerns expressed in surveys by the public over the relative importance of inflation and unemployment and their impacts on wellbeing and how these have changed over time.

In 2011 a Eurobarometer survey asked respondents in all EU countries "what do you think are the two most important issues facing our country?" They were able to provide up to two responses including unemployment or rising prices/inflation. Overall, 47 per cent said unemployment and 26 per cent said inflation. In only Austria and Germany were the preferences reversed: 20 per cent and 41 per cent and 21 per cent and 36 per cent respectively. In the UK 47 per cent said unemployment was the biggest problem compared with 21 per cent who said inflation. So people care more about unemployment than they do about inflation, but how much more?

In a couple of weeks there is a major conference bringing together academics and central bankers, called "Fulfilling the Full Employment Mandate; Monetary Policy and the Labor Market", organised by the Federal Reserve Bank of Boston, where I am a visiting scholar. This conference revisits the role that a full employment mandate should play in guiding monetary policy and examines the associated outcomes. Questions include: how much weight should central bankers place on employment? How useful are estimates of full employment for the conduct of monetary policy? Have these estimates changed recently, and if so, why?

I will present a joint paper at the conference with three colleagues from the University of Stirling* that attempts to answer these questions. We explicitly examine the weights central bankers should place on unemployment and inflation, and find that it is unemployment that matters most. We base this conclusion on evidence drawn from a sample of 1.1 million people drawn from 31 European countries for the period 1975-2012, again in Eurobarometer Surveys. Respondents were asked: "On the whole, are you very satisfied, fairly satisfied, not very satisfied, or not at all satisfied with the life you lead?" Using these data we estimate the impact of a one percentage point increase in unemployment compared with a one percentage point increase in inflation on reported life satisfaction, or wellbeing – we call this the misery ratio. We should note that the impact of unemployment is measured by the loss of wellbeing of the individuals who are unemployed, plus the decline in wellbeing of everyone else when unemployment rises. It turns out the happiness literature unequivocally finds that the unemployed are especially unhappy, suggesting being jobless is not by choice.

Rather than making up some mathematical model in the dream world of macroeconomic theorists, it makes sense to go out into the real world and look at the evidence. We find the wellbeing cost of a one percentage point increase in unemployment lowers life satisfaction by 3.8 times as much as the equivalent rise in inflation and this effect has risen over time. Across the five hawkish eurozone countries of Austria, Finland, France, Germany and the Netherlands, the effect is 0.7, so residents in those countries fear inflation more than unemployment.

As one might expect, in the remaining countries of the eurozone, including Greece, Portugal, Spain and Ireland, where unemployment is a huge problem, the opposite is the case: it is 6.4. Of interest also is how this estimate varies by group; it is higher among the least educated (6.6) than among the best educated (2.7).

Perhaps surprisingly, we find evidence that the effect is higher among older age groups. For example, it is 1.8 for those under 25, and 6.1 for those over 55. The older group are disproportionately savers, so it is of interest that they are especially concerned about unemployment, which suggests that the calls to raise interest rates – which would raise the cost of borrowing, lower house prices, slow the birth rate and raise the death rates of new firms and raise unemployment rates especially among the young – to raise their unearned income, may well be misplaced. They know how much unemployment hurts families.

In the Budget, the Chancellor reaffirmed the commitment to a 2 per cent CPI inflation target, but what he should have done was explicitly switch to an unemployment target as the Fed has done, because unemployment hurts more than inflation does. And now unemployment is going to start rising again. I never did get all the fuss about inflation.

* The effects of macroeconomic shocks on wellbeing, David Blanchflower, David Bell, Alberto Montagnoli and Mirko Moro.