Home > Uncategorized > NAIRU — a harmful fairy tale

NAIRU — a harmful fairy tale

from Lars Syll

The NAIRU story has always had a very clear policy implication — attempts to promote full employment is doomed to fail, since governments and central banks can’t push unemployment below the critical NAIRU threshold without causing harmful runaway inflation. LARS P. SYLL | Non-ergodic, realist and relevant economics.

Although a lot of mainstream economists and politicians have a touching faith in the NAIRU fairy tale, it doesn’t hold water when scrutinized.

One of the main problems with NAIRU is that it is essentially a timeless long-run equilibrium attractor to which actual unemployment (allegedly) has to adjust. If that equilibrium is itself changing — and in ways that depend on the process of getting to the equilibrium — well, then we can’t really be sure what that equlibrium will be without contextualizing unemployment in real historical time. And when we do, we will see how seriously wrong we go if we omit demand from the analysis. Demand policy has long-run effects and matters also for structural unemployment — and governments and central banks can’t just look the other way and legitimize their passivity re unemployment by refering to NAIRU. 

NAIRU does not hold water simply because it does not exist — and to base economic policy on such a weak theoretical and empirical construct is nothing short of writing out a prescription for self-inflicted economic havoc.

The conventional wisdom, codified in the theory of the non-accelerating-inflation rate of unemployment (NAIRU) … holds that in the longer run, an economy’s potential growth depends on – what Milton Friedman called – the “natural rate of unemployment”: the structural unemployment rate at which inflation is constant …

macroeconomics_beyond_the_nairu-naastepad_c_w_m-14299648-frntWe argue in our book Macroeconomics Beyond the NAIRU that the NAIRU doctrine is wrong because it is a partial, not a general, theory. Specifically, wages are treated as mere costs to producers. In NAIRU, higher real-wage claims necessarily reduce firms’ profitability and hence, if firms want to protect profits (needed for investment and growth), higher wages must lead to higher prices and ultimately run-away inflation. The only way to stop this process is to have an increase in “natural unemployment”, which curbs workers’ wage claims.

What is missing from this NAIRU thinking is that wages provide macroeconomic benefits in terms of higher labor productivity growth and more rapid technological progress …

NAIRU wisdom holds that a rise in the (real) interest rate will only affect inflation, not structural unemployment. We argue instead that higher interest rates slow down technological progress – directly by depressing demand growth and indirectly by creating additional unemployment and depressing wage growth.

As a result, productivity growth will fall, and the NAIRU must increase. In other words, macroeconomic policy has permanent effects on structural unemployment and growth – the NAIRU as a constant “natural” rate of unemployment does not exist.

This means we cannot absolve central bankers from charges that their anti-inflation policies contribute to higher unemployment. They have already done so. Our estimates suggest that overly restrictive macro policies in the OECD countries have actually and unnecessarily thrown millions of workers into unemployment by a policy-induced decline in productivity and output growth. This self-inflicted damage must rest on the conscience of the economics profession.

Servaas Storm & C. W. M. Naastepad

  1. originalsandwichman
    May 29, 2016 at 9:18 pm

    What could be clearer? There is no such thing as involuntary unemployment but if it falls below a certain level, inflation will result. Seems legit.

    • Paul Schächterle
      May 30, 2016 at 10:06 am

      LOL. Touché.

  2. May 30, 2016 at 7:39 pm

    False theory makes wrong policy: economics as loose cannon
    Comment on Lars Syll on ‘NAIRU — a harmful fairy tale’

    The NAIRU aberration goes back to the false interpretation of the Phillips curve (2012). The correct curve is reproduced here

    From the structural Phillips curve, which is entirely FREE of rational expectation and natural rate nonsense, follows inter alia:
    (i) An increase of the expenditure ratio rhoE leads to higher employment L (the letter rho stands for ratio).
    (ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
    (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

    The complete structural Phillips curve is a bit longer and contains in addition public deficit spending and import/export.

    Item (i) and (ii) cover the familiar arguments about how aggregate demand affects employment. Item (iii) embodies the price mechanism. It works such that overall employment L INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa. The structural Phillips curve contains the original curve as limiting case.

    The NAIRU model is provably false and leads to wrong policy advice.*

    Egmont Kakarot-Handtke

    References
    Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
    http://ssrn.com/abstract=2130421

    * See ‘What Keynes really meant but could not really prove’
    http://axecorg.blogspot.de/2016/05/what-keynes-really-meant-but-could-not.html

  3. postkey
    June 12, 2016 at 11:32 pm

    “The NAIRU story has always had a very clear policy implication — attempts to promote full employment . . . ”

    Do you have a definition of ‘full employment’?

    Thanks.

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