Home > Uncategorized > Debunking the NAIRU hoax

Debunking the NAIRU hoax

from Lars Syll

powemp3In our extended NAIRU model, labor productivity growth is included in the wage bargaining process … The logical consequence of this broadening of the theoretical canvas has been that the NAIRU becomes endogenous itself and ceases to be an attractor — Milton Friedman’s natural, stable and timeless equilibrium point from which the system cannot permanently deviate. In our model, a deviation from the initial equilibrium affects not only wages and prices (keeping the rest of the system unchanged) but also demand, technology, workers’ motivation, and work intensity; as a result, productivity growth and ultimately equilibrium unemployment will change. There is in other words, nothing natural or inescapable about equilibrium unemployment, as is Friedman’s presumption, following Wicksell; rather, the NAIRU is a social construct, fluctuating in response to fiscal and monetary policies and labor market interventions. Its ephemeral (rather than structural) nature may explain why the best economists working on the NAIRU have persistently failed to agree on how high the NAIRU actually is and how to estimate it.

Servaas Storm & C. W. M. Naastepad

Many politicians and economists subscribe to the NAIRU story and its policy implication that attempts to promote full employment is doomed to fail​ since governments and central banks can not push unemployment below the critical NAIRU threshold without causing harmful runaway inflation. 

DENNETTAlthough this may sound convincing, it’s totally wrong!

One of the​ main problems with NAIRU is that it essentially is​ a timeless long-run equilibrium attractor to which actual unemployment (allegedly) has to adjust. But 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 equilibrium​m will be without contextualizing unemployment in real historical time. And when we do, we will — as highlighted by Storm and Naastepad — 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 referring​ to NAIRU.

The existence of long-run equilibrium is a very handy modelling​ assumption to use. But that does not make it easily applicable to real-world economies. Why? Because it is basically a timeless concept utterly incompatible with real historical events. In the real worl​d, it is the second law of thermodynamics and historical — not logical — time that rules.

This importantly means that long-run equilibrium is an awfully bad guide for macroeconomic policies. In a world full of genuine uncertainty, multiple equilibria, asymmetric information and market failures, the long run equilibrium is simply a non-existent unicorn.

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

NAIRU is a useless concept, and the sooner we bury it, the better​.

  1. patrick newman
    May 10, 2018 at 3:20 pm

    NAIRU seems to have a religious quality but it is having a good afterlife with the well-funded laissez-faire free market lobby groups that scandalously call themselves think tanks!

  2. Dr. Helen Sakho
    May 10, 2018 at 5:06 pm

    Thus an all time personal favourite by the most competent and insightful manager of the system, Keynes: “ in the long run, we are all dead” .

    • Calgacus
      May 11, 2018 at 8:24 pm

      Then you might like Harry Hopkins’ reply to a US Senator who suggested that in the long run laissez faire would let the Great Depression’s problems solve themselves:

      “People don’t eat in the long run, Senator. They eat every day.”

  3. May 11, 2018 at 1:52 am

    Unbelievable that these ‘zombie’ ideas just keep walking. Unemployment was much lower in the 1950s and 60s, averaging 3.2% for the OECD, only 1.3% in Australia.

    NAIRU is such an obvious fudge. If you do more than point out the obvious contradiction with observations you only keep it alive.

    Same goes for equilibrium. Economies are far from equilibrium – end of neoclassical nonsense.

  4. Jan Milch
    May 11, 2018 at 2:45 am

    William Vickrey, that was awarded the 1996 Nobel Memorial Prize in Economic Sciences
    explained the irrelevance of the NAIRU concept in his “Fifteen Fatal Fallacies of Financial Fundamentalism” like this :

    “It is thought necessary to keep unemployment at a “non-inflation-accelerating” level (“NIARU”) in the range of 4% to 6% if inflation is to be kept from increasing unacceptably.

    Currently the unemployment rate as officially measured has fallen to 5.1%, while the Congressional Budget Office (CBO) has put the NIARU for 1964 at 6.0 percent, having ranged between 5.5 and 6.3 since 1958. Recent CBO protections were for unemployment to remain steady at 6.0 percent through the year 2005, with inflation in the urban consumer price index fairly steady at about 3.0 percent (Economic and Budget Outlook, May 1996, pp xv, xvi, 2, 3).

    This may be a fairly optimistic forecast of the results to be expected from current tendencies, but as a goal it is simply intolerable. While even five percent unemployment might be barely acceptable if it meant a compulsory extra two weeks of unpaid furlough annually for everyone, it is totally unacceptable when it means 10%, 20% and 40% unemployment among disadvantaged groups, with serious consequences for poverty, homelessness, family breakups, drug addiction and crime. The malaise that pervades our cities may be attributable in no small measure to the fact that for the first time in our history, an entire generation and more has grown up without experiencing reasonably full employment, even briefly. In contrast, while most other industrialized countries are currently experiencing higher rates of unemployment than the U.S., they have nearly all had relatively recent periods of close to full employment. Unemployment insurance and other welfare programs have also been much more generous so that the sociological impacts have been much less demoralizing.

    The underlying assumption that there is an exogenous NIARU imposing an unavoidable constraint on macroeconomic possibilities is open to serious question on both historical and analytical grounds. Historically, the U.S. enjoyed an unemployment rate of 1.8% for 1926 as a whole with the price level falling, if anything. West Germany enjoyed an unemployment rate of around 0.6% over the several years around 1960, and most developed countries have enjoyed episodes of unemployment under 2% without serious inflation. Thus a NIARU, if it exists at all, must be regarded as highly variable over time and place. It is not clear that estimates of the NIARU have not been contaminated by failure to allow for a possible impact of inflation on employment as well as the impact of unemployment on inflation. A Marxist interpretation of the insistence on a NIARU might be as a stalking horse to enlist the fear of inflation to justify the maintenance of a “reserve army of the unemployed,” allegedly to keep wages from initiating a “wage-price spiral.” One never hears of a “rent-price spiral”, or an “interest-price spiral,” though these costs are also to be considered in the setting of prices. Indeed when the FRB raises interest rates in an attempt to ward off inflation, the increase in interest costs to merchants may well trigger a small price increase.

    Analytically, it would be more rational to expect that there could be a maximum non inflation-accelerating rate of reduction of unemployment (NIARRU), such that if an attempt were made to proceed more rapidly by a greater recycling of excess savings into purchasing power through government deficits, prices would start to rise more rapidly than had been generally anticipated. This would occur as a result of a failure of supply to keep up with the increased demand, giving rise to shortages and the dissipation of part of the increased demand into more rapidly rising prices. This NIARRU may be determined by limits to the rates at which labor can be hired and put to work to meet anticipated increases in demand, and perhaps lags in the realization that demand will be increased, and even new productive facilities created, installed, and brought up to speed. The ultimate technological constraint to putting unemployed to work more rapidly in the private sector may reside in a limited capacity in the capital goods industries such as construction, cement, and machine tools.

    In any case much will depend on the degree of confidence that can be engendered in the proposed increase in demand. It might be wise to start slowly, with a reduction of unemployment by say 0.5% the first year, and increasing to say 1% per year as confidence is gained. Possibly the growth rate should subsequently be reduced somewhat as full employment is approached, allowing for the increasing difficulty of matching workers to vacancies. It is mainly at the later stages of the approach to full employment that training and improving the organization of the labor market may become needed. In the face of a policy of maintaining a fixed NIARU, “workfare” efforts to retrain and assist welfare clients amount to assistance in the playing of a cruel game of musical chairs.

    Such a NIARRU is likely to prove somewhat volatile and difficult to predict, and in any case it might prove desirable to push to full employment somewhat faster than would be permitted by an unaltered NIARRU. This would call for the introduction of some new means of inflation control that does not require unemployment for it to be effective. Indeed, if we are to control three major macroeconomic dimensions of the economy, namely the inflation rate, the unemployment rate, and the growth rate, a third control is needed that will be reasonably non-collinear in its effects to those of a fiscal policy operating through disposable income generation on the one hand, and monetary policy operating through interest rates on the other.

    What may be needed is a method of directly controlling inflation that do not interfere with free market adjustments in relative prices or rely on unemployment to keep inflation in check. Without such a control, unanticipated changes in the rate of inflation, either up or down, will continue to plague the economy and make planning for investment difficult. Trying to control an economy in three major macroeconomic dimensions with only two instruments is like trying to fly an airplane with elevator and rudder but no ailerons; in calm weather and with sufficient dihedral one can manage if turns are made very gingerly, but trying to land in a cross-wind is likely to produce a crash.

    One possible third control measure would be a system of marketable rights to value added, (or “gross markups”) issued to firms enjoying limited liability, proportioned to the prime factors employed, such as labor and capital, with an aggregate face value corresponding to the overall market value of the output at a programmed overall price level. Firms encountering a specially favorable market could realize a higher than normal level of markups only by purchasing rights from firms less favorably situated. The market value of the rights would vary automatically so as to apply the correct downward pressure on markups to produce the desired overall price level. A suitable penalty tax would be levied on any firm found to have had value added in excess of the warrants held.

    In any case it is important to keep in mind that divergences in the rate of inflation either up or down, from what was previously expected, produce merely an arbitrary redistribution of a given total product, equivalent at worst to legitimized embezzlement, unless indeed these unpredictable variations are so extreme and rapid as to destroy the usefulness of currency as a means of exchange. Unemployment, on the other hand, reduces the total product to be distributed; it is at best equivalent to vandalism, and when it contributes to crime it becomes the equivalent of homicidal arson. In the U.S. the widespread availability of automatic teller machines in supermarkets and elsewhere would make the “shoe-leather cost” of a high but predictable inflation rate quite negligible.”

  5. May 11, 2018 at 7:00 am

    “This importantly means that long-run equilibrium is an awfully bad guide for macroeconomic policies.”

    More to the point, if you take out all the economic qualities of the real world that prevent equilibrium from being a useful concept in economics you have nothing left to give the answer to why Kenya and Japan should have different equilibrium attractors. Unless of course you are racist, I guess. (Conversely when you come up with valid reasons for why Japan should have a stronger economy than Kenya in 20 years, these reasons will be easily seen to be incompatible with an equilibrium based on skills and desires of economic actors).

  6. Prof James Beckman, Germany
    May 11, 2018 at 2:57 pm

    Like the simpleton I am, I just look at GDP per capita over the past 30 years & compare the US, Germany, China & Japan. The only theory I really pay attention to is economic history. Germany & China are winning with models which are not Friedmanite, it seems to me…. Of course the kicker is the feudalising of the US wealth/income structure, with little public or private benefit going to the bottom third or so of the wealth/income cohort. Oh, perhaps this is consistent with Friedman….

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