NAIRU — a false and harmful concept

4 Nov, 2014 at 11:25 | Posted in Economics | 4 Comments

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.
But 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. 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.

This NAIRU depends on the extent to which labor markets deviate from the benchmark competitive labor market model as a result of regulatory interventions in the form of minimum wages, employment protection legislation, unemployment benefits, and wage-bargaining institutions, many of which are designed to reduce inequalities in pay, provide security to workers, and reduce inter-firm competition. If the labor market is more regulated, the NAIRU must be higher and potential growth lower.

It follows that if one wants to reduce structural unemployment, the only way to achieve this is by abolishing regulatory interventions in the labor market; the price of a dynamic economy and low unemployment is heightened inequality and “traumatized workers.” A second implication of NAIRU economics is that neither central bank policy nor fiscal policy affects natural unemployment. Macro policy is presumably ineffective.

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. Seems to be a lot like shadowstats, the unemployment rate minus an arbitrary amount

  2. Wow Ralph, good ending!

  3. “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.”

    As a supporter of the NAIRU idea, I have never entertained the crude and simple minded idea that NAIRU is some sort of “fixed for all time” level of unemployment. That is, the level of unemployment at which inflation becomes a significant problem will pretty obviously vary in reaction to numerous factors e.g. one or more of the following: minimum wage levels, standards of education and training, the amount spent by state employment agencies. Plus a rapid change in the pattern of supply or demand would tend to raise NAIRU until relevant new skills are learned. Plus there is hysteresis: the fact that an extended and recent period of higher than normal unemployment results in lost skills, which in turn will raise NAIRU.

    As for Neil Wilson’s idea that NAIRU is an idea dreamed up by some unspecified collection of evil-doers who (for reasons not spelled out by Neil) want to keep unemployment artificially high, that is plain nonsense: conspiracy theory. No doubt there are SOME EMPLOYERS who think it’s in their interest to keep unemployment high because that keeps wage demands down. On the other hand, more demand means more profit for employers: particularly as employers are free to raise prices to compensate for inflation and wage increases.

    And that is confirmed by several employer surveys in which employers say their main problem is lack of orders: you don’t find employers in those surveys complaining about excessive wage demands.

    The basic NAIRU idea, at least as the acronym is defined in the Oxford Dictionary of Economics is simply the idea that there is a relationship between inflation and unemployment, and at that some level of unemployment, inflation rises too far.

    If in fact there is no such relationship, how come the opponents of NAIRU don’t advocate a MASSIVE INCREASE in demand with a view to cutting unemployment to a fraction of its present level? It’s because they know perfectly well that given a big enough increase in demand, inflation goes thru the roof. In short, the opponents of NAIRU in their heart of hearts know perfectly well they are talking nonsense.

  4. It’s deliberate IMO. Designed specifically to provide justification for the ‘reserve army of the unemployed’.

    Particularly as it is easily and permanently solved via a Job Guarantee.

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