NAIRU — more religion than science

26 Jan, 2015 at 13:58 | Posted in Economics | 12 Comments

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In an interesting comment on a recent attempt at measuring NAIRU in the U.S., Matias Vernengo notes that NAIRU is basically measured as an average of actual unemployment and that a fortiori NAIRU

is NOT an attractor around which the actual unemployment level fluctuates. It is an average of the actual rate, which is essentially another way of writing the same data. It is the actual unemployment rate that determines the natural one, and if unemployment rates were reduced sufficiently with expansionary policies, the natural (being an average) would also come down. Economics is NOT a serious science.

NAIRU has been the subject of much heated discussion and debate lately. 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’t push unemployment below the critical NAIRU threshold without causing harmful runaway inflation.

One of the main problems with NAIRU is that if it essentially seen as a timeless long-run equilibrium attractor to which actual unemployment (allegedly) has to adjust, then 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.

When the NRH [the Natural Rate Hypothesis, or as it is often called today, the NAIRU theory] was first proposed, Friedman assumed that expectations are adaptive. The combination of adaptive expectations and the NRH led to a theory where variations in the unemployment rate are caused, primarily, by incorrect expectations. In this theory, households and firms forecast price inflation and their forecast determines which Phillips curve prevails in the period. Expected price inflation feeds into wages, and, through mark-ups, into realised inflation.

According to the NRH, unemployment differs from its natural rate only if expected inflation differs from actual inflation. If expectations are rational, we should see as many quarters when inflation is above expected inflation as quarters when it is below expected inflation. That suggests the following test
of the NRH.

ignore-the-facts-cartoonBecause a decade contains 40 quarters, the probability that average expected inflation over a decade will be different from naverage actual inflation should be small. If the NRH and rational expectations are both true simultaneously, a plot of decade averages of inflation against unemployment should
reveal a vertical line at the natural rate of unemployment … This prediction fails dramatically.

There is no tendency for the points to lie around a vertical line and, if anything, the long-run Phillips curve revealed by this chart is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically biased over decades, I conclude that the NRH is false.

Defenders of the Natural Rate Hypothesis might choose to respond to these empirical findings by arguing that the natural rate of unemployment is time varying. But I am unaware of any theory which provides us, in advance, with an explanation of how the natural rate of unemployment varies over time. In the absence of such a theory the NRH has no predictive content. A theory like this, which cannot be falsified by any set of observations, is closer to religion than science.

Roger Farmer

12 Comments

  1. It’s slightly more than that. Any policy based on any theory that requires millions and millions of citizens to live in penury is simply not fit for purpose.

    There is a reason they always talk in percentages. So that they don’t have to explain that means several cities worth of real individuals left *with no hope whatsoever*.

    It’s a disgusting anti-human concept.

  2. “One of the main problems with NAIRU is that if it essentially seen as a timeless long-run equilibrium attractor…”. Who ever said that NAIRU remains the same till the end of time (if that’s what you’re saying)? Those who use the NAIRU concept (like me) have always accepted that NAIRU will change with changes in other factors, like levels of education, the support that government gives to job search efforts by the unemployed, etc. Plus it is widely accepted that demand itself may influence NAIRU: that is, given a significant period of excess unemployment, those out of work may lose skills, which itself may raise NAIRU (though there is actually one study which disputes that point).

    NAIRU is essentially just the idea that there is a relationship between inflation and unemployment and that there is some level of unemployment at which “inflation remains constant” (to quote from the Oxford Dictionary of Economics definition of NAIRU). If in fact there is no such relationship, then the we can abolish unemployment tomorrow simply by organising a huge increase in demand. I suspect that unemployment in fact can’t be reduced to literally zero simply by raising demand.

    Re the fact that NAIRU cannot be measured with any accuracy, that doesn’t matter. The fact that it cannot be measured accurately doesn’t invalidate the idea that there is a relationship between inflation and unemployment. We haven’t the faintest idea what dark matter is or where it is or what its density is, etc etc. But it seems to exist, based on theory and observation. That’s good enough for me.

    • “Re the fact that NAIRU cannot be measured with any accuracy, that doesn’t matter. The fact that it cannot be measured accurately doesn’t invalidate the idea that there is a relationship between inflation and unemployment.”

      But it means we don’t know what that relationship is, so it’s not a useful policy tool.

  3. Neil,

    I’m moved to tears by your concern for “millions and millions of citizens to live in penury”. Millions and millions of people die in very unpleasant circumstances every month due to old age. Both my parents died, essentially from old age, recently. Their final weeks were pretty obviously pure Hell.

    You would deduce from that presumably that old age is thoroughly wicked and therefor doesn’t exist and/or doesn’t cause death.

    • Ahahahaha! Analogy is an excellent way to lie isn’t it! Economists really excel in its art. You pretend that you are studying a natural phenomenon, which you are obviously not doing.

      Please stop lying with analogies that are invalid and unfounded, thats how we got into this mess in the first place.

  4. When I think about accelerating inflation, I wonder why there is no Non-Accelerating Rate of Profit. In the runaway feedback loop of accelerating inflation, why is the focus on unemployment instead of other links in the loop?

    • There’s an obvious possible feedback loop in the case in the inflation / unemployment relationship. In the case of profit, there is no obvious loop – well nothing that’s obvious to me, anyway.

      • Thanks, Ralph.

        Suppose that we have full employment (like 2% plus). Employees have money to spend. But they don’t have enough to buy what they produce, or there would be no profit. Also, they save some of it. So what drives price increases? Profit has to be part of it, right?

        We are talking about an accelerating feedback loop, not a stable one. Given full employment, what causes the acceleration? Employers have to raise prices, right? They are human agents, not robots.

      • In Friedman, ’68, the source of the NAIRU idea, it seems, Friedman postulates a natural rate of unemployment that is higher than the level of unemployment that the gov’t targets. He then supposes that the gov’t increases the money supply, which increases aggregate demand. At first, he says, unemployment decreases, among other results, then inflation begins to increase. He states, “Because selling prices of products typically respond to an unanticipated rise in nominal demand faster than prices of factors of production, real wages received have gone down.” That is, real profits have risen.

        Friedman goes on to argue that as real wages catch up to real profits, unemployment will increase, tending to return to its natural rate, while the higher prices remain the same. (OC, if there is no natural rate, we cannot predict this phenomenon.) Then the gov’t will increase the money supply to reduce unemployment, leading to more inflation. Nowhere in his argument does he show that this feedback cycle leads inflation to increase without limit. That is, he does not show accelerating inflation. Nor does he address possible countermeasures to prices and profits increasing while wages remain the same.

        If I have misunderstood anything, I would be happy to be corrected. 🙂

  5. No religion, merely incompetence
    Comment on ‘NAIRU — more religion than science’
    .
    The discussion about NAIRU has always been vacuous because employment is given by the testable formula:

    For the scientifically valid derivation see (2014) or (2012).
    .
    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.
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics:
    Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.

  6. History and Theory of the NAIRU: A Critical Review
    MARCO A. ESPINOSA-VEGA AND STEVEN RUSSELL
    https://www.frbatlanta.org/-/media/Documents/filelegacydocs/ACFC1.pdf

    Espinosa is a senior economist at the Federal Reserve
    Bank of Atlanta.
    Russell is an assistant professor of
    economics at Indiana University-Purdue University
    at Indianapolis

    WHAT CAUSES CHANGES IN THE RATES OF INFLATION AND UNEMPLOYMENT? HOW ARE
    THE PRICE LEVEL AND THE LEVEL OF EMPLOYMENT RELATED? THESE HAVE BEEN KEY QUESTIONS FACING ECONOMISTS FOR AT LEAST FORTY YEARS…

    “An important element of this approach is the concept of a nonaccelerating inflation rate of unemployment, or NAIRU.

    Despite the extensive press coverage the NAIRU concept
    has received recently, the theory of the inflation unemployment
    relationship that it is part of is quite controversial.

    Although the NAIRU is alive and well in the media and among economic policymakers, it is no longer very popular among academic economists.

    It has fallen out of favor partly because its conceptual foundation is
    weak and partly because its empirical track record does
    not inspire confidence.

    Its survival is due largely to the
    fact that economists have not been able to reach any consensus
    about alternative guides for monetary policy.

    The purpose of this article is to provide some historical perspective
    on the “NAIRU theory” and the assumptions behind it… Readers interested in additional details should consult the reference list.”

  7. Naive arithmetic
    Comment on Jan Milch about ‘NAIRU — more religion than science’
    .
    Thank you for the link.
    .
    You summarize: “It [NAIRU] has fallen out of favor partly because its conceptual foundation is weak and partly because its empirical track record does not inspire confidence.”

    The conceptual foundation is not weak but false.

    The original Phillips curve was about the relation of the rate of unemployment and the rate of change of the wage rate (Phillips, 1958). Phillips studied more than a century’s worth of data and established the stable inverse relation for the United Kingdom. Phillips’s original curve was a remarkable empirical finding. It has to be emphasized that Phillips ‘had not made an explicit link between inflation and unemployment’ (Ormerod, 1994, p. 120).

    The original curve was transformed by Samuelson with the simple formula: rate of inflation = rate of wage growth — rate of productivity growth (Samuelson und Nordhaus, 1998, p. 590). This formula, according to Samuelson an ‘important piece of inflation arithmetic’, says that price inflation runs in tandem with wage inflation and that both have basically the same effect on employment respectively the rate of unemployment. The difference between the original and the bastard Phillips curve consists of a 1 percent productivity growth. This naive arithmetical exercise led to the far-reaching policy conclusion that there exists an exploitable trade-off between inflation and unemployment.

    Needless to say that this basic version experienced refinement, reinterpretation and qualification in the sequel. It was completely overlooked in the ensuing filibuster, though, that, to begin with, the underlying arithmetic was fallacious. The lack of a sound theoretical foundation did not prevent the application of the Samuelson-Solow Phillips curve. Quite the contrary. Phillips is said to have remarked ‘if I had known what they would do with the graph I would never have drawn it.’ (Quiggin, 2010, p. 91).

    You summarize: “Despite the extensive press coverage the NAIRU concept has received recently, the theory of the inflation unemployment relationship that it is part of is quite controversial.”

    The correct inflation unemployment relationship is given in the most elementary form by:

    Roughly speaking, this structural Phillips curve says: if price inflation is ‘stronger’ than wage inflation unemployment increases; if price inflation is ‘weaker’ than wage inflation unemployment decreases; if both are of ‘equal strength’ then the structural Phillips curve is a vertical at the actual unemployment rate. For the details see (2012).
    .
    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.
    Ormerod, P. (1994). The Death of Economics. London: Faber and Faber.
    Phillips, A. W. (1958). The Relation Between Unemployment and the Rate of
    Change of Money Wage Rates in the United Kingdom, 1861-1957. Economica,
    25: 283–299. URL http://www.jstor.org/stable/2550759.
    Quiggin, J. (2010). Zombie Economics. How Dead Ideas Still Walk Among Us.
    Princeton, NJ, Oxford: Princeton University Press.
    Samuelson, P. A., and Nordhaus, W. D. (1998). Economics. Boston, MA, Burr
    Ridge, IL, etc.: Irwin, McGraw-Hill, 16th edition.


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