NAIRU — more religion than science

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

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.

Because 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