Debunking the NAIRU myth

18 Feb, 2017 at 17:54 | Posted in Economics | 9 Comments

In 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’t push unemployment below the critical NAIRU threshold without causing harmful runaway inflation.

Although 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 equlibrium 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 refering to NAIRU.

The existence of long-run equilibrium is a very handy modeling 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 world 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.