Debunking the NAIRU myth

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

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’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.

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9 Comments

  1. Totally agree. Central banks claim that they have buried NAIRU but I do not believe them.

  2. “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.”

    Complete nonsense. NAIRU advocates are perfectly well aware of the very obvious point that labour market characteristics can change over time. Amazing as it might seem, they are not so dumb as to be unaware that improved training and better employment agencies will cut NAIRU.

    • But NAIRU advocates are dumb enough to believe in a number that no one can honestly say what it is?

      • Science (chemistry, astronomy, etc) are full of instances where it’s obvious there is some sort of relationship between two variables, but it is not possible, given the present state of the art, to accurately measure the relationship.

        Prior to pictures being taken of the far side of the Moon, no one knew exactly how many craters there were there more than 1km across. But neither astronomers, nor anyone with a grain of common sense, suggested there were therefor no craters on the far side of the Moon.

      • Ralph, if you want to believe in a number that is not quantifiable then go right ahead. That’s fairly harmless. Just don’t advocate policy based on this belief. That can do real harm.

  3. Also, the implicit assumption behind the NAIRU should be stated outright: that uncontrollable price rises will invariably destroy economic life as a whole if women, minorities, and poor persons are all guaranteed meaningful and decently paid jobs. This assumption is both logically absurd and socially abhorrent.

  4. I have never been without work in my life. I have however been without pay for suprisingly much of the time. I have also had a severe lack of access to the material means to do work. But never without work.

    NAIRU should really be. Non Accelerating Inflation Rate of Pay, or Non Accelerating Inflation Rate of Access to Material Means of Production.

    But put that way it certainly makes no sense what so ever.

  5. Perhaps the antagonism to NAIRU of Bill Michell and other MMTers is because they believe that a Job Guarantee scheme would both make unemployment zero and also “anchor” inflation. Ergo NAIRU does not exist.
    The fallacies of this view are:
    1. In the concept of NAIRU, “unemployment” is a reflection of the output gap. JG jobs and other types of “concealed” unemployment should therefore be included in unemployment data for the purposes of NAIRU.
    2. The JG wage might have some influence on the lowest wage rates, but it would have only a very limited effect on inflation in most of the economy (c.f. minimum wage legislation).

  6. A small amount unemployment is inevitable simply to reflect the dynamics of the economy and some inflation is desirable. To tip the balance in favour of labour the economy needs to be run to the point of ‘overheating’ i.e. 2% unemployment is a good target!


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