It’s high time to bury Milton Friedman’s natural rate hypotheis

31 Jan, 2018 at 17:23 | Posted in Economics | 1 Comment

Fifty years ago Milton Friedman wrote an (in)famous article arguing that (1) the natural rate of unemployment was independent of monetary policy and that (2) trying to keep the unemployment rate below the natural rate would only give rise to higher and higher inflation.

The hypothesis has always been controversial, and much theoretical and empirical work has questioned the real-world relevance of the ideas that unemployment really is independent of monetary policy and that there is no long-run trade-off between inflation and unemployment.

In the latest issue of Journal of Economic Perspectives there are three articles — by Greg Mankiw/Ricardo Reis, Robert Hall/Tom Sargent, and Olivier Blanchard — on Friedman’s natural rate hypothesis.

The first two articles are of the nowadays common Chicago-New Keynesian mumbo jumbo ilk and will not be further commented on here.

Although Blanchard has his doubts — after having played around with a ‘toy model’ and looked at the data — he lands on the following advice:

iwf-chefvolkswirt-olivierWhere does this leave us? It would be good to have a sense of … the specific channels at work. The empirical part of this paper has shown that we are still far from it. Thus, the general advice must be that central banks should keep the natural rate hypothesis (extended to mean positive but low values of b and a) as their baseline, but keep an open mind and put some weight on the alternatives. For example, given the evidence on labor force participation and on the stickiness of inflation expectations presented earlier, I believe that there is a strong case, although not an overwhelming case, to allow U.S. output to exceed potential for some time, so as to reintegrate some of the workers who left the labor force during the last ten years.

My own view on the subject is that the natural rate hypothesis does not hold water simply because the relations it describes have never actually existed.

The only thing that amazes yours truly is that although this is pretty ‘common knowledge,’  so-called ‘New Keynesian’ macroeconomists still today use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why? Because without it ‘New Keynesians’ have to give up their (again and again empirically falsified) neoclassical view of the long-run neutrality of money and the simplistic idea of inflation as an excess-demand phenomenon.

The natural rate hypothesis approach (NRH) is not only of theoretical interest. Far from it.

The real damage done is that policymakers that take decisions based on NRH models systematically implement austerity measures and kill off economic expansion. The unnecessary and costly unemployment that this self-inflicted and flawed illusion eventuates, is something its New Classical and ‘New Keynesian’ advocates should always be kept accountable for.

 74-7495-LTNQ100ZIf 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 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 …

Roger Farmer

It is definitely time to bury the natural rate hypothesis!

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