Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 24 February 2017

The NAIRU: a response to critics

When I wrote my piece on NAIRU bashing, I mainly had in mind a few newspaper articles I had read which said we cannot reliably estimate it so why not junk the concept. What I had forgotten, however, is that for heterodox economists of a certain hue, the NAIRU is a trigger word, a bit like methodology is for mainstream economists. It conjures up lots of bad associations.

As a result, I got comments on my blog that were almost unbelievable. The most colourful was “NAIRU is the economic equivalent of "Muslim ban"”. At least two wanted to hold me directly responsible for any unemployment at the NAIRU. For example: “So according to you a fraction of the workforce needs to be kept unemployed.” Which is a bit like saying to doctors: “So according to you some people have to be allowed to die as a result of cancer.”

I have to say straight away that not everyone responded in that way. Some were much more thoughtful and constructive (like Jo Michell, for example). But the less thoughtful reactions are interesting in a way too.

I need to recap what the NAIRU is, particularly because heterodox economists seem to imagine it is many things it is not. Let’s take a very simple Phillips curve

Inflation this period = expected inflation next period - aU +b

where ‘a’ is a parameter and U is a measure of excess supply/demand in the economy. Unemployment will be one measure of that excess supply, but it is far from a perfect measure. (That my previous post was about excess supply, rather than actual unemployment, was obvious from what I wrote.) ‘b’ stands for a collection of slow moving variables. These could include a measure of union power, or how mobile labour was, or the degree of monopoly in the goods market. The NAIRU is defined as

NAIRU = b/a

If U is less than the NAIRU over a sustained period then inflation will rise, which will increase inflation expectations, which increases inflation further etc.

The concept is of interest to policymakers involved in demand management. They have to decide how much they can push demand before inflation starts rising. If they are independent central banks, they have to accept the world as it is. The NAIRU is a description of how the economy works: nothing more or less. This is why complaints that economists who use or estimate the concept are somehow responsible for those left unemployed are so dumb.

Of course you can criticise the concept of the NAIRU, but logically that has to involve criticism of the Phillips curve from where it comes. It is also reasonable to argue that the concept is fine, but the NAIRU is so difficult to measure that it would be better not to try and estimate it or let it guide policy. I have a lot of sympathy with that view at the moment, which is why I argue that, in the US right now, policy makers should find the NAIRU by allowing inflation to rise above target. But that point of view was irrelevant in my previous post, which was about the concept of the NAIRU, not its measurement.

As far as the concept is concerned, I think the strongest attacks come from thinking about hysteresis, as Jo Michell suggests. But even here, we add a complication to the NAIRU analysis, rather than overturn that analysis altogether. What hysteresis does is to make periods where unemployment is above the NAIRU extremely costly. It also means that periods of being slightly below the current NAIRU might be justified if they reduce the NAIRU itself.

I want to end by adding two reflections. The first relates to modelling the NAIRU. There once was, following the work of Layard and Nickell, an empirical literature that attempted to model for OECD countries a time series for the NAIRU, using proxy variables for things like union power, the benefit regime and geographical mismatch. With the dominance of the microfoundations methodology that work appears to have decreased, although to some extent it is still there in work based on matching models. I would be very interested to know if that time series analysis, now potentially enriched by matching models and flow data, has continued in any way.

The second relates to the sharp reactions to my original post I noted at the start, and the hostility displayed by some heterodox economists (I stress some) to the concept. I have been trying to decide what annoys me about this so much. I think it is this. The concept of the NAIRU, or equivalently the Phillips curve, is very basic to macroeconomics. It is hard to teach about inflation, unemployment and demand management without it. Those trying to set interest rates in independent central banks are, for the most part, doing what they can to find the optimal balance between inflation and unemployment.

Accepting the concept of the NAIRU does not mean you have to agree with their judgements. But if you want to argue that they could be doing something better, you need to use the language of macroeconomics. You can say, as many besides myself have done, that the NAIRU is either a lot lower than central bank estimates, or is currently so uncertain that these estimates should not influence policy. But if you say that the NAIRU has to be Bashed, Smashed, And Trashed, you will not get anywhere.

I also get very annoyed when I hear refutation by reference (as here for example). It would be so easy to write my blog posts that way. Instead I generally try to explain or present an argument that I hope is understandable. Economics is usually not so hard that this is impossible, although finding the right words is never easy. Economics is certainly not a religion, where all you have to do is choose which sect you belong to and then follow great works.     

25 comments:

  1. I will mostly repeat most of my comments from your previous blog post.

    NAIRU is not a general concept but rather a very specific concept. It forecasts inflation ACCELERATING below a certain unemployment level. As such it is a very specific, linear model of the economy and assumes a certain functional form for the Phillips Curve, the Accelerationist type.

    It is very hard to define a NAIRU if you have anchored inflationary expectations with a very weak effect of past inflation on them. It becomes even harder to do so if the PC slope is exceptionally small and thus it takes large swings in the unemployment rate in order to raise inflation sufficiently to influence expectations. If you also include investment and the capital stock as one of the "small moving variables" and do not assume perfect substitution of capital by labor then any NAIRU concept becomes endogenous to the state and the pressure of the economy.

    From the above it is clear (and quite consistent with recent research) that you can easily postulate a level (instead of an accelerationist) Phillips Curve model where inflation is stationary, expectations anchored, current inflation has minimum effect on expectations and the PC slope is small.

    That is a perfectly reasonable model which allows the central bank to test the waters by lowering unemployment until inflation starts moving without such actions leading to inflation accelerating. The question then becomes why economists must remain committed to a model which forecasts accelerating inflation and thus creates a large cost for lowering unemployment.

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  2. I don't think critics really understand what you are saying. Most of them are not arguing about the existance of NAIRU: they are simply argueing that NAIRU exists but it should be close to zero.

    On this it would seem easy to agree with them: we should promote policies that lower NAIRU. Or at least research on what such policies would look like.

    Sometimes they seem to just assume that such policies are possible (and on that they seem a bit optimistic), but the goal itself seems reasonable.

    I think there is a reasonable arguement that zero is an impossible target (a bit like you'll never have a friction-less surface). But it's hard to get a sense of what the friction should be. At the limit, a NAIRU of zero requires an economy where an unlimited number of people can find a job overnight even when entering the workforce for the first time. That sounds impossible to me...

    I very much doubt you disagree with this. But maybe you should just state that the concept of NAIRU does not imply that NAIRU could be very close to zero.

    There is a different aspect of this debate as well: I agree that central bankers haven't got the tools to influence NAIRU substantially. Politicians are and should be in charge of that aspect of economic policy. Central banks already struggle in managing the demand cycle as well as they can. Arguing that they should manage the structural side of the economy seems a bit crazy to me.

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  3. “What I had forgotten, however, is that for heterodox economists of a certain hue, the NAIRU is a trigger word…”. Too right.

    The best example of this is Bill Mitchell, who foams at the mouth at the mention of “NAIRU”, but who (like those who are comfortable with the acronym) finds the CONCEPT indispensable. So what does Bill do? He has his own acronym: “IB”, which stands for “inflation barrier”.

    But I should say that Bill has done a great job in combating what SW-L calls “Macromedia”: the belief that in a recession we have to endure austerity in order to keep the deficit and debt within bounds.

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  4. "Inflation this period = expected inflation next period - aU +b"

    Wrong model.

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  5. There is a rich PK literature working with a NAIRU that follows up on he NK analysis of the OECD data. E.g http://www.postkeynesian.net/downloads/working-papers/PKWP1406.pdf

    Unsurprisingly LMIs are not the bad guys in that story but rather, as you say, hysteresis caused by inadequate demand. I think the wider heterodox commmunity get upset because they've given up waiting to be heard even when they show willing to play the NK game.

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  6. In the broadest possible sense the NAIRU seems sensible because it is reasonable to assert at any given time there must a possible macroeconomic state where inflation will not accelerate.

    Unfortunately this broad sense of NAIRU helps little because the stable state is unknown and instantaneous, fluctuating with time. Of what use can such an uncertain concept be in demand management except in the crudest way and if used to manage future inflation by erring on the side of reducing demand too much.

    We would seem to agree on this, policies makers have focussed too much on the potential risk of higher inflation at the expense of higher unemployment.

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  7. This is a question rather than a criticism.

    You say that " you can criticise the concept of the NAIRU, but logically that has to involve criticism of the Phillips curve from where it comes".

    Is that right? It seems to me that you could endorse your Phillips curve equation (or many other) and still criticise the cogency of the NAIRU concept.

    A simple case, if the parameter a=0, then the NAIRU, defined as (b/a) is undefined.

    Another case, suppose various values of (a,b) are consistent with the Phillips curve equation. Then we shouldn't speak of *the* NAIRU. If there are indefinitely many values of (a,b) yielding a single value for inflation, it's not clear we should even speak of a family of NAIRUs. But this could be the case even if the Phillips curve equation holds true.

    Finally, suppose b is a function of current inflation (call it f[π]). Maybe union power, mobility of labour, etc. depend on the rate of inflation in some way. Then the NAIRU will be (f[π]/a). And it that case it doesn't correspond to the usual concept of the NAIRU, since it depends on inflation rather than being part of what determines inflation. But the Phillips curve equation you have can still hold true, e.g. if inflation is determined in some other way.

    I'm not saying any of these is plausible - I'm not an economist. But it seems to me they are some ways you could critique the NAIRU concept without this logically entailing a rejection of the Phillips curve relationship. Just wondered what you thought, or if I'd misinterpreted you.

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  8. Here's an explanation of how SFC models don't have NAIRU:

    http://www.concertedaction.com/2017/02/24/the-non-existence-of-nairu-in-sfc-models/

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  9. My thoughts as a non economist:

    I don't actually understand enough about NAIRU to say one way or another if it's a good thing for demand management or not, but surely if policy requires that there needs to be a balance between inflation and unemployment, then how can policymakers also justify the deep and discriminatory attack on the unemployed? After all, those unable to get jobs due to the lack of available jobs are surely performing an economic benefit by being unemployed? And is unemployment really the only buffer stock solution to inflation control?

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  10. Professor,
    You are drawing a distinction between the concept of something and the measurement of that something. You are suggesting that measurement difficulties do not invalidate the concept of the thing you are discussing. At least, this is how I read your commentary.

    As an example, you might have a pint of beer in your hand. I might argue that it is not precisely a pint, the volume is a bit variable depending on how quickly the beer evaporates (and how effectively you assist the evaporation process). But obviously it is still a beer and I am wrong when I say that the challenges associated with measuring the volume of your beer invalidates the fact that you have a pint of beer in your hand. If I am right, this is a fair analogy of your argument.

    But pretend I state that I have magical powers. You might argue it is extremely hard to measure them. I might retort that your challenges associated with measuring my powers does not invalidate my powers. But obviously I am wrong. If I can't demonstrate the ability to perform magic at any point in the future, and I don't have strong evidence of having performed magic in the past, the presumption should be that my powers are bogus.

    My view is that NAIRU is not a tangible thing like a beer. It is intangible, like my magical power assertion. For an intangible item such as this, if the difficulties in measurement are too great, it really does invalidate the concept.

    The other obvious point is that if the concept of NAIRU does not itself lead to falsifiable predictions, it is useless. If no one in the US can say what NAIRU is right now, nor what it has been for the last 20 years (say, since 1997), what, really, is the utility of this concept? Would it not be equally useful to have as a concept that when inflation starts to increase, one should raise interest rates?

    I believe I am agreeing with your instruction that "that the NAIRU is [...] currently so uncertain that these estimates should not influence policy." Except I am not sure about the word "currently." And if it should not influence policy, I think whether the thing exists or not is highly academic. At that point it is not a useful model.

    Thank you for the opportunity to share my thoughts. Respectfully,

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  11. One point which is beyond the comprehension of NAIRU bashers is that just because one cannot measure something accurately (and indeed NAIRU cannot be measured accurately) that does not make it illogical to assume in an argument or set of equations that there is some precise level of unemployment at which inflation starts to accelerate. Astronomers may have no idea what % of the Moon is made up of iron. That does not make it illogical to assume a particular percentage and see how that ties up with other aspects of the Moon: its orbit or whatever.

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  12. If, as you argue here, the NAIRU may be much lower than central bank estimates or there is a great deal of uncertainty in its calculation, (as Paul Krugman also argues here https://krugman.blogs.nytimes.com/2015/09/18/the-receding-nairu/?_r=0 and here https://krugman.blogs.nytimes.com/2015/03/06/the-nairu-straitjacket-and-cromwells-rule/) is it possible that the adherence to an overestimated NAIRU has been responsible for a great deal of slack in the labour market over the last four decades and has at least been a contributory factor to growing inequality, keeping demand for labour low and thereby suppressing wage growth? Obviously it would only be one of many factors responsible for this.

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  13. Keynes knew that as we approached full employment then increasing demand would begin to go more into prices than into increasing employment

    so that attempting to increase demand past a certain point offers no increase production, only increased prices, in the short run

    in the long run it might have a positive effect on productivity but that is not under discussion here

    so lets not forget that this is all about demand side policy, government spending or not

    we are so worried that "inflaton will get out of control" and prices will keep going up causing real income to go down

    nope

    when full employment is achieved, and profits are maximized,

    and there is no return on further investment


    then are they saying people and governments wont figure that out?

    the implication, by those who oppose full employment policies is that it will cause a supply side inflation

    that is always their argument, full employment will make businesses inefficient and employees fat and lazy

    so lets put the argument where it really is

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  14. NAIRU can be taken as a package-deal, and selling that can fail on other elements in the package than you discuss. From centuries of histories I got the impression that you can decide on how to write. Some will disagree while others will thisagree, that is on what they read, which may be another thing. A teacher has to try making his pupils or students obey, as it is required to pass the test, but else where in live 51% is quite something.

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  15. Lies are alternative facts. Unemployment consistent with NAIRU is full employment. Too bad if it's you who's unemployed and not an Oxford professor. The capitalist economy requires it!

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  16. As far as I can see the criticism isn't about the concept that inflation and unemployment are related. The criticism is about the use of the NAIRU as a target. The assumption seems to be that 5%, or whatever the number is, of people have to be kept unemployed in order to keep inflation down. The idea of deliberately imposing misery on millions of people as a policy decision seems pretty immoral. Why is inflation considered worse than unemployment?

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    1. Because when unemployment is below NAIRU, it would mean inflation keeps increasing, so it will become hyperinflation if you keep unemployment below NAIRU. Some commenters here dispute that there will always be a level of unemployment that will have that effect.

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  17. As Brian says:

    "Given the advances in digital computing, you could put a grid over the range of UR values, and calculate all the potential NAIRU time series, and reject all of them.

    According to the definition, deviations from NAIRU has an easily inferred effect on inflation, which is allegedly only affected by "random shocks". The probability of those shocks lining up to actual outcomes is about 0%.

    Mainstream macro abolished uncertainty, and replaced it with randomness. Complaining about an "uncertain" NAIRU without a theory that allows uncertainty is ridiculous.

    Meanwhile, if you cannot come up with a NAIRU estimate, how does the representative household?"

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  18. Philip Inman in the Graun today:

    "Last week MPs asked four Bank policymakers how they could be so wrong year after year. They asked the question after the Bank’s monetary policy committee revised down the natural level of unemployment from 5% to 4.5%

    It is easy to see why they would be perplexed. The level was 7% in 2013 when the current governor Mark Carney arrived and declared that he would need to consider raising interest rates once unemployment dropped to 7%. The thinking behind the policy was that once unemployment hits its natural rate, the labour market will be so tight that workers can almost walk into a job and in their newly confident state, start to bid up their wages.

    Today unemployment stands at 4.8%, which according to the 5% rule means wages should be starting to soar, but under the revised 4.5% target, it is reasonable to expect wages to inch forward at best."

    From you piece:

    "Those trying to set interest rates in independent central banks are, for the most part, doing what they can to find the optimal balance between inflation and unemployment."

    As you also say "You can say ... that the NAIRU is either a lot lower than central bank estimates, or is currently so uncertain that these estimates should not influence policy."

    I think the point that most critics would say is that, while NAIRU might exist conceptually, it has no utility.

    Yet we have seen over the last 30 years that it has been used as an argument/excuse to suppress both demand and wages.

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  19. NAIRU and the scientific incompetence of Orthodoxy and Heterodoxy
    Comment on Simon Wren-Lewis on ‘The NAIRU: a response to critics’ and Lars Syll on ‘Simon Wren-Lewis — flimflam defender of economic orthodoxy’

    The NAIRU Phillips curve is an explicit formal description of the functioning of the macroeconomic labor market. Formal description means that one has a number of variables and their relationships which summarize the current knowledge of how the economy or some part of it works. Scientific knowledge is embodied in the true theory.

    Right policy depends on true theory: “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum)

    The two questions that arise with any description are: (i) is it conceptually/logically consistent, and (ii), is it materially consistent? The second question involves the measurability of variables, the practical problem of measurement, data gathering, and statistical methodology. From a description that is either formally inconsistent or materially inconsistent ANY economic policy conclusions can be drawn. Put the other way round, policy proposals that are not based on a materially/formally consistent theory are at the same level as sitcom blather, storytelling, or soap box agenda pushing.

    Economic policy guidance that is not based on the true theory is pretty much the same as ancient Roman poultry entrails reading.

    The NAIRU Phillips curve is scientifically worthless because it is conceptually inconsistent.#1 So, any discussion about measurement problems or the economic policy implications of a NAIRU is pointless. Needless to emphasize that most of the discussion circles around these distracting side issues.

    The NAIRU Phillips curve is integral part of standard economics: “The concept of the NAIRU, or equivalently the Phillips curve, is very basic to macroeconomics. It is hard to teach about inflation, unemployment and demand management without it.”#2

    Standard economics is built upon this set of foundational propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub)

    It should be pretty obvious that the standard axiom set contains THREE NONENTITIES: (i) constrained optimization (HC2), (ii) rational expectations (HC4), (iii) equilibrium (HC5).

    See part 2

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  20. Part 2

    Methodologically, the neo-Walrasian axioms are forever unacceptable but scientifically incompetent economists from Jevons/Walras/Menger onward accepted them as defining the ‘language of economics’: “Accepting the concept of the NAIRU does not mean you have to agree with their judgements. But if you want to argue that they could be doing something better, you need to use the language of macroeconomics.”#2

    Not at all! The neo-Walrasian language of macroeconomics is composed of NONENTITIES and this leads quite naturally to measurements problems, material inconsistency, and vacuous political blather. So Heterodoxy is right in saying that “the NAIRU has to be bashed, smashed, and trashed”.

    The problem of traditional Heterodoxy is that it has nothing better to offer.#3 The standard microfoundations HC1/HC5 are false, but Keynesian macrofoundations are also false. So, both orthodox and traditional heterodox labor market theories are proto-scientific rubbish.#4 As an inevitable consequence, the whole discussion about NAIRU has degenerated to the squabble of political sects. Wren-Lewis tries in vain to deny this plain fact: “Economics is certainly not a religion, where all you have to do is choose which sect you belong to and then follow great works.“

    What has to be done to get out of confused sectarian squabble is to fix the labour market theory by putting it on consistent macrofoundations.

    Two factors determine macroeconomic employment: overall demand and the price mechanism, or more specifically, the actual configuration of average wage rate, price, and productivity. By consequence, economic policy is about private/public demand management AND wage/price management.

    The correct theory of the macroeconomic price mechanism tells us that ― for purely SYSTEMIC reasons ― the average wage rate has in the current situation to rise faster than the average price. THIS opens the way out of mass unemployment, deflation, and stagnation and NOT the blather of scientifically incompetent orthodox and heterodox agenda pushers.#4

    Egmont Kakarot-Handtke

    #1 See ‘NAIRU, wage-led growth, and Samuelson’s Dyscalculia’
    http://axecorg.blogspot.de/2015/01/nairu-wage-led-growth-and-samuelsons.html
    #2 See SWL ‘The NAIRU: a response to critics’
    https://mainlymacro.blogspot.de/2017/02/the-nairu-response-to-critics.html
    #3 See LPS ‘Simon Wren-Lewis — flimflam defender of economic orthodoxy’
    https://larspsyll.wordpress.com/2017/02/25/simon-wren-lewis-flimflam-defender-of-economic-orthodoxy/
    #4 See ‘Mass unemployment: The joint failure of orthodox and heterodox economics’
    http://axecorg.blogspot.de/2017/01/mass-unemployment-joint-failure-of.html

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    1. Egmont I see you on Economist's View as well as here and the reason ppl don't pay attention to you is your verbose, sneering, purple prose which will do nothing to entice ppl to go and read your papers. You should change your approach.

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  21. Economics is certainly not a religion, where all you have to do is choose which sect you belong to and then follow great works.“

    This is an ignorant remark that it is no doubt a criticism of those who condemn macroeconomics as a fictitious construction built for the sake of allowing people to solve simultaneous equations and of those who argue that reform in economics should start with familiarity of the classics. You do not follow "A great book". You read a number. What; do you think if you read Smith, Keynes and Marx you are following a sect? The views of these authors at a fundamental philosophical level could not be more different. You would get a far more balanced and informed view of the economy than you will from reading a single text Mankiw (which is copiously reproduced elsewhere with essentially the same drivel).

    The problem with NAIRU is that it encourages intellectual laziness and a lack of curiousity. You should try and understand what the capacity constraints are in the economy, not try and find some magic number for aggregate employment which sets off accelerating inflation.

    NK.

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    1. Anonymous

      For the final word on NAIRU see the comment on David Glasner’s recycling of dead but not yet buried Phillips curve stuff ‘NAIRU and economists’ lethal swampiness’
      http://axecorg.blogspot.de/2017/03/nairu-and-economists-lethal-swampiness.html

      You are certainly right in stressing that economics is not a religion: actually it is a fake science. This applies to Walrasianism, Keynesianism, Marxianism, Austrianism.

      Egmont Kakarot-Handtke

      Delete

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