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.