Wednesday, September 6, 2017

The Economist and the natural rate of unemployment

The Economist new series on 'big ideas' tackled in a recent issue the concept of the natural rate unemployment (subscription required; other ideas included Say's Law and Human Capital, just to give you the broad picture of what they think it's big). I will only comment very briefly on two issues, one related to the history of ideas and the other to the concept itself.

The Economist suggests that the natural rate of unemployment can somehow be connected to the ideas of Keynes. In their words:
John Maynard Keynes, the great British economist, took a first step towards the natural-rate hypothesis when he focused minds on 'involuntary' unemployment. In his book 'The General Theory'.
The idea of a natural rate of interest can be clearly traced back to marginalist economics, and was a central concept discussed by Knut Wicksell. The idea of the natural rate of unemployment, as The Economist correctly points out, is essentially related to Milton Friedman's American Economic Association Presidential address of almost half a century ago, and the Monetarist interpretation of the Phillips Curve (PC).

However, Keynes' Wicksellian days were over by about 1932, when in the aftermath of the Circus discussions, he abandoned the theoretical framework of the Treatise on Money and started on his way to effective demand and the General Theory (GT). Note that the idea of a natural rate of interest is intrinsically connected to the natural rate of unemployment, since the former would be the rate of interest that corresponds to full employment and stable prices, meaning the equilibrium in the labor market.

On the natural rate of interest, Keynes had this to say in chapter 17 of the GT:
... it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment. 
I am now no longer of the opinion that the concept of a 'natural' rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis.
There is little room for doubt that Keynes rejected the natural rate rather than taking the "first steps" in its direction, as The Economist suggests. He was clearly moving away decisively from that flawed concept, which leads me to discuss the concept itself and what the magazine (they think somehow they're a newspaper, strangely enough) thinks one must do to reject the concept.* The Economist says:
... to reject the natural rate entirely, you would need to believe one of two things. Either central banks cannot influence the rate of unemployment even in the short term, or they can peg unemployment as low as they like—zero, even—without sparking inflation. Neither claim is credible.
The second part shows that they presume that the absence of a natural rate means that the economy could be driven to zero unemployment without inflation (I'll deal with the first statement about the effect of monetary policy on employment subsequently). This is the case because for The Economist, as much as for many in the mainstream of the profession, inflation is always a demand phenomenon. Too much spending, often government (meaning fiscal policy) is behind inflationary pressures. Of course, the PC only works empirically when supply side factors, like the price of oil, are included as explanatory variables. So they think that if you reject the natural rate you must think there is no limit to demand expansion.**

Inflation, more often than not, is a cost push phenomenon associated to higher prices of commodities, devalued exchange rates, and more social conflict reflected in higher wage resistance. So, lower unemployment would eventually strengthen the labor force, and would lead to higher wages, and that combined with possible sectoral shortages of raw materials, which would also be more expensive, would lead to inflation. So you might very well get inflation before you reach zero unemployment rate, but the reasons are not the ones the magazine authors think. The point is that there is no reason to think that there is one level of unemployment that magically would lead to inflation. No natural rate, but several possible rates of unemployment compatible with stable prices, depending on a whole set of social and institutional conditions.

And the central bank can affect unemployment, even if its ability is not straightforward and is asymmetrical. In a recession, a lower rate of interest is, as Eccles famously said (he really popularized the phrase, but he did not coin it), like pushing on a string. You need fiscal spending in that situation, as has been painfully obvious during the long Obama recovery. But in a boom a hike to the rate of interest, in particular if it affects debtors, might cause a recession. So The Economist is wrong (I'm shocked, shocked!). You can believe that central banks affect unemployment and that there is some inflation barrier, but that does NOT mean that there is a natural rate.

Interestingly enough, they do admit that they (and economists in general) have no clue what is the correct natural rate of unemployment, and that should make the natural rate concept of limited usefulness for policymakers. So what they propose central banks should do? Use a flawed concept that cannot be measured as the guide for policy? That's some serious thinking, isn't it?

* Too many posts on the problems with the natural rate have been discussed over the years in this blog, just click on the hashtag and check a few if you're interested.

** Note, also, that when demand goes up, firms do invest to adjust capacity, which means that the capacity limit is not fixed either.

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