Stirati on the NAIRU

Surprisingly there was no entry on the Non Accelerating Inflation Rate of Unemployment (NAIRU) in the New Palgrave Dictionary of Economics. There is, and remains there, one on Milton Friedman's Natural Rate of Unemployment, written by Michael J. Pries. Both are deeply interconnected concepts. In fact, Antonella Stirati, who I asked to write it, presents the NAIRU as a reformulation of Friedman's natural rate within models that allow for real wage rigidities and involuntary unemployment.

Despite differences in microeconomic foundations, both concepts imply a vertical long-run Phillips curve and share three central propositions. First, the equilibrium unemployment rate is determined independently of aggregate demand. Also, unemployment below it causes accelerating inflation. Finally, actual unemployment is eventually drawn back toward it.

In the standard wage-setting/price-setting model, the NAIRU is the unemployment rate required to reconcile workers' real-wage claims with firms' desired markup. Labor-market institutions (e.g. unemployment benefits, employment protection and union bargaining power) do not directly determine the real wage, which is constrained by productivity and the markup. Instead, they determine how much unemployment is required to discipline workers sufficiently to make wage claims compatible with the markup.

This framework generates a wage-price spiral whenever unemployment departs from the NAIRU. In New Keynesian versions, stronger aggregate demand first reduces involuntary unemployment. Then lower unemployment raises wage claims, which are assumed to pass fully into prices because the real markup is fixed. Monetary policy subsequently raises interest rates, reduces investment and aggregate demand, and restores unemployment to the NAIRU. Stirati emphasizes that this adjustment mechanism depends on two weak assumptions, one that interest rates reliably control private investment and demand, and then that departures from the NAIRU have a sufficiently strong and predictable effect on inflation.

 

The policy consequences are strongly supply-side. Because the NAIRU is attributed to labor-market institutions, reducing unemployment supposedly requires weaker employment protection, lower unemployment benefits, diminished union bargaining power and, sometimes, greater product-market competition. The whole neoliberal policy agenda. Keynesianism is impossible, since aggregate-demand policy can affect unemployment only temporarily, while permanently changing the inflation rate.

 

Her principal criticism concerns estimation. The NAIRU is unobservable, yet it is central to monetary policy, potential-output calculations and European fiscal rules. In practice, estimates are extracted from the trend of actual unemployment or chosen so that the estimated unemployment gap best explains inflation. Consequently, movements in unemployment that do not produce inflation are simply absorbed into a changing estimated NAIRU and relabeled as "structural." The resulting estimates are highly uncertain, frequently revised and closely track actual unemployment, often without corresponding changes in labor-market institutions.

 

The evidence is really against it. Major historical episodes completely contradict the model predictions. For example, persistently high European unemployment did not produce accelerating deflation. Or the low unemployment of the Clinton boom did not produce accelerating inflation, and the sharp post-2008 rise in unemployment did not cause sustained deflation. This suggests that the estimated NAIRU is less an independent structural attractor than a moving average of unemployment shaped by aggregate demand and capital accumulation.

 

The entry’s central argument is that all three defining properties of the NAIRU, its independence from demand, its role as an inflation barrier and its status as an attractor, are theoretically questionable and empirically unsupported. Nevertheless, the concept survives because it remains embedded in macroeconomic models and policy institutions, especially European fiscal policy.

 

The entry requires access to the Palgrave. But many of the same arguments are discussed in her Godley-Tobin Memorial Lecture, freely available here.

Atonella Stirarti's Godley-Tobin Lecture

There was a problem during the 7th Godley-Tobin Lecture. I disconnected everyone when I was trying to fix a problem with Professor Stirati's presentation, and I didn't notice until much later. The worst part is that the recording was lost. I'm posting here the PowerPoint presentation for those interested. We will also post the link for the published version of the lecture, which will be open also on the website of the Review of Keynesian Economics (ROKE).

Beyond the NAIRU, 7th Godley-Tobin Lecture by Antonella Stirati

 

The 7th Godley-Tobin Lecture in a bit more than a week. For those not in Boston registration here.

Beyond the NAIRU - 7th Godley-Tobin Lecture

The 7th Godley-Tobin Lecture will be given by Antonella Stirati at the Eastern Economic Association meeting next Spring in Boston. The previous lecture by Professor Joseph Stiglitz will be published in the January issue of ROKE.

Lavoie on Inflation Theory: Conflicting claims versus the NAIRU

New Paper by Julia Braga and Franklin Serrano. From the abstract:

The conflicting claims approach to the theory of inflation so thoroughly surveyed and well presented in Chapter 8 of Lavoie’s (2022) book is deservedly becoming increasingly consensual among heterodox (and even some notable mainstream) macroeconomists. However, the relevance of a concept (and the very existence of) a NAIRU (Non-Accelerating Inflation Rate of Unemployment) derived consistently from the very premises of the conflicting claims approach is still very controversial. In this review article, we will be to argue that a NAIRU is not really useful for the conflicting claims approach. First, it can only properly be derived under quite restrictive assumptions; second, if a NAIRU actually existed, it would render demand management policies undesirable and very destabilizing anyway. With that in mind, the key aspects explored here are: 1) the different roles of hysteresis in the output and labour markets; 2) the assumptions concerning real profit markups of firms; and 3) the extent to which money wage increases actually incorporate past (or expected) inflation. We also add some remarks regarding the role of changes in international commodity prices and nominal exchange rates that further illustrate the necessary relation between conflicting claims inflation and the theory of distribution and relative prices.

Read the rest here.

The NAIRU or why economics is not a serious science

This is from Watson's AER paper from last year (another version here). Same methodology he has used before, with Staiger and Stock, as far as I can tell, to measure the non-accelerating inflation rate of unemployment (NAIRU) or natural rate. The estimation is based on the Phillips curve (PC), in which inflation is the result of deviations of unemployment from its natural level, that is, essentially demand. He estimates that it is at 6.3%, but will soon return to its pre-2007 crisis level of 5.5%, basically were we are now.

Couple of things. In the estimation of the PC he does, as normally is done, include supply shock elements. My guess (results are not clearly shown in the tables) is that a good chunk of inflation is actually explained by this rather than the unemployment gap. In other words, cost matters for inflation, and whether unemployment was above 10%, as right after the crisis, or 5.6% like now, has little impact. Also, that means that the unemployment gap is basically orthogonal to inflation, and that the measure of the NAIRU or natural rate could be obtained as an average of the actual unemployment. In one of the methods of obtaining it that is exactly what is done (not in this paper).

In other words, the black line in the middle is NOT an attractor around which the actual unemployment level fluctuates. It is an average of the actual rate, which is essentially another way of writing the same data. It is the actual unemployment rate that determines the natural one, and if unemployment rates were reduced sufficiently with expansionary policies, the natural (being an average) would also come down. Economics is NOT a serious science.

Felipe & McCombie: The Aggregate Production Function And The Measurement Of Technical Change

 

In a recent post, see here, it was explicated that TFP only leads to confusion in mainstream analysis of economic growth. Jesus Felipe & John S.L. McCombie's new book provides an invaluable extensive analysis of the issue at hand. 

Felipe and McCombie have gathered all of the compelling arguments denying the existence of aggregate production functions and showing that econometric estimates based on these fail to measure what they purport to quantify: they are artefacts. Their critique, which ought to be read by any economist doing empirical work, is destructive of nearly all that is important to mainstream economics: NAIRU and potential output measures, measures of wage elasticities, of output elasticities and of total factor productivity growth. – Marc Lavoie, University of Ottawa, Canada

See here

On Marx and Keynes, the NAIRU and Say's Law, again

Many of the entries in this blog directly or indirectly deal with the relation between the old classical authors of the surplus approach and the more radical authors that followed after the Keynesian Revolution (see here, for example).  David Fields has pointed out this post by Michael Roberts on Marx and Keynes, from a Marxist point of view (after a debate with someone he refers to as left post-Keynesian).

This is not a bad post at all. The interpretation of Keynes given by the post-Keynesian author (in Roberts' description) is not the best, but it is one of the possible interpretations for sure. The unknown postie also correctly notes that:

"Keynes and Marx were united in their critique of Say’s law (that supply creates its own demand) as a common starting point for theorising about the possibility of insufficient effective demand and the realisation problem."

Which is important to emphasize, since some Marxists tend to have an attachment to Say's Law. In this respect the postie [again in Robert's description of what he said] is actually unfair to Marx and Ricardo, suggesting that:

"But he [Marx] did (like the other classical political economists) expected the economy to always tend towards full capacity utilisation even if he (like Ricardo) theorised about technological unemployment in an economy operating at full capacity utilisation."

Actually there is no indication that Marx or Ricardo suggested full capacity utilization. Ricardo's version of Say's Law does not require full employment, and there is no mechanism to bring investment to the level of full employment savings. Investment equals savings by definition, and it might be at a level with significant levels of unemployment and spare capacity. Reductions in the real wage or the rate of interest would not bring about full utilization of resources. That's a concept that appears only with Marginalism.

When Roberts comes to his argument, it starts with a discussion of Keynes' political position (saving Capitalism) rather than the analytical elements of his theory. Then he discusses the limits to Keynesian policies, which he narrowly defines as fiscal activism (note that this could have been the position of an Old or New Keynesian, defending fiscal activism on the basis of market imperfections). Roberts misses the radical component in Keynes analysis, which implies that market economies are NOT efficient in the allocation of resources, and that long-term equilibrium could imply unemployment (yes long-term equilibrium unemployment, not disequilibrium, and not short-term unemployment is Keynes' central proposition).

Further, Keynes' Principle of Effective Demand requires to be fully operational the abandonment of the neoclassical (Marginalist) theory of distribution, since variations of the rate of interest (or the real wage) do not lead to full utilization of capacity, and are compatible with a coherent recovery of the old and forgotten theories of the classical authors and Marx. So, complementing the postie, Keynes and Marx are united, not only the rejection of Say's Law, but also on the need for an alternative to the Marginalist theory of distribution, one in which conflict is necessary.

Keynes didn't get to this point, but understood the need of getting rid of the natural rate of interest concept. And that leads to an abandonment of the neoclassical theory of distribution per force.

Then Roberts gets to his main point. He says:

"Keynes says the crisis comes about through a lack of ‘effective demand’, namely an unaccountable fall in investment and consumption and this causes profits and wages to fall. Marx says: let’s start with profits. If profits fall, then capitalists would stop investing, lay off workers and wages would drop and consumption would fall."

This is a variation of the traditional Marxist theory of the business cycle. There are multiple versions, from Andrew Glyn profit squeeze to Goodwin predator prey (which by the way suggests full utilization of resources in his model in Marxo-Marginalist fashion), and many others. All rely, like Roberts above on the notion that the rate of profit (or the profit margin in Marglin and Bhaduri) drives investment.

In this case, high employment generates wage inflation which can increase the wage share of workers in output; but this will, in turn, reduce the profits of capitalists and thus reduce future investment and output, leading to a recession. The recession, in turn, reduces labor demand and employment and consequently leads to lower wage inflation or even deflation and reduces the wage share of workers. But as workers wage share declines, then profits increase and, with them, investment and a new boom starts.

There are a few problems with this view, the profit-led view of investment, discussed here before (and here). As mentioned before, from a theoretical point of view, it is difficult to justify why a firm would invest, even if the rate of profit is high, if demand is not growing. And, in reverse, why would a firm not invest, and increase its capacity, if demand is growing even if the rate of profit is relatively low. Wouldn't it make sense to keep pace with demand, rather than let the competition take advantage of expanding demand? From an empirical point of view (as noted here, and here) the accelerator principle rules the roost.

Finally, note that all of the profit-led based theories of cycles and growth are fundamentally dynamic Say's Law stories, in which savings, determined by profits determine the behavior of investment, and the system fluctuates around a level of output in which worker's bargaining power does not lead to inflation, or in other words stable inflation. That is the so-called Marxist version of the NAIRU (see my previous post on the late Andrew Glynn on the subject; for a relatively recent Marxist defense of the NAIRU see Pollin here; subscription required). As I noted before (and here) there are reasons to be skeptical about the Phillips curve and the NAIRU, in all their versions.

PS: Comment by Franklin Serrano, that I paste in full:

"In Marx there is indeed no indication of a tendency to full capacity utilization nor full employment of labour. But the author is right about Ricardo. Ricardo assumed Say's law which means that all that "demand is only limited by production", this DOES imply that investment is equal to and determined by full capacity savings as in Ricardo it is only capital (full capacity) not labor that determines potential output. Ricardo did NOT contemplate "spare capacity"  and yes his technological unemployment was based on the fully capacity output not generating enough jobs for the economy to get to full employment. You are right that in Ricardo investment does not adapt to full employment savings. But it does adapt if arbitrarily to full capacity saving."

Same issue brought up by PGB below. I conflated full capacity with full employment. Mind you, I suspect that this is what the post-Keynesian author referred in the post was doing, and hence my mistake.

Hysteresis and the natural rate

I've been teaching on the price and quantity interactions, and the natural rate or NAIRU (Non Accelerating Inflation Rate of Unemployment), that is the level of activity at which you have price stability. One of the papers assigned is the one by Franklin Serrano (here or here for a Spanish version; another assigned paper is this one by yours truly). By the way, I've dealt with the issue of hysteresis briefly before here, mostly to distinguish it from path dependency, following Setterfield (Serrano also suggests differences between heterodox and more conventional views on hysteresis).

As noted by Serrano, the research by Nelson and Plosser (1982) (here; subscription required) and Real Business Cycle (RBC) authors suggests that GDP follows a random walk, and as a result after a productivity shock (which they measure as changes in TFP, in spite of significant problems with that measure; see here) output does not return to its previous trend. The point is that once the output trend is affected there are persistent effects that change the trend itself, that is hysteresis. Fluctuations are variations of the optimal level itself.

Serrano correctly points out that "this means that the long run trend of output is not only partially determined by whatever drives short run output (presumably aggregate demand) but rather that potential output is actually fully determined by the trend of whatever drives actual output. As it is well known, this result of strong hysteresis in the output (GDP) series has been taken to provide evidence in favor of the 'real business cycles' strand of new classical macroeconomics in which the common element driving trend and cycle are factor supplies and their productivity." The natural rate or NAIRU is supply determined, but is variable (something that, in a different context, Robert Gordon would call the Time Varying NAIRU or TV-NAIRU).

Supply shocks imply that in a boom the potential output moves first, and actual output adjusts as individuals readjust to higher productivity. Hence, the output gap, if defined as the difference between actual and potential output, becomes negative. And if you believe in a Phillips curve and some sort of central bank monetary rule, a negative output gap suggests a deflationary pressure (and yes RBC authors do believe in endogenous money). Yes, that's what the RBC theory implies! In fact, according to Kydland and Prescott (1990): "the price level has displayed a clear countercyclical pattern."*

Serrano points out a simpler (Occam's Razor applies) explanation for the favorable evidence on hysteresis, namely that demand (in fact, the autonomous components of demand) determine potential output (the supermultiplier). Note that this approach does not require, as the RBC or the acceleracionist versions of the Phillips Curve, any definite relationship between prices and quantities. As noted here (and here) before, there is no reason to expect an unambiguous or systematic relation between prices and quantities, unless you think that prices are always driven by excess (or lack of) demand.

As Serrano argues the: "trend and the cycle indeed have a common nature as the empirical literature shows but this common nature reflects that both are explained by demand (not supply) factors" and "with full hysteresis in output levels and partial inertia on inflation, 'demand-pull' inflation is just a temporary phenomenon and therefore does not determine 'core' or persistent inflation." And it is hard not to agree on this with New Keynesians, and their dismissal of supply shocks as the main cause of business cycles. It is harder to agree with their insistence on a natural rate, even if it's variable.

* The obvious historical event they would have in mind is the stagflation of the 1970s. Note, however, that more often than not deflationary periods are contractionary, like the 1930s. Of course the oil shocks and the increase in costs can explain, together with wage resistance and price inertia, the inflationary pressures of the 1970s in a model that is perfectly compatible with demand driven recessions.

The real legacy of Mrs. Thatcher

Nicholas Crafts has published what is probably the mainstream view of Mrs. Thatcher economic legacy. For him higher Total Factor Productivity (TFP) and a lower NAIRU (natural rate of unemployment) are the results of her policies. I have discussed in other posts the problems with both concepts, so I won't delve into that right now (also not much time to deal with anything now). I just want to point out her legacy in terms of what Crafts calls 'ending the Trade Union veto.'

Graph above shows the fall in unionization rates and the share of wages in total income. The former fell around 10%, from around 50% of the labor force to below 40%, while the latter fell 5% or so. Higher unemployment, no negotiation with unions, lower taxes for the wealthy (marginal income tax rates) and higher for the poor (higher Value Added Tax, VAT), all combined to bring labor into line (end its veto power). That's her legacy. The rest is confusion, or worse just concealing the truth.

PS: A more critical perspective from Krugman here.

How to solve the crisis without doing a thing

Are you concerned with unemployment and the effects of austerity on the very slow recovery? The Congressional Budget Office (CBO), with the help of mainstream theory, has a solution. Just hike the natural rate of unemployment. Now there are less people involuntarily unemployed, and we are only about 2.2% above 'full employment.' If they hike it a bit more we are done, and John Taylor and Martin Feldstein will be correct in pressing the Fed to hike the rate of interest.

It is a convenient solution no doubt. Mind you the most typical way of deriving the natural rate is from some kind of average of the actual unemployment. In other words, they [mainstream] tell you that the average of a series is the attractor of the actual series. Talk about having things upside down!

This reminds me of the time Bob Solow gave a talk at the New School (in 2001) and suggested at the beginning that the idea of the natural rate was incorrect and should be avoided. By the end of the talk he argued that most analysts think that the natural rate was, back then, at around 5.2%. There it is, the natural rate doesn't exist, but it is 5.2%.

Too many contradictions, not enough cumulation

In 1996, if I'm not wrong, there was a conference at the New School in honor of David Gordon, who had just passed away.  The late Andrew Glynn, gave a very nice talk, but he said something that left me uneasy.  For him, the NAIRU (Non Accelerating Inflation Rate of Unemployment) was our concept, meaning by our radical economics' idea, not mainstream's idea.  The point was that the NAIRU, in contradistinction to Milton Friedman's natural rate, does not imply full employment.

The NAIRU does suggest that output is supply determined, and that expanding demand beyond that level is inflationary, but the fundamental reason is that after that the bargaining power of workers increases and leads to wage-price spirals.  This could happen way before the economy is fully utilizing its productive capacity, and would depend on social factors like the relative strength of the trade unions, for example.

While that is correct, I noted, after the conference, that this still meant that demand had no role, in this view, in expanding the capacity limit of the economy (my students are rolling their eyes, and saying there he goes with Kaldor-Verdoorn again!).  Glynn's reply was a quote from a title of paper by David Gordon.  My views implied too much cumulation and not enough contradictions.  The notion is that if you think that the demand determines long term growth we should live in a paradise with full employment, since demand can be managed.

Of course, in developing countries that is almost never possible. You expand demand, imports increase, current account deficits balloon, and contraction follows.  The external constraint at work.  Well we are finally in an American example of the contradictions that impede demand expansion.  Today, the NYTimes tells us in the editorial that:

"When consumers are constrained, so is hiring, because without customers, employers are hard pressed to retain workers or make new hires."

Yep, the Times got effective demand right (it must be a Krugman thing)!  However, no fiscal package is at hand to solve this simple technical problem.  I'm not going to explain Republicans and American politics (wouldn't dare).  But the political contradictions associated with expanding demand are staggering.  It's a pity that only now I have a good answer for Andrew.

PS: The paper by David cited above is Gordon, D. "Kaldor's Macro System: Too Much Cumulation, Too Few Contradictions." In Nicholas Kaldor and Mainstream Economics, edited by Edward J. Nell and Willy Semmler, pp. 355-83. New York: St. Martin's Press, 1991.