Lets drop the NAIRU

Jan. 29, 2006
The central bank's continuing obsession with interest rate rises is a consequence of their dogmatic attachment to a theory associated with the concept of the NAIRU, the non accelerating inflation rate of unemployment which argues that any attempt to lower inflation below the natural rate or the NAIRU rate will generate expectations of accelerating inflation in the future.

The origins of this theory go back to Milton Friedman's paper presented at the American Economic Association's annual meeting in 1968. Friedman borrowing the concept of the natural rate from the Swedish economist Knut Wicksell who as early as the end of the nineteeenth and the beginning of the twentieth century had argued for the existence of the natural rate of interest below which one would get inflation argued that in the long run any rate of inflation was compatible with the natural rate of unemployment.(See the discussion of Wicksell`s doctrine in David Laidler`s excellent work, Fabricating the Keynesian Revolution:Studies in the inter-war Literature on Money, the Cycle and Unemployment,Cambridge university Press, 1999 pp.27-34)

(For a thorough discussion of the history of the concept and an alternative approach which I call the natural rate of inflation see Harold Chorney, "Restoring Full Employment:The natural rate of inflation versus the natural rate of unemployment", a paper presented to the Adelphi University Conference on Social Policy as if People Matter, Garden City , New York available on line at www.adelphi.edu/peoplematter/schedule2.php or simply google Harold Chorney and click on the Adelphi entry)

Friedman argued that whatever short run trade offs that might exist with the Phillips curve would be eliminated in the long run when workers realised the illusory benefits of wage increases in an inflationary environment. In other words money illusion would disappear. Because workers initially overestimated the value of their wage they sacrificed leisure time for work and ended up working for lower real wages than they would truly accept if there were no money illusion.

Once money illusion disappeared they would refuse to work for these lower real wages and would demand ever accelerating wage increases to compensate for inflation.Hence, in order to keep the unemployment rate below the natural rate the cost would be accelerating inflation.

This doctrine which is based on a number of heroic assumptions also ignores the fact that when the central bank preempts inflation by diagnosing inflationary expectations it almost always guarantees an accelerating rate of unemployment and a serious recession as a consequence.

In fact, what Friedman and his followers at our central banks have done is re-invent Marx's concept of the reserve army of the unemployed whose role it is to keep inflation low at the cost of unnecessary high unemployment, greater poverty and greater homelessness . (See the excellent discussion of the NAIRU in Dean Baker, The Nairu:Is it a real constraint? , in Dean Baker, Gerald Epstein and Robert Pollin, Globalization and Progressive Economic Policy ,Cambridge university press, 1998 pp369-388. See also Robert Eisner's comment on Baker in Baker et al, pp.388-390.)

An actual econometric study of the NAIRU for 17 OECD countries by Baker and one by Eisner for the US shows that there is little evidence for the existence of the NAIRU as a real as opposed to theoretical constraint. What is real of course, however, is the behaviour of the central banks and their attachment to the concept.

Baker's study analyses data from 1950 to 1995 and Eisner from 1956 to 1995. Both of them do so on a quarterly basis.When Eisner analysed the data on an assymetrical basis separating observations above the NAIRU rate from those below the rate he found that the NAIRU hypothesis was not confirmed."The sums of past inflation co-efficients summed to less than unity,and/or for low unemployment the sums of unemployment co-efficients were close to zero; for regressions with the consumer price index they were even slightly positive. This indicated...that at worst, unemployment below the hypothesized NAIRU would generate a slightly higher equilibrium but not accelerating inflation, and that it might even lower inflation."( P.389 in Baker et al) Eisner goes on to suggest that optimal unemployment rates for the US from the point of view of low inflation and low unemployment are in the 4-5 % range. Only below 4 % does inflation appear to be a significant threat. My view of the Canadian case is that we could achieve unemployment as low as 4.5 to 5 % before having any sort of threat of rapidly rising inflation. This a great deal lower unemployment than what David Dodge and the Bank of Canada are working with when they trigger their increased interest rates.

Unemployment bottomed out at 6.4 % and in fact had only dipped below 7 % when Dodge began increasing the rates.

Its time to drop the NAIRU and get up to date on the virtuous circle of low unemployment and low inflation.A single percentage point reduction in the unemployment rate generates over 100,000 additional jobs for the economy and considerably more GDP.

It really is time to bring monetary policy at the central bank up to date and discard old discredited theories that have cost us unnecessary unemployment, poverty and homelessness.