Thursday, 9 March 2017

A bit more NAIRU basher bashing.

One of the poor criticisms made of NAIRU is that it cannot be estimated accurately, thus it is allegedly of little practical use.

Well the answer to that is that, far as I can see, the original proponents of NAIRU never said it can be estimated with much precision!

At least one of the first papers to propose NAIRU was Franco Modigliani and Lucas Papademos’s Brookings paper “Targets for Monetary Policy in the Coming Year.” (1975). The authors certainly do not suggest NAIRU can be estimated accurately. For example they suggest it is “somewhat over 5.5%”. They also admit that NAIRU varies over time depending on sundry factors like terms of trade (p.142).

And another sentence reads,  “The shading of an area on either side of NIRU indicates both uncertainty about the exact location of NIRU and the implausibility that any single unemployment rate separates accelerating and slowing inflation”.

Having said that, strikes me the above authors are too optimistic as to the accuracy with which NAIRU can be estimated. E.g. my guess is that there’s a 90% chance it’s between 3% and 7% of the UK. The above authors seem to think they can estimate it more accurately than that. But that’s a technicality: the important point is that NAIRU advocates have never suggested for example that NAIRU is definitely 5% rather than 5.1%.

Indeed, I’d have thought it was obvious to anyone with a grain of common sense (and that excludes half the economics profession) that NAIRU cannot be estimated accurately.

NAIRU is a bit like the statement “good looking people have more sexual partners than ugly people”. Anyone with a grain of common sense knows the statement is true, even though “good looks” cannot be defined or measured accurately. Plus anyone with common sense knows that the above statement is a very poor guide as to exactly how many sexual partners a good looking person will have in the next five years.

But if you were to announce that good looking people have more sexual partners than ugly people, you'd then find yourself being lectured to about the fact that good looks cannot be accurately measured, thus the “good looks / sexual partner” theory must be nonsense.

Roger Farmer.

Roger Farmer is an academic and NAIRU basher, and author of a Bank of England article entitled “The Natural Rate Hypothesis: an idea Past its Sell-by Date.” He tells us that “Defenders of the Natural Rate Hypothesis might choose to respond to these empirical findings by arguing that the natural rate of unemployment is time varying.  But I am unaware of any theory which provides us, in advance, with an explanation of how the natural rate of unemployment varies over time.  In the absence of such a theory the NRH has no predictive content.  A theory like this, which cannot be falsified by any set of observations, is closer to religion than science.”

Incidentally the “natural rate” is an idea very close to NAIRU and which preceded NAIRU.

I suggest that is what is really close to religion is the obviously false idea that labour shortages have no effect on inflation. To illustrate, are we seriously supposed to believe that given an unemployment rate of say 1%, shortages of particular skills would not arise and employers would not be tempted to bid up the salaries of those with those skills? And are we seriously supposed to believe that given low unemployment and a general scarcity of skills, trade unions are not tempted to put in for bigger wage increases?

Far from NAIRU being a religion, the religious fanatics are the people who seem to believe (at least implicitly) in the later obviously nonsensical stuff about skill shortages.

To assume NAIRU = X is perfectly legitimate.

Another point which seems to be too subtle for NAIRU bashers is this. The fact that human beings cannot accurately estimate some variable like NAIRU does not mean it is illogical or unacceptable to assume the variable does in fact have some specific and very precise value. Astronomers, for all I know, may not be able to estimate the amount of iron that makes up the Moon to an accuracy of better than plus or minus 10%. However, it is indisputable that the amount of iron in and on the Moon has a very specific and precise value. The only thing that ever changes that amount is the odd meteorite hitting the Moon, thus given an infinite amount of knowledge about the Moon, the amount of iron in and on the Moon could be stated to an accuracy of plus or minus about 0.0000001%.

Likewise it is perfectly legitimate to give NAIRU some precise value, like X or Y, and then write equations that aim to describe the economy, or get involved in discussions which assume NAIRU has some precise value.


  1. But why NAIRU and not a natural rate, and why must inflation continue to increase below NAIRU? Why accelerating, and not a one-off increase in the rate of inflation?

    1. Taking your points in turn, I've never been much concerned about the difference between the so called natural rate and NAIRU. Looks like Roger Farmer isn't either.

      Re "continue to increase", I can see the logic there. If aggregate demand is excessive, employers will bid up the price of labour and other inputs so as to ensure a continued supply thereof. But if ALL employers do that, that gets each individual employer nowhere. So each employer ups the price again, so as to out-bid other employers. That means a continuously rising rate of inflation.


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