NAIRU Should Be Bashed, Smashed, And Trashed

Professor Simon Wren-Lewis recently wrote an article "NAIRU Bashing," in which he attempts to salvage some value out of the concept. As observed by Ramanan, his defense of NAIRU can be summarised as: There Is No Alternative (TINA), A lot of what Professor Wren-Lewis wrote might appear similar to what I have written on the topic. (I will publish the relevant excerpt from Interest Rate Cycles: An Introduction  shortly, in case readers would wish to contrast and compare.) However, the belief that there is no alternative to NAIRU is silly. If economics were scholarly (as I discuss here), knowledge would be additive, and we would not have such debates.

What is NAIRU?

NAIRU stands for the "nonaccelerating inflation rate of unemployment." As noted by Ramanan and others, this phrase does not actually make sense; people just liked the cool acronym. I discuss it in the upcoming book excerpt, but I have some already published articles on the concept (example).

The quick summary of the NAIRU story is that if the unemployment rate is below the NAIRU level, inflation will rise (the time series of the price level will accelerate); inflation falls if the unemployment rate is above NAIRU.

A Vaguely-Defined NAIRU is Meaningless

Professor Wren-Lewis accepts that the NAIRU is hard to measure, and so it is a easy target for ridicule,

The NAIRU is the level of unemployment at which inflation is stable. Ever since economists invented the concept people have poked fun at how difficult to measure and elusive the NAIRU appears to be, and these articles often end with the proclamation that it is time we ditched the concept. Even good journalists can do it. But few of these attempts to trash the NAIRU answer a very simple and obvious question - how else do we link the real economy to inflation?

I believe it is safe to say that most post-Keynesians accept the link between labour market tightness and (wage) inflation, and so one might interpret this as being qualitatively similar to "NAIRU." However, this is perhaps too generous to NAIRU.

NAIRU implies that there is a well-defined number which can be compared to the unemployment rate that allows us to give quantitative estimates for the changes in the inflation rate. If that well-defined number cannot be inferred from the data, it contradicts the entire premise.

If we want to create a mathematical model of the economy, it looks like the best that we can hope for is some form of a "generalised output gap" that does not have a direct correspondence to any particular economic time series. The unemployment rate probably offers useful information about capacity pressures within the economy, but its usefulness depends highly upon the institutional context (as discussed in the next section).

[Update] I have had a few comments, as well as being in a multi-way argument on Twitter. I am not particularly good at following Twitter arguments when they involve 4+ people, so I did not have a lot to say there. I just wanted to add a few points here.

• I have written similar things to Professor Wren-Lewis. I just wanted to try to explain what the standard post-Keynesian objections (as well as mine) to his remarks. The complaints are theoretical, and do not imply that post-Keynesians believe there is no relationship whatsoever between labour market "capacity pressures" and inflation. In fact, I am sure there are some teaching models somewhere used by post-Keynesians that are functionally equivalent to NAIRU. The point is that "teaching models" are not viewed as a gospel truth.
• Revising NAIRU to be a range of values for the unemployment rate where there is no effect on inflation is a change of definition; the "R" stands for "rate", not "range." One can make this revision, but it makes the concept even more useless. We now need to estimate a range for this deadzone. Since inflation has not really moved over the past few decades, that estimated deadzone could easily be between 3%-10%, which means that the model is almost entirely non-falsifiable; we just increase the deadzone to match the increased volatility of the unemployment rate.
• Furthermore, NAIRU estimates in the euro periphery are implausibly high (basically just the moving average of the realised unemployment rate). As such, this is an example of the NAIRU concept breaking down at high unemployment rates.
• NAIRU estimates are based on looking at observed changes in inflation and the unemployment rate (plus whatever variables the modeller wants to add, such as inflation expectations). The level of NAIRU is often moving at a pace comparable to the measured economic series, and so the model is just telling is that trends in the inflation rate are persistent, and so the model cannot distinguish between the case where the unemployment rate affects inflation, and the case where it does not.

For an analytical example of the failure of NAIRU, we need not look any further than the behaviour of the U.S. economy over the past cycle. Despite the massive spike in the unemployment rate after the crisis, deflationary pressures were mild. Meanwhile, the steady drop in the unemployment rate during the expansion has had no observable effects on inflation. We have seen hawks warn for almost a decade that the unemployment rate was "near NAIRU," and that inflation would take off any minute now. However, the classic example of the failure of NAIRU was during the 1990s, which I discussed in Interest Rate Cycles.

Dubious Policy Implications

Simon Wren-Lewis:

I could go on and on, and write my own NAIRU bashing piece. But here is the rub. If we really think there is no relationship between unemployment and inflation, why on earth are we not trying to get unemployment below 4%? We know that the government could, by spending more, raise demand and reduce unemployment. And why would we ever raise interest rates above their lower bound?
I’ve been there, done that. While we should not be obsessed by the 1970s, we should not wipe it from our minds either. Then policy makers did in effect ditch the NAIRU, and we got uncomfortably high inflation.

This is an example of the questionable policy advice that belief in the NAIRU brings. By attaching magical significance to a single time series, we apparently do not need to think about economic institutions.

I am not going to hold myself out as an expert on the 1970s inflation. That said, I would point out that observers pointed out the inflationary bias of various government policies in real time. (I have Hyman Minsky in mind, but he was hardly alone in making such claims.) If your policies have an inflationary bias, you should not be surprised by high inflation. Meanwhile, policymakers were surprised that high inflation coexisted with high unemployment, so Professor Wren-Lewis' comment that they "ditched NAIRU" does not appear to fit the historical record of what policymakers were thinking.

Take the MMT Job Guarantee as an example of the importance of institutions. If the Job Guarantee were implemented with no indexation of the guaranteed wage rate, there is no plausible reason to expect any form of inflation to result (looking through any one-time changes that result to the change in the structure in the labour market). If government policy were aimed at preserving price level stability, it would be entirely reasonable to expect that 0% inflation would coexist with 0% involuntary unemployment. (There would presumably be people not in work, yet not in a Job Guarantee job, but that would represent a voluntary choice. For example, professionals would likely prefer to remain unemployed and undertake a job search while living off of savings.) Such an institutional framework would make the NAIRU concept utterly useless for forecasting inflation.

Bonus Point: Contradicts Rational Expectations

One of the side effects of accepting that NAIRU is hard to measure is that it invalidate rational expectations. If economists who specialise in monetary policy cannot come up with a method of predicting inflation in a quantitative fashion, it is clear that the households -- even the magical "representative household" -- cannot do so either.

Realism and Inflation Forecasting

The post-Keynesian literature on inflation is broad and deep. My flippant summary: inflation is complicated.

Although that sounds useless, it is unfortunately realistic. I was involved in the inflation-linked bond market. This is a huge market, with returns directly linked to inflation (as the name suggests...). The ability to forecast said returns using a reduced form model and one time series would be of utmost interest to market participants.

The reality is that NAIRU-based models do not work. And it is not just a question of adding a few wrinkles to the model. At this point in time, tens of thousands of people have had access to time series databases and analysis software, and they have been hammering away at all of the possible models like the proverbial infinite monkeys on typewriters. (I write from the experience of being one of those monkeys earlier in my career.) If a reduced form model was even close to being able to provide useful forecasts, that model would have been discovered by trial and error alone.

As a result, inflation strategists have been forced to dig around the ugly details of the construction of the CPI, and employ a lot of ad hoc guesswork. The post-Keynesian approach helps explain why the reduced form modelling approaches are generally failures.

(c) Brian Romanchuk 2017