The dreaded NAIRU is still about!

The dreaded NAIRU is still about! I was thinking – rather optimistically – that it would just disappear from whence it came! But sorry to disappoint. Some economists just won’t learn. Yesterday the ABS released the latest data from the Australia Treasury Model (TRYM) database. You can get it here. Among other things of great interest that you can find in that database, is the Treasury TRYM model’s estimates of the so-called NAIRU. Sounds scary. Well, it stands for the the Non-Accelerating Inflation Rate of Unemployment and has a central place in neo-liberal mythology. The NAIRU is an important component of the TRYM model and influences the way it produces economic outcomes and policy simulations. So how much reliance should we place on this important component of the policy making process. Answer: not much!. My conclusion: any model that relies on a NAIRU is a crock!

According to the Treasury the “Treasury Macroeconomic (TRYM) model of the Australian economy has been developed within the Commonwealth Treasury of Australia. For 25 years, Treasury has developed and maintained models of the Australian macroeconomy.” The models supports their policy analysis and forecasting work which informs final policy decisions of the Government. So, while other information and analysis is used by the Government to determine macroeconomic policy outcomes, the modelling section of the Treasury is significant. You would then want the model to be useful. I could go on at length about how its structure fails to capture the essence of a modern monetary economy but then that would be a book not a blog.

Yesterday’s data shows that the Treasury considers that the NAIRU (the unemployment rate which would deliver stable inflation) in December 2008 was 4.98 per cent (up from 4.77 per cent in the September quarter).

What exactly is this all about? In the Treasury Trym documentation. In Section 2.8, we learn that:

The wage equation is in the form of an expectations augmented Phillip’s curve. Hence, the aggregate supply curve is vertical in the long term at a level of employment and production consistent with the estimated NAIRU (non-accelerating inflation rate of unemployment). More precisely, in long run equilibrium the economy grows along a steady state growth path consistent with the NAIRU. There is a wide confidence interval around the NAIRU leading to a degree of uncertainty on the supply side

To put this in context a brief historical excursion will help. There have been two striking developments in economics over the last thirty years. First, a major theoretical revolution occurred in macroeconomics (from Keynesianism to Monetarism and beyond). Second, unemployment and broader labour underutilisation rates have persisted at high levels. In past work I have written about the development of the concept of full employment since the 1940s starting with the debate in the 1940s which emphasised the need to create enough jobs to absorb the available labour force. In the 1950s, economists quickly shifted the focus and debated the magnitude of unemployment associated with full employment based on some spurious notion that if unemployment was too low then inflation would occur. This led to the so-called Phillips curve era which was marked by policy makers contriving to achieve a politically acceptable trade-off between inflation and unemployment. The Phillips curve is “god-like” in economics and represents the relationship between unemployment and inflation as a smooth inverse curve. The underlying statistics that were used to get that curve (and since) are highly dubious. Anyway, in this period, fortuitous circumstances meant that unemployment remained low but the focus had clearly changed from generating a given quantity of jobs.

Full employment as genuine policy goal was abandoned with the introduction of the so-called natural rate hypothesis (NRH) and its assertion that there is only one unemployment rate consistent with stable inflation. In the NRH, there is no discretionary role for aggregate demand management and only microeconomic changes can reduce the natural rate of unemployment. Accordingly, the policy debate became increasingly concentrated on deregulation, privatisation, and reductions in the provisions of the Welfare State with tight monetary and fiscal regimes instituted. High unemployment persisted. The fact that quits were strongly pro-cyclical made the natural rate hypothesis untenable.

But the idea of a cyclically-invariant steady-state unemployment rate persisted in the form of the NAIRU concept, first introduced in the mid-1970s. The NAIRU was constructed as meaning that when unemployment is above it then inflation should decelerate and vice-versa. While various theoretical structures have been used to justify the NAIRU as a viable concept, the conclusion from each is simple: there is only one cyclically-invariant unemployment rate associated with stable price inflation. The NAIRU concept has dominated macroeconomic policy making in most OECD countries since the late 1970s and the “fight-inflation-first” strategies have exacted a harsh toll in the form of persistently high unemployment and broader labour underutilisation. Under the sway of the NAIRU, policy makers around the World abandoned the pursuit of full employment as initially conceived.

Of-course they couldn’t admit that so they started redefining what full employment meant. So if you read this literature you will quickly realise that the neo-liberals define full employment as being the NAIRU which is divorced from any notion that there has to be enough jobs available to meet the desires of the available labour force. So in one small change in taxonomy governments have been able to turn their failure to provide enough jobs into a success – well we are at full employment now because we are at the NAIRU. So it is a pernicious concept indeed.

In Australia, the major economic policy arms – the Reserve Bank of Australia (RBA) and the Federal Treasury have been influenced significantly by the NAIRU concept. The RBA was constituted in 1959 to maintain full employment as one of its three goals (see Section 10 of the Reserve Bank Act 1959. Subsection 2). However, since the abandonment of monetary targetting in the 1980s (the failed Monetarist experiment), the RBA has been increasingly influenced by the NAIRU concept. Until the GFC, it religiously has conducted monetary policy in Australia to meet an inflation target and, in my view, has abandoned its legal obligations to maintain full employment.

Repeated Statements on the Conduct of Monetary Policy, which set out how the RBA was approaching the attainment of its three identified policy goals, represent inflation targetting as the RBA’s primary goal. The Statements typically avoid any discussion about full employment except that price stability in some way generated full employment even though the price stability required “disciplined monetary and fiscal policy”. They justify this nonsense by claiming that although the RBA is sensitive to the state of capacity utilisation when it sets interest rates, the trade-off between inflation and unemployment is not a long-run concern because, following NAIRU logic, it simply doesn’t exist.

Under the NAIRU approach, policy makers use unemployment as a tool to suppress price pressures and the OECD experience in the 1990s and beyond shows that this strategy has been successful. The empirical evidence is clear that the Australian economy has not provided enough jobs since the mid-1970s and the conduct of monetary policy has contributed to the malaise. The RBA has forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities have further worsened the situation with complementary austerity.

How useful is the NAIRU as a guide to policy? While the topic is vast, in this blog I will just have a brief look at the NAIRU. In my latest book with Joan Muysken Full Employment Abandoned we analyse this topic in depth. So if you are looking for references or authorities for the statements I make here the book would be a good place to start. Not that I permit advertising on this blog!

The first graph shows the annual inflation rate and the official unemployment rate in Australia since March 1970 to December 2008 (using official TRYM data). The experience is common for most OECD countries. What is apparent from the graph is the disparate behaviour of the inflation rate and the unemployment rate.

It is difficult to construe an unemployment rate over the period where you would witness accelerating inflation if the actual unemployment rate were lower or decelerating inflation if the unemployment rate was higher.

To make more sense of this I constructed the following table. It uses quarterly ABS data (for the unemployment rate and CPI-based inflation) from September 1970 to December 2008 and compares the frequency of accelerating inflation with decelerating inflation for given ranges of the unemployment rate.

If there were a well-defined and stable NAIRU we would expect to find some unemployment rate range where all the changes in inflation were negative and below that range most of the changes in inflation positive. The results clearly do not support the existence of such a rate. We are unlikely to get any definitive information from the unemployment data about the likely movements in the inflation rate. In other work, I have estimated a range of so-called Phillips curve regressions, which also fail to find any evidence of a stable NAIRU specification.

I also plotted the latest Phillips curve which you can see next. While there may be stability between inflation and unemployment for a period, a sudden shock, especially from the supply side (as in the OPEC oil crisis in 1974) can worsen the unemployment resulting from a deflationary strategy, which is attempting to exploit a given Phillips curve. Evidence from the OECD experience since 1975 suggests that deflationary policies are effective in bringing inflation down but impose huge costs on the economy and certain demographic groups, which are rarely computed or addressed.

But if you study the graph you will soon see there is very little relationship between inflation and unemployment unless you are prepared to permit huge period shifts in the relationship which seem to occur around recessions. Given recessions are demand events it is hard to put a structural interpretation on the shifts. The NAIRU literature tries and fails to interpret these shifts as structural changes (workers becoming lazier; poorly crafted changes in welfare policy; less effective job search etc). All nonsense and all these explanations ultimately fail the evidence test.

So what about the estimates of the NAIRU itself. Various techniques are used to come up with this mythical time series. The TRYM model uses an econometric approach after deriving a wage equation. Others such as the OECD and many others get even dirtier and use what is known as a Hodrick-Prescott filters which is just a linear representation of the smoothed evolution in the actual data. The following graph compares the two methods with the actual unemployment rate. Before you laugh, the characters that use these synthetic series are serious!

Updated: added graph – Friday, April 17, 2009

I thought these added graphs would also help you understand how stupid these NAIRU estimation techniques actually are. Given that the NAIRU is meant to be the rate of unemployment that stabilises inflation, how would you interpret the TRYM time series in this context. Inflation ranges from some negative number to around 17 per cent over the same NAIRU value. Stupid is what I call it. But dangerous given its policy influence.

There is a huge body of evidence now that poses considerable challenges at both the both the theoretical and empirical levels for those who adhere to the NAIRU hypothesis. Here is a summary of the Non-NAIRU facts (we detail the arguments and literature in the book).

• Unemployment rates exhibit high degrees of persistence to shocks.
• The dynamics of the unemployment rate exhibit sharp asymmetries over the business cycle. There is mounting evidence against the dynamics implied by the NAIRU approach Unemployment responds to demand shocks in an asymmetrical manner. The unemployment rate rises quickly and sharply when demand contracts but persists and falls slowly when expansion occurs.
• Inflation dynamics do not seem to accord with those specified in the NAIRU hypothesis. Reconsider the graphs and table above to see this point.
• The constant NAIRU has been abandoned and replaced by so-called Time-varying-NAIRUs (just another ad hoc fudge), which have such large standard errors. The NAIRU-concept is now all but meaningless for policy analysis. The majority of econometric models developed to estimate the NAIRU are misspecified and deliver very inaccurate estimates of the NAIRU. Most of the research output confidently asserted that the NAIRU had changed over time but very few authors dared to publish the confidence intervals around their point estimates. I note that the TRYM documentation does indicate how unreliable their estimates are in statistical terms. One major study used so-called “state-of-the-art” estimation techniques and said their NAIRU estimates were imprecise. In 1994, for example, some of the 95 percent confidence intervals around the NAIRU estimates ranged from of 2.9 percent to 8.3 percent. So this range of uncertainty about the “true” value of the NAIRU is too large to be useful.
• Estimates of steady-state unemployment rates are cyclically-sensitive (hysteretic) and thus the previously eschewed use of fiscal and monetary policy to attenuate the rise in unemployment has no conceptual foundation.
• There is no clear correlation between changes in the inflation rate and the level of unemployment, such that inflation rises and falls at many different unemployment rates without any systematic relationship evident. See Table above.
• The use of univariate filters (Hodrick-Prescott filters) with no economic content and Kalman Filters with little or no economic content has rendered the NAIRU concept relatively arbitrary. Kalman Filter estimates are extremely sensitive to underlying assumptions about the variance components in the measurement and state equations. Small signal to noise ratio changes can have major impacts on the measurement of the NAIRU. Spline estimation is similarly arbitrary in the choice of knots and the order of the polynomials. Why not ask yourself: what caused the sudden arbitrary jump in the TRYM estimate in the last graph around 1974? They haven’t a coherent explantion. It is just a data fudge.

Conclusion

Its a crock! Time to move on.

Digression: Private wealth plummets

The TRYM database also contains a series Private wealth at market prices (so not adjusted for inflation). The following graph which is average private wealth per capita (so I expressed the raw data in terms of $000s per person in Australia) tells all. It peaked in December 2008 at $249, 000 and a year later it was $225,000. With the markets still in decline over the first part of this year, the next time we get an estimate (March quarter) that loss will be more than the $24,000 per person since December 2007.

Of-course, that figure includes Adults and children. If we just considered the adult population, then in December 2007, average private wealth per adult was $311,320. This had slumped to $280,669 by December 2008 a fall of $30,000 per adult or 9.8 per cent in nominal terms. Given that inflation has been running at around 4 per cent over that period, the loss is probably around 14 per cent.

To put that in context, it is the first time since June 1961 (the earliest available data) that private wealth has fallen. So these are different times indeed.

Digression: Lord Layard calls for a Job Guarantee

In the Peninsular Times, Qatar’s leading English-speaking newspaper, Lord Richard Layard called for a job guarantee. Not the billy blog JG but a bastardised, cut-down version of it. But some progress. For context, Layard is a Professor of Economics at LSE and is one of the principle architects of pernicious supply-side labour market policies which have ruled the day since the early 1990s.

You can read the article but Layard is quoted as saying it is “excellent” the the UK Government was maintaining an iron fist in terms of welfare rules, but he now thinks you need a “job guarantee” to stop long-term unemployment from becoming a bigger problem than what it already is. He proposes jobs are provided for “young people who have been unemployed for 12 months and adults unemployed for 18 months – jobs such as maintaining schools and hospitals or in social care.”