The NAIRU/Output gap scam reprise

It is Wednesday and despite being on the other side of the Planet than usual (in Helsinki at present) I am still not intending to write a detailed blog post today. I am quite busy here – teaching MMT to graduate students and other things. But I wanted to follow up on a few details I didn’t have time to write about yesterday concerning the role that NAIRU estimates play in maintaining the ideological dominance of neoliberalism. And some more details about the Textbook launch in London on Friday, and then some beautiful music, as is my practice (these days) on Wednesdays. As you will see, my ‘short’ blog post didn’t quite turn out that way. Such is the tendency of an inveterate writer.

Macroeconomics Textbook Launch – London, Friday, March 1, 2019

There are a few places left and the list closes 17:00 (Wednesday).

If you want to come, please E-mail me and I will get your name put on the door.

The program for the Book Launch in London of Friday is more or less decided:

• 17:00 Doors open (light refreshments will be served)Doors open (light refreshments will be served)
• 17:20 A welcome from Macmillan International Higher Education & introduction to the launch of Mitchell, Wray & Watts: Macroeconomics 1e – (Philip Rees/Jon Peacock/Jon Finch)
• 17:30 An introduction to the book! – Dr Sandy Hager (City University)
• 17:45 Integrating the MMT approach into the delivery of Macroeconomics HE courses – Professor Heikki Patomaki (Helsinki University)
• 18:00 A word from our author! – Professor Bill Mitchell (University of Newcastle, Australia & Director of CofFEE – (Centre of Full Employment & Equity, University of Newcastle))
• 18:15-18:30 Q&As (compered by Philip Rees, Macmillan)
• 18:45 Finish

Location: The event will be held at the Macmillan publishers complex at the Springer Nature – Stables Building, Trematon Walk, Kings Cross, London from 17:00 to 19:00.

Here is a short video introducing the features of the new textbook

Helsinki Lecture Series

My lecture series at the University of Helsinki in my role as Docent Professor of Global Political Economy, at that university, is underway.

Lecture 1 (Tuesday) attracted a good number including many non-enrolled people from the general public.

The lectures are part of a formal program but the public is welcome to attend subject to lecture hall space being available.

The remaining lecture schedule is:

• Wednesday, February 27 – 12.15-13.45
• Thursday, February 28 – 12.15-13.45
• Tuesday, March 5 – 10.15-11.45
• Wednesday, March 6 – 12.15-13.45
• Thursday March 7 – 12.15-13.45

They will be held in Lecture hall XV (fourth floor) at the University of Helsinki main building, entrance from Unioninkatu.

I have arranged for them to be filmed and when I get access to the footage I will make them available to those who cannot attend.

Output gaps and unemployment gaps – short reprise

In yesterday’s blog post – The NAIRU/Output gap scam (February 25, 2019) – we considered in some detail the way in which economists seek to ‘measure’ when an economy is operating at full capacity or full employment. We learned that the measurement process is fraught but not unmanageable. But the real problem is that the process can be hijacked using loaded concepts (such as the NAIRU), which deliberately bias the results of the empirical work towards concluding that fiscal deficits are too expansionary when, in fact, they are too contractionary and vice versa.

At the extreme, we get ridiculous claims from technocratic economists in places such as the European Commission that a nation’s full employment unemployment rate rises from below 10 per cent to 23 per cent in a matter of two or so years due to structural forces that are immutable to government fiscal policy action (such as spending more cash to stimulate sales and create more work).

But even within the limits of the ridiculousness, the bias is profound and nations are forced into imposing fiscal settings that are totally inappropriate for their economies, given the state of non-government spending at the time.

So we see fiscal austerity being imposed when private sales are lagging and unemployment is rising.

And harsh microeconomic policy changes invoked – privatisation, deregulation, wage and income support cuts, etc – which are justified by the claim that the prevailing mass unemployment is purely structural in nature and cannot be dealt with through increasing total spending in the economy.

There was one other graph I constructed to highlight the problems of measurement in this realm of applied economics.

The output gap is conceptually the real output shortfall in an economy relative to its potential (or full capacity) limit.

So in Modern Monetary Theory (MMT) parlance it measures the real resource space available in the economy.

It is a conceptual quantity – that is, you cannot observe it.

We observe manifestations of it – mass unemployment, unsold inventories, idle capital etc – which then can help us create proxies in order to measure the unobserved gap.

It is typically derived (estimated) by mainstream economists using another unobserved concept – the NAIRU, which is the unemployment rate where inflation is stable.

The NAIRU was the mainstream replacement for the older notion of full employment.

It was always recognised that some unemployment would always be evident (people moving beteween jobs, for example).

So full employment was logically conceived as there being enough jobs to meet the desires for work from the labour supply.

We can refine that concept to include desired hours of work (to eliminate underemployment).

But the NAIRU recast that conceptualisation and instead redefined full employment to be the unemployment rate where inflation is stable.

Thus, conceptually, the gap between the actual unemployment rate and the estimated (unobserved) NAIRU should measure the non-inflationary space available to reduce actual unemployment.

If that gap – NAIRU minus unemployment rate – is positive then we would expect (according to the theory) inflation to be accelerating.

Conversely, if the gap is negative, then we should expect the opposite.

Various bodies (such as the European Commission, IMF, etc) provide estimates of the NAIRU through a variety of econometric/statistical gymnastics.

The problem is that the estimated gaps between the NAIRU and actual unemployment do not correspond with movements in inflation.

This became very evident early on in the 1990s.

For example, the NAIRU estimates (after the 1991 recession) rose significantly.

Then as the economies around the world recovered and the actual unemployment rates fell, we observed inflation also falling even though the gaps (NAIRU minus actual) were becoming strongly positive.

How could that be?

More gymnastics – bring in the so-called time-varying NAIRU – that is allow it to shift downwards and upwards.

Cutting through all the technical stuff at the time, it was obvious that the estimated NAIRUs were just filtered versions of the actual, which moved in concert with the spending cycle.

In other words, the ‘structural’ benchmark (the NAIRU) was just another representation of the cyclical shifts in employment and unemployment and there was very little if anything structural about it.

I wrote about that in one of my early academic publications where I was the first person to really provide an applied framework for estimating the dependency between the two (hysteresis) – see The NAIRU, Structural Imbalance and the Macroeconomic Equilibrium Unemployment Rate (June 1987).

The point is that the two measures of free capacity – the output gap and the unemployment gap – should be closely related if they are to be of any policy use.

If they deviate significantly in estimating how much free resource capacity there is then there is a problem of measurement.

This graph demonstrates that problem.

It is constructed using AMECO data (mentioned in yesterday’s blog post) and shows the correlations for the nation’s concerned of their NAIRU and output gap time series going back to 1985.

The correlations are not particularly strong across the board.

In Italy’s case, the output gap and the NAIRU measures are very divergent, which tells us that one or both are not fit for their stated purpose.

Relatedly, a central bank friend reminded me today of some of the detail surrounding the European Commission’s NAIRU antics in 2013 concerning Spain.

I discussed that in yesterday’s blog post.

In this Working Paper from the German-based Macroeconomic Policy Institute from January 2015 – The European Commission’s New NAIRU: Does it Deliver? – we read that:

1. “The NAIRU is a key component of potential output and as such critically affects output gap estimates” – which is the point I made yesterday. If the NAIRU estimates are cooked, so will the potential output measures be cooked.

2. “Potential output, in turn, is of great relevance for economic policy makers because it represents a barrier to inflation- stable growth and determines the extent to which a given fiscal deficit is interpreted as cyclical or structural” – again what this seemingly technical debate is all about.

Cooked NAIRU -> cooked Potential Output -> cooked Output Gap.

And if the cooked NAIRU is biased to find that the economy is closer to full employment than it actually is, then the cooked output gap measures will suggest the economy is closer to full capacity, which will then mean the current fiscal position will be interpreted as being ‘mostly’ structural.

3. “The autumn 2013 forecast of the Spanish NAIRU for 2014 (25 %) almost equaled the unemployment rate in November 2014 (25.8 %). As Spanish unemployment was declining at the time, the unemployment rate was poised to undershoot the NAIRU in 2015 … An unemployment rate of over 20% entailing youth unemployment of more than 50% was thus interpreted labor market tightness.”

And anyone with half a brain immediately concluded as the MPI concluded that this was an “implausible outcome”.

The European Commission came under sustained attack for this ridiculous result and by the European Spring of 2014 they announced they were changing the model specification of NAIRU.

Okay, and then what?

We read that:

Rather than climbing to 26.6% in 2015, the new NAIRU estimate for 2015 was 20.7%.

Remember, that just two years before the NAIRU was estimated to be around 8 per cent.

In the intervening few years, it was implausible to believe that sudden ‘structural’ forces had changed the full employmnet unemployment rate so markedly, especially as Spain was in the midst of a major cyclical downturn.

The European Commission was trying to tell people that there were no cyclical factors at work determining the Spanish unemployment rate.

Absurd.

It is not my intention to review the technical detail in the MPI paper notwithstanding how interesting it is.

Suffice to say, their Figure 1 shows how dodgy this whole exercise is. The different NAIRU estimates keep failing (when considered against the trajectory of the actual unemployment rate) and what the gap between the two would signify for the state of the economy.

So the next time the Commission technocrats crank out the estimates – we see different profiles.

And as the actually unemployment rate rises (around 2007) the NAIRU estimates are also revised upwards, following the actual rate up.

The point the MPI paper makes, which is the point I made in the 1987 paper I cited above is that the unemployment rate trajectory is dominated by cyclical shifts in spending, sales, output and employment.

If the NAIRU basically tracks the actual rate then what independent ‘structural’ information is it providing.

The answer is none, in all probability.

The MPI paper thus tests:

… the dependence of the NAIRU on unemployment versus structural factors …

Leaving aside the technical details of how they did that – essentially they ran regressions of the NAIRU estimates on structural and cyclical variables, to differentiate the two influences – their conclusion is categorical

1. “the NAIRU does not seem to be very responsive to changes” to the structural proxies “as compared to changes in the unemployment rate”.

2. “In general … [the structural shocks] … are largely irrelevant”.

3. “Although interpreted as structural unemployment unaffected by aggregate demand, the EC’s NAIRU turns out to be quite resilient to structural reforms. The estimate is largely driven by actual unemployment.”

Which means that such measures are misleading when applied to policy, and, given the way the bias plays out in the measures – the application is likely to be highly damaging – as we have seen in many countries.

The MPI paper concludes that “output gaps be given less weight in fiscal policy decisions”.

I would conclude that there are much better ways of estimating these things if one abandons the neoliberal mindset that shapes the statistical representations to deliver results that reinforce the dominant ideology.

As the MPI paper notes “the EC does not model the NAIRU to include hysteresis effects”, for a start!

Music for a busy Wednesday

Jet lag means one wakes up in the middle of the night ready for work – notwithstanding the accompanying headaches from lack of sleep. We all know the drill.

So in the quiet, dark hours one seeks comfort from some music to provide the metre for the typing.

This morning, I have been listening to a Dutch pianist, Annelie de Vries, who recently released her debut Post Minimalist CD – After Midnight.

It is a very soothing set of piano pieces, recorded on a very creaky upright piano that she apparently loves to play.

Here is one of the tracks – At Night – it is very lyrical. I think I will work it out and play it myself when I get home to my piano.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.