Job Insurance – Part 9 (What is NAIRU?)

In Economic Planning, Economics, Full Employment, History and Politics, Liberalism, New Deal, Political Ideology, Politics of Policy, Progressivism, Public Policy, Public Works, Social Democracy, Social Policy, Taxes, Unions, Welfare State, WPA on October 14, 2009 at 5:56 am
No, the other one.

No, the other one.

Introduction:

(For previous parts in the series, see here)

In talking about job insurance, or indeed any policy that seeks to help the working class, there is always someone who will argue that any effort to reach a lower rate of unemployment will cause inflation to achieve Zimbabwean levels. The intellectual justification for this is NAIRU – a term invented by monetarist economists as part of their war against Keynesianism.

But what is NAIRU? Does it really exist? Is it a constant or does it change? And most importantly, is it a valid objection to attempting to lower the unemployment rate?

Background:

But to understand how we got there, we have to understand that economics have always interacted with the idea of unemployment in a political way. In the classical economics of the late 18th and 19th century, involuntary unemployment cannot exist. Supply and demand automatically adjust the economy towards full utilization of all resources. If unemployment does exist, then classical economists argued that it’s voluntary, because workers prefer being idle to the wage rate that the market has set for their labor. The solution therefore is to cut wages. Late 19th century economists added onto this view by equating unions with monopolies, arguing that they raised the price of labor above the market rate, and developed Say’s Law, arguing that, in a competitive economy, production produces creates its own demand, which means that on their own, corporations could never create a glut in the market that would cause prices to fall so drastically as to cause an economic slump.

One of Keynes’ major innovations was to prove that you can actually have involuntary unemployment. (You can find the General Theory here; everyone should read it at least once). The upshot is that, for the first time, economists understood that the unemployment rate could actually be shaped by conscious policy, and that full employment was possible. William Beveridge, the great British policy designer, famously broke down unemployment into three categories, structural (long-term unemployment caused by a defect in the economy), cyclical (unemployment caused by the business cycle, or alternatively by seasonal fluctuations in fields like agriculture), and frictional (temporary unemployment caused by people moving between jobs), and argued that in a free society, one could eliminate both structural and cyclical unemployment through Keynesian economic policies and maintain an unemployment rate of below 3% at all times (this being his estimate for normal frictional employment). Beveridge’s Full Employment in a Free Society(1944), along with his more famous report on welfare, became the British Labour Party’s foundational text for the next forty-odd years.

At the same time that Beveridge was guiding British foreign policy, FDR’s National Resources Planning Board was designing America’s own commitment to post-war full employment, and the Swedish Social Democrats (assisted by the Stockholm school of economists) had been experimenting with full employment policy for over a decade. Later, France, West Germany, the Benelux countries, and the rest of the Scandinavian countries, followed these initial forays.

Opposition and the origins of NAIRU:

The idea that government activism could so radically reform capitalism for the better was deeply threatening to ideological camps outside of the broad spectrum of the center/center-left/left that had signed onto the full employment project. On the far left, full employment seemed to directly conflict with the idea that capitalism would inevitably trend towards immiseration and crisis, that the reserve army of the unemployed was a core element of the wage system, and that the state was merely the board of directors of the ruling class. However, it was the political right that felt the greatest threat. Full employment shot straight at the heart of the laissez-faire project: the failure of the market to eliminate unemployment made the private sector appear less than perfect; the idea that government intervention and planning could work threatened their belief that the public sector was inherently incompetent and that intervention into the economy would always be counter-productive; and the idea that all of this could be politically popular inflamed their fears of a “road to serfdom.”

Hence, NAIRU.

Like most terms invented by economists, NAIRU is an acronym, in this case standing for the Non-Accelerating Inflation Rate of Unemployment. It was invented in the 1970s by monetarist economists like Milton Friedman was that Keynesian efforts to boost demand and thereby maintain low unemployment rates were making things worse, because they were increasing inflationary expectations, thereby reducing investment incentives and resulting in ever-accelerating inflation instead of a lowered unemployment rate. Indeed, Friedman argued that there was a “natural rate” of unemployment – driven by minimum wage statutes and union wage demands – below which the government can’t push.

As an intellectual and political weapon, NAIRU was devastating. At a stroke, it argued that the central promise of Keynesianism – the idea that permanent full employment could be created through government action – was an impossible dream, and that chasing it would only wreck the economy on Weimarian shoals. Intellectually, it reinforced the idea of the free market as natural and self-correcting, while shifting the goals of economic policy-making from unemployment where laissez-faire economists could offer little in the way of expertise, to inflation, where the formulas of monetarist economics would make them key players in the Reagan administration. At the same time, it gave conservatives and business interests justification for their hatred of the minimum wage and unions, while presenting their opposition as virtuous and disinterested science. And for a time in the 1970s, as the economy spiraled into stagflation, which baffled Keynesian economists (although it probably wouldn’t have baffled Keynes), the monetarists seemed to be economic prophets. The monetarists, once they had come to power within the Federal Reserve and the Reagan administration, were able to use NAIRU as leverage to argue that the only way for the economy to recover from inflation was to accept much higher interest rates and thus higher average unemployment rates. Whereas the 1950s had seen an average unemployment of less than 5% and the 1960s a four-year stretch of sub-4% unemployment, the monetarists argued that this level of unemployment was unacceptably low and that an average of 7% would be necessary to stave off inflation – workers would have to accept as normal levels of unemployment previously only experienced in recessions.

There’s just one problem with NAIRU: it doesn’t make any sense. The natural rate argument put forward by Friedman has been widely discredited, given the fact that the level of employment associated with accelerating inflation has varied wildly. The 1950s were a period of extremely low inflation, with yearly averages between 0-1%, yet unemployment rates averaged less than 5% , suggesting a NAIRU of 5%; the U.S saw an unemployment rate of 1.9% in 1943, 1.2% in 1944, and 1.9% in 1945 with a manageable inflation rate of about 3%, suggesting a NAIRU much closer to 2%. Viewed historically, NAIRU is a moving target – and if you look at the advice of monetarist economists throughout the 1970s, NAIRU is described as 4, 5, 6, or 7%, always at a level above of where it was at the time. Even if we take up the more moderate version of NAIRU, which doesn’t assume that there is a “natural” rate, but still argues that inflationary expectations will exist if unemployment falls below a certain level, there are problems:

  1. Inflation isn’t inevitable – one of the flaws in NAIRU is that, in suggesting that government policy can shape the unemployment rate but with side-effects, it then assumes that the government either can’t or won’t counter inflation at the same time. Now, if one is using standard “fiscal” Keynesian methods of raising and lowering interest rates and aggregate spending levels (which in turn are based on certain assumptions about inflation and unemployment), trying to do both at once is like trying to push and pull a door at the same time. However, as I have noted, there are many historical examples of countries achieving full employment or something close to it with low inflation, using either bonds to shift spending into the future or wage and price controls to set the inflation rate directly. Thus, we can’t assume that government policy to reduce unemployment will increase inflation unless we take into account how other government policies might also shape inflation.
  2. There’s no natural rate of inflation – The other major problem is that NAIRU doesn’t particularly answer what the appropriate level of inflation should be, which is a central question if one is trying to draw bright lines of unacceptable rates. People’s views about inflation are relative and historical – in the late 1960s, when the pressures of the Vietnam war and LBJ’s Great Society first convinced people that inflation was “out of control,” the inflation rate bounced between 4-5%, which a disinterested observer might conclude as within normal limits, but which a country used to the below 2% rates of the 1950s saw as abnormal. In the late 1970s, when inflation reached double-digits, a 4-5% rate would have appeared mild. This raises the question of whether we can “objectively” determine at what point an unacceptable level of inflation has arrived, suggesting that efforts to reduce unemployment have gone too far.
  3. Inflation is NOT politically neutral – And of course, the major elephant in the room is that inflation does not help or hurt evenly. Inflation is very damaging to capital formations, and is thus a major threat to corporations, especially banks, and the rich. People without capital have different interests – especially if low inflation comes at the cost of high unemployment rates. Thus, inflation is a trade-off, not necessarily with unemployment, but rather between capital and labor (given that low inflation/deflation increases the real net worth of capital formations, yet creates higher unemployment for workers), between rentiers whose income comes from their capital and workers whose income comes from their wages (one major consequence of monetarist economics is a narrow fixation on wage growth as a danger as opposed to a positive outcome), and between the young and the old. And yet, NAIRU presents inflation as a universal evil, and stable prices as a universal good.

Conclusion:

One of the major successes of the conservative movement in the last thirty years has been to normalize a kind of political dialogue in which economic conditions are seen as equivalent to natural forces and therefore unalterable by human means (except when those economic forces threaten the financial industry). One element of that has been to derail a form of politics in which a society collectively determines what level of unemployment it wants to have, and replaces it with a form of politics that treats nigh-10% unemployment as something that can’t be changed.

While this is beginning to change – the stimulus was a good first step – we’ve yet to really transition to thinking of the unemployment rate as something under the public’s control. And yet, we know from experience that it is, in fact, possible to sustain low unemployment for quite some time. Even without job insurance, we’ve been able to hold unemployment rates below 5% for as long as seven years, and below 4% for periods of up to four years. In other nations, unemployment has successfully been held below 3% for decades.

So why let NAIRU get in the way?

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  1. […] before I even started the Job Insurance series, I wrote this post on presenting a plan for public employment.  And I still believe that […]

  2. […] of the most intellectually-daunting objections to full employment is the fear that it would create unstoppable inflation. But contrary to arguments that proponents of Keynesianism and full employment policies […]

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