Excerpts from -- "Time to ditch the NAIRU"

By James K. Galbraith

Journal of Economic Perspectives, Winter 97, Vol. 11 Issue 1, p. 93,

"First, the theoretical case for the natural rate is not compelling. Second, the empirical evidence for a vertical Phillips curve and the associated hypothesis that lowering unemployment past the NAIRU leads to unacceptable acceleration of inflation is weak, and has become much weaker in the past decade. Third, viewed collectively, attempts to estimate the location of the NAIRU have become a professional embarrassment; disagreements remain on too many basic issues. Fourth, adherence to the concept as a guide to policy has major costs and negligible benefits. Conversely, the risks of dropping the natural rate hypothesis are minor, while the benefits from a sustained pursuit of full employment could be substantial."

"The Phillips curve had always been a purely empirical relation. . . Friedman supplied no theory for a short-run Phillips curve, yet he affirmed that such a relation would 'always' exist. And Friedman's argument depends on it. If the Phillips relation fails empirically -- that is, if levels of unemployment do not in fact predict the rate of inflation in the short run -- then the construct of the natural rate of unemployment also loses meaning."

". . .while Friedman's core argument was macroeconomic, a gloss on then-prevalent Keynesianism and the Phillips curve, he also phrased a version of it in microeconomic terms. According to this alternate version, the natural rate of unemployment is the point of intersection of supply and demand curves in an aggregative, classical market for labor. . ."

"Such a labor market is free of money contracts and money illusion. Employment is purely a function of the real wage, acting on the marginal physical productivity of labor and on the marginal disutility of work. In such a market, nominal shocks can have only nominal, not real, effects: money (for which, read macroeconomic policy) is neutral, perhaps even in the short run. Friedman's formulation states explicitly that persistent unemployment below the natural rate must lead through the labor market to rising real wages, whose nominal element is at least the proximate cause of rising prices."

"This story is pre-Keynesian in all its essentials. And the essential theoretical objections to it were set forth by Keynes (1936) in the General Theory. First, labor supply and demand cannot be modeled in terms of the real wage, for workers care about relative wages as well as real wages; this introduces an asymmetry between nominal wage cuts and nominal price increases. Second, workers cannot actually negotiate for their own real wages, because of an interdependency between money wages and the price level. These two objections, which are the foundations of the General Theory, undermine the concept of the labor supply curve (the 'second classical postulate,' as Keynes called it) and hence the very construct of an aggregative 'labor market.' The neoclassical synthesis buried these objections issue long ago, but never actually resolved them."

"If there is no aggregative labor market in any sense meaningful to economics, then theories based on shifts in wages clearing labor markets will fail to hold. From a proper Keynesian perspective, the correct response to the neo-Walrasian formulation of the natural rate hypothesis is simply, 'Sorry, but the labor market is a misconception; it doesn't exist.' Aggregate demand for output, and not supply and demand for labor, determine employment. By these lights, the aggregative labor market, lacking a defensible supply curve as well as any internal clearing mechanism, is simply a failed metaphor, unsuitable for use as the foundation of a theory."

The Costs of NAIRUvianism

"Speaking politically, the natural rate hypothesis has served a conservative cause. Since Friedman's speech, orthodox macroeconomics has virtually always leaned against policies to support full employment. In spite of stagnant real wages, it has virtually never leaned the other way."

Conclusion: A World Without the NAIRU?

"Can economics live without the aggregative labor market, the natural rate and the NAIRU? Could physics survive without ether? Surely the measure of scientific maturity lies in a willingness to match theory with evidence, to discuss anomalies with an open mind, and to move on when it is appropriate to do so. Occasionally, this may mean reconstructing one's thinking from the ground up."

"Of course, when inflation hits, it can be repressed by recession and stifled by stagnation. The test of policy, however, is to reconcile reasonable price stability with acceptable growth at the highest achievable levels of employment and to manage shocks with the least disruption."

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