Oh NAIRU don’t: part one


Raych always makes fun of me for being bad at explaining stuff. Like when someone asked me what ‘sub-prime’ meant and I said ‘less than prime’. But often arcane terms in economics hide something really banal or else something economists really can’t explain very well. So last week comes the question: what is the NAIRU? My paraphrase of the news reports: Shadow Treasurer Malcolm Turnbull asked Treasurer Wayne Swan what he thought the level of the NAIRU was, and isn’t it hilarious because what the hell is it? (As a former Fairfax subeditor I disapprove, but cheers Simon Jackman for saving the above image before it was dumped in posterity’s Recycle Bin. And you’re quite right, it’s the layoffs.)

NAIRU stands for Non-Accelerating Inflation Rate of Unemployment. It’s a very clumsy way of saying, well, that rate of unemployment at which inflation does not accelerate. Why so clumsy? Please, allow me to explain at great length over multiple posts.

The concept has its roots in the idea of the ‘natural rate of unemployment’, a term I think coined by Milton Friedman. This was the unemployment rate that would be “ground out by the Walrasian system of general equilibrium equations” – that is, it’s the rate of unemployment that would exist if every market were in equilibrium. Unemployment below that level would be possible only temporarily, because firms were fooled, interpreting increased money demand for their products as an increase in real demand rather than generalised inflation. To the extent that inflation is anticipated, this mistake will not be made. Therefore, further reductions in unemployment can be bought only at the expense of an increased rate of inflation, because only the unanticipated part of price rises will fool the markets.

The ‘natural rate’ should not be confused with ‘full employment’. This is not a term Friedman would use, but it was the goal of postwar macropolicy, and indeed pretty much achieved in many countries, including Australia. (It’s a complicated question how much policy was responsible however.) ‘Full employment’ is a non-technical term where the commonsense definition actually matched the economic definition for a few years in the 1940s and 1950s. To most people ‘full employment’ means that everyone who wants a job has one. Technically, full employment was never quite zero unemployment, because there were always people in transition between jobs. But in Australia it was pretty close, way closer than we are now. When unemployment topped 2 per cent in 1961 it was a political crisis and the Coalition was saved from election defeat only by spectacular disarray in the Labor camp.

Gradually, though, the economic meaning of ‘full employment’ departed from the commonsense definition. By the late 1950s in Australia it was not uncommon to hear economists talk about ‘over-full employment’. The idea that the price level could keep rising slowly but surely upwards – permanent ‘creeping’ inflation – was strange and slightly evil to a generation used to cycles of inflation and deflation. Since the war, prices had not fallen, and a number declared the situation fundamentally unsound – though, apart from a spike around the Korean War, inflation rarely topped 3 per cent. But Australia was plagued also by recurring balance-of-payments problems, which in those days meant something because the central bank had not built up enough foreign exchange reserves to sustain a deficit for too long. The Bretton Woods agreement had fixed exchange rates, and the Korean War price spike had affected Australia particularly strongly and left its price structure comparatively high compared with its trading partners. Policymakers were won over to the idea that prices and wages had to be held down.

Strange as it may seem, it was a great worry to business and government that the centralised industrial bargaining system seemed to be breaking down. No sooner did arbitration judgements begin to take inflation into account in setting wages (the precedent was set in the 1953 Commonwealth Basic Wage case, which ended the indexation of wages to inflaton) than actual wages began to break away from the awards. Workers were getting better wage deals at an enterprise level than the arbitration system was giving them, and this was quite a headache. Theoretically, a market system which ground out inflation could be in no kind of equilibrium, so the level of unemployment which caused this outcome must be ‘over-full employment’. ‘Full employment’ = zero inflation.

In the political environment of the late 1950s, though, this economic judgement was politically poisonous. We are as yet a long way from a Coalition government being able to declare war on inflation, much less the ALP, and woe to the government who allowed unemployment to rise above 2 per cent!

But the long ‘full employment’ honeymoon finally ended in the ‘credit crunch’ of 1960/61. It took another balance-of-payments ‘crisis’. Even more, it took a new weapon, which had been forged quietly and painfully over the previous 15 years – monetary policy. (That’s another post.) Monetary policy was believed to be weaker than fiscal policy, but, in the words of economist D. C. Rowan, it was “tactically agile”. Monetary policy was less well understood by the public, and did not need to be publicly announced and shepherded through caucus, Cabinet and Parliament.

Since the ‘political’ constraints affect mainly the use of fiscal devices, it is urgent to consider whether the admitted lags in fiscal policy cannot be partly offset by endowing our monetary techniques with greater breadth, precision and flexibility. This is not to deny that ‘political’ difficulties also exist in the monetary field as do constitutional obstacles. It is merely to suggest that, in this particular field, it may be possible to overcome them – at least in part. [Rowan, “The problem of economic policy”, Economic Record, November 1956]

There are differing accounts as to whether the government meant to provoke a recession, or even whether it actually did provoke that recession, but there is no doubt that it went down well at the Treasury, and stimulus was a long time coming. For a couple of years there was no inflation. 2-3 per cent unemployment was the price, and the Menzies government weathered it, just.

The rest of the decade was a reprieve. Macroeconomic policy was widely seen in the press as a mess: ‘stop-start’ was the popular term, and Menzies et al were lambasted for a failure to ‘plan’ – ‘planning’ being a buzzword equivalent to, say, ‘innovation’ these days. It meant different things to different people, and to the government it meant very little, or perhaps mainly the idea that wages needed to be restrained so that Australians did not “live beyond their means”. But meanwhile, the balance-of-payments constraint was fading away as foreign investment flowed into mining and exports flowed out, and as the dose of unemployment apparently really had held back inflation. The last phase of the world boom was underway.

To be continued…

By the way, this is based on a paper I wrote a year or two ago, where it is all put in slightly more detail with slightly less snark.

Published in: on 25 February, 2008 at 8:59 pm  Leave a Comment  

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