What is the NAIRU?
The relationship between unemployment and inflation, at least as measured by official statistics, has not behaved in a Keynesian-style way for a decades.
And yet even today, many economists are of the view that once the unemployment rate falls below an "optimal" rate--called the Non-Accelerating Inflation Rate of Unemployment (NAIRU)--it sets off an inflationary spiral. This acceleration in the rate of inflation takes place through increases in the demand for goods and services. It also lifts the demand for workers and puts pressure on wages, reinforcing the growth in inflation.
So the theory goes. Economists used to say that the NAIRU was 6 percent. In a recent Brookings Institution study three economists, William Dickens, George Perry and George Akerlof, concluded that inflation stabilizes at an unemployment rate of 4.5 percent. This finding is considered a radical revision of the generally accepted view.
However, the authors don't take issue with the basic Keynesian model itself. Instead, they argue that eradicating inflation altogether may do more harm than good. If inflation were to fall to zero, worker productivity would decline, unemployment would rise and the overall economy would sink. According to the authors, an inflation rate of 3.4%, which is consistent with the unemployment rate of 4.5%, is the ideal situation for the economy. It seems that while too much inflation can destroy your health, a little bit of it can actually be good for you.
But does this make sense? The NAIRU is an arbitrary measure, derived from a statistical correlation between changes in the consumer price index and the unemployment rate. What matters here is whether the theory "works", i.e., whether it can predict the future rate of increases in the consumer price index. It doesn't matter whether the theory actually corresponds with any underlying reality; anything goes so long as one can make accurate predictions.
The purpose of a theory, is to present the facts of reality in a simplified form. The theory must originate from the reality and not from some arbitrary idea that is based on a statistical correlation. Using statistical correlation as the basis of theory means that "anything goes." We could find by means of statistical methods all sorts of formulas that could serve as forecasting devices.
For example, let us assume that high correlation has been established between the income of Mr. Jones and the rate of growth in the consumer price index. The higher the rate of increase of Mr. Jones’ income, the higher the rate of increase in the consumer price index. Therefore we could easily conclude that in order to exercise control over the rate of inflation the central bank must carefully watch and control the rate of increases in Mr. Jones’ income. This example is no more absurd than the NAIRU framework.
Contrary to mainstream thinking, strong economic activity doesn't cause a general rise in the prices of goods and services and an economic overheating known as inflation. Regardless of the rate of unemployment, so long as every increase in expenditure is supported by production, no "overheating" can actually occur. The overheating emerges once expenditure is rising without being backed up by production, a situation that can only occur when the money stock is increasing. Once money increases, it generates an exchange of nothing for something, or consumption without preceding production, which leads to the erosion of real wealth.
As a rule, increases in the money stock are followed by increases in the prices of goods and services. Prices are another name for the amount of money that people spend on goods they buy. If the amount of money in an economy increases while the amount of goods remains unchanged more money will be spent on the given amount of goods, i.e., prices will increase. Conversely, if the stock of money remains unchanged it is not possible to spend more on all the goods and services, hence no general rise in prices is possible. By the same logic, in a growing economy with a growing amount of goods and an unchanged money stock, prices will fall.
If the general rise in prices is the outcome of the rising money stock, how can it benefit the economy if inflation stabilizes at 3.4%? This doesn't promote economic growth and stability. It merely erodes real income year by year. People's capacity to save out of their eroding incomes will diminish. Reduced savings hampers the future of economic growth.
Curiously, writers of the Brookings report imply that a higher inflation rate is bad for the economy--a view which represents progress over the old position that a high inflation rate is a good thing. But it is not progress enough. The authors don't recognize that inflation is always bad news, for it alway implies an erosion of real wealth. The only difference between the 3.4% rate of inflation as versus 10% is that the larger number will cause greater damage. Yet all inflation undermine people's well-being. Contrary to the Brookings report then, the ideal setup is the complete eradication of inflation. This however, means that the central bank must stop its monetary pumping and subsidization of fractional reserve banking through deposit insurance.
Ignoring the facts of reality by means of an arbitrary theory is an attempt on behalf of the Brookings report to justify the central bank’s tampering with the economy. This however, can only further undermine people's living standard.
Frank Shostak is chief economist at Ord-Minnett, Australia.