Wednesday, May 19, 2010

The (??) Natural Rate of Unemployment

Milton Friedman defined the natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), at least at the level of abstraction of this post:
"The 'natural rate of unemployment' in other words, is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets." -- Milton Friedman (1968), as quoted in James K. Galbraith (1998)
Two mathematical mistakes are embedded in the above definition.

First, what does Friedman mean by the "Walrasian system"? At the time of his statement, the Arrow-Debreu model of intertemporal equilibrium was becoming the canonical statement of general equilibrium theory. But the Arrow-Debreu model is a very short run model, in which the initial quantities of capital equipment are among the given endowments. Consequently, a solution to the model yields neither a rate of employment nor a rate of unemployment, independent of time. Rather, these rates are time-varying. So he cannot mean to refer to that model.

Now, Walras himself presented a model with given quantities of capital goods and a supposed steady state set of prices and quantities. But this model was just logically inconsistent. In consistent long-run economic models the set of capital goods are found by solving the model, not taken as givens. Thus, the logic of such models is not about allocating given resources among alternative ends. To refer to such a model as "the Walrasian system of general equilibrium" is dubious.

Second, Friedman's definition relies on an implicit mathematical theorem: that the equilibrium solution of whatever model he is talking about is unique. But no reason exists for such a theorem to hold in either the Arrow-Debreu model or a long run equilibrium model with many markets. I have myself created a model with multiple equilibria.

Here, then, is another example of right-leaning economists giving decades of policy advice based on theoretical claims with no support in economic theory. Unsurprisingly, the policy did not work empirically either, as can be seen by looking at results in the 1980s and 1990s. (These claims are not new. James Galbraith made my second point long ago.)

Have mainstream economists ever addressed this failure? Did they not mostly just continue their mistake with Dynamic Stochastic General Equilibrium (DSGE) models?

  • Milton Friedman (1968) "The Role of Monetary Policy", American Economic Review Papers and Proceedings (May): pp. 1-17
  • James K. Galbraith (1998) Created Unequal: The Crisis in American Pay, The Free Press.


Mathew Toll said...
This comment has been removed by the author.
Mathew Toll said...

For the longest time now, I’ve thought that Freidman’s thesis is a re-articulation of Marx’s “labour reserve army” – ‘naturalized’ of course.

Patch said...

This relatively new article might be of interest for you:

Robert Vienneau said...

Thanks for the comments and recommendations. It does seem like Volker and Greenspan were deliberately trying to ensure the reserve army was big enough not to frighten the capitalists.

Anonymous said...

The notion that neo-liberalism was creating a "reserve army" to tame the working class was raised at the time.

Nicholas Kaldor argued in the 1980s that inflation may have dropped but this lay "in their success in transforming the labour market from a twentieth-century sellers' market to a nineteenth-century buyers' market, with wholesome effects on factory discipline, wage claims, and proneness to strike." [The Scourge of Monetarism, p. xxiii]

Another British Keynesian economist described this policy memorably as "deliberately setting out to base the viability of the capitalist system on the maintenance of a large 'industrial reserve army' [of the unemployed] . . . [it is] the incomes policy of Karl Marx." [Thomas Balogh, The Irrelevance of Conventional Economics, pp. 177-8]

And they were right. For all their claims about creating labour-market "flexibility", the authorities manipulated the economy whenever unemployment fell or wages rose. In other words, only flexible downwards...

As Michal Kalecki correctly predicted, the 1970s saw the rise of "a powerful bloc" between "big business and the rentier interests" against full employment and that "they would probably find more than one economist to declare that the situation was manifestly unsound." The resulting "pressure of all these forces, and in particular big business" would "induce the Government to return to . . . orthodox policy." Friedman was one of those economists and he played his part with vigour...

Why? As Balogh put it, full employment "generally removes the need for servility, and thus alters the way of life, the relationship between classes . . . weakening the dominance of men over men, dissolving the master-servant relation. It is the greatest engine for the attainment by all of human dignity and greater equality." (p. 47) Or, to quote Alexander Berkman, unemployment "is a whip in [the bosses'] hands, constantly held over you, so you will slave hard for him and 'behave' yourself"

This role of unemployment was acknowledged when Edmund Phelps won the (so-called) Nobel Prize for economics a few years back... yet did they not give it to Karl Marx?

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