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How Milton Friedman’s NAIRU Has Increased Inequality, Damaging Innovation and Growth

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Yves here. Advocates of Galtian “winner take all” markets frequently invoke both moralistic and efficiency-based arguments for more income inequality. The problem with their argument that “creators” should get to hoard their winnings is that their success does not take place in a vacuum, but is built on the back of generations of cultural, technological, and procedural advances, as well as public-provided infrastructure. And as the post below describes, the idea that a more Darwinian economic order produces higher growth is also spurious.

By Servaas Storm and C. W. M. Naastepad , both Senior Lecturers in Economics at the Delft University of Technology

For many years, economic fatalism ruled the roost: markets are sovereign, governments must never interfere, social democracy is passé, and politics is effectively dead. The big bang of the crisis has ended this fatalism, and is—albeit slowly—leading to calls for a fairer capitalism (as by the Occupy movement).

What has been not widely understood however is that inequality actually matters: the deeper roots of the financial crisis lie in deregulated labour markets and the consequent wage squeeze and sharp rise in inequality. Alan Greenspan spoke appreciatively of “traumatised workers”, who out of fear of job loss accepted deteriorating working conditions, longer hours, stagnant pay (in real terms) and sharply rising inequalities, because all this supposedly helped to keep down inflation, raise firms’ profits and investments, thus promoting growth with low unemployment (the Great Moderation). In actual fact, the wage squeeze depressed aggregate demand and lowered inflation, and thus prompted monetary policy to react by maintaining low interest rates—cheap credit in turn allowed private household and corporate debt to increase beyond sustainable levels. The flip side of this has been an increase in profits, unprecedented income concentration at the top and superabundant liquidity in financial markets, all of which transformed financial markets into unstable institutions, unable to self-correct.

Greenspan’s stance reflected the conventional wisdom, codified in the theory of the non-accelerating-inflation rate of unemployment (NAIRU). It must take the blame for unleashing and at the same time legitimizing a vastly unequal and ultimately unsustainable growth process. It holds that in the longer run, an economy’s potential growth depends on—what Milton Friedman called—the “natural rate of unemployment”: the structural unemployment rate at which inflation is constant. This NAIRU depends on the extent to which labour markets deviate from the benchmark competitive labour market model as a result of regulatory interventions in the form of minimum wages, employment protection legislation, unemployment benefits and wage-bargaining institutions, many of which are designed to reduce inequalities in pay, provide security to workers and reduce inter-firm competition. The more regulated is the labour market, the higher must be the NAIRU and the lower is potential growth. It follows that if one wants to reduce structural unemployment, the only way to achieve this is by abolishing regulatory interventions in the labour market; the price of a dynamic economy and low unemployment is heightened inequality and “traumatised workers”. A second implication of NAIRU economics is that neither central bank policy nor fiscal policy does affect natural unemployment; macro policy is presumably ineffective.

We argue in our book “Marcoeconomics Beyond the NAIRU” that NAIRU doctrine is wrong, because it is a partial, not a general, theory. Specifically, wages are treated as mere costs to producers. Higher real wage claims necessarily reduce firms’ profitability and hence, if firms want to protect profits (needed for investment and growth), higher wages must lead to higher prices and ultimately run-away inflation. The only way to stop this process is to have an increase in “natural unemployment”, which curbs workers’ wage claims.

What is missing from this NAIRU thinking is that wages provide macroeconomic benefits in terms of higher labour productivity growth and more rapid technological progress. This happens for three reasons. First, higher wages raise demand and this increases profits as well as investments; new investments, embodying the latest, most productive technologies, in turn raise productivity. Second, growth raises productivity directly, because it makes possible a further deepening of the division of labour and greater learning-by-doing by firms. Third, higher wages induce firms to step up the pace of labour-saving technological progress. The bottom line is that higher wages raise demand, promote technological progress and increase labour productivity, thereby offsetting at least part (and perhaps all) of the negative impact of higher wages on profits.

NAIRU wisdom holds that a rise in the (real) interest rate will only affect inflation, not structural unemployment. We argue instead that higher interest rates slow down technological progress — directly by depressing demand growth, and indirectly by creating additional unemployment and depressing wage growth. As a result, productivity growth will fall, and the NAIRU must increase. Macroeconomic policy does in other words have permanent effects on structural unemployment and growth―the NAIRU as a constant “natural” rate of unemployment does not exist. This means we cannot any longer absolve central bankers from charges that their anti-inflation policies contribute to higher unemployment. They have actually done so: our estimates suggest that overly restrictive macro policies, in the OECD countries, have actually and unnecessarily thrown millions of workers into unemployment by a policy-induced decline in productivity and output growth. This self-inflicted damage must rest on the conscience of the economics profession.

In our general approach, there is no conflict between growth and egalitarianism ― the trade-off is fictitious, not a natural state of affairs. The reason is that labour productivity growth is higher in economies having more regulated and co-ordinated industrial relations systems. The explanation for this is that the more co-operative are the social relations of production, the more strongly workers will reciprocate firms by providing higher productivity — which is good for profitability and investment. We find, for the OECD countries, that the net impact of regulation is to actually reduce unemployment. High structural unemployment in the OECD cannot therefore be blamed on “excessive” regulation (as in NAIRU doctrine), but must be blamed on the slowdown of demand growth and structurally higher real interest rates. This point is illustrated best by Europe’s heavily regulated, egalitarian and open Nordic countries, which manage to combine growth, technological dynamism and low unemployment. Most other OECD countries, in contrast, have been paying the price of rising inequality (in the last two decades) for no good reason. A fairer capitalism is definitely possible. NAIRU-based economics is an obstruction to more sensible, co-operative and egalitarian macro-management of our economies and it has to change— for economics to revive its earlier sense of purpose and worthiness, which it has lost over the past three decades.

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26 comments

  1. Edward Lambert

    Great article!!! The drum beat continues… Productivity is definitely constrained by tight consumer liquidity from weak labor compensation.
    Economists are going to learn a big lesson, when they see unemployment get stuck above 6.7%. They will try to explain it by pointing to problems in the economy or government. But the dynamic to limit employment is already established and it is due to low labor share. My calculations say the limit is 7.0% but I am allowing some margin of error.

    The next two years should certainly be enlightening for many economists, including Krugman, Delong and Thoma. They do not see the effective demand limit coming.

  2. Impishparrot

    Hello? All talk of policy and regulations have left-out the workers. They make shit and they buy shit. Without them, how would multi-national corporations be able to afford the lawyers, lobbyists, members of Congress – both House and Senate, and it would now appear, members of the US Supreme Court.

  3. Min

    “Higher real wage claims necessarily reduce firms’ profitability and hence, if firms want to protect profits (needed for investment and growth), higher wages must lead to higher prices and ultimately run-away inflation. The only way to stop this process is to have an increase in “natural unemployment”, which curbs workers’ wage claims.

    “What is missing from this NAIRU thinking is that wages provide macroeconomic benefits in terms of higher labour productivity growth and more rapid technological progress.”

    True. But that aside, the original argument is a non-sequitur. Certainly, a fight between labor and capital over how to share the economic pie can lead to inflation, but it does not follow that full employment leads to accelerating inflation instead of converging inflation or fairly constant inflation. The NAIRU argument takes the behavior of capital as given and puts the onus of responsibility on labor. It amounts to special pleading.

    BTW, it is not unusual in human systems to have conflicts that threaten to become a runaway feedback cycle. But somehow that rarely happens, for reasons that are not always clear. We still do not understand human systems all that well.

    1. nonclassical

      ..Greenspan’s (therefore Rand “goddess”) ideological position is based upon equal access and most especially information to markets…this “equality” is undone by secrecy, insider trading, HFT, etc, etc.

      In other words, it’s all ideological-never existed, anywhere, any time, in reality..

  4. Hugh

    In a kleptocracy, looters are not called looters. That might cause the serfs to rebel. So they are called “creators” instead, and their stolen loot becomes the just and righteous reward for their work. Indeed it is the manifestation of natural law without which society and the economy would fall into darkness, etc., etc.

    “Greenspan’s stance reflected the conventional wisdom, codified in the theory of the non-accelerating-inflation rate of unemployment (NAIRU). It must take the blame for unleashing and at the same time legitimizing a vastly unequal and ultimately unsustainable growth process.”

    NAIRU is not to blame but the looters who espoused it. They are afterall the crafters of the conventional wisdom. There were no mistakes. As looting-enabling propaganda, NAIRU functioned exactly as it was supposed to.

    “firms want to protect profits (needed for investment and growth)”

    No. Firms are inanimate. They do not want anything. Nor is it the case that their managements want to protect their profits for the purpose of investment and growth. In a kleptocracy, management wishes not just to keep but increase profits in order to loot them.

    The authors of this article, like those they criticize, leave out the social purposes for why we have an economy and why we allow corporations to exist. Both look on the economy as a natural process governed by natural laws (that is what this article is about: which laws best describe the economy), and not the human enterprise it is. The real measure of the economy is whether it is producing the society we want to live in. Classical measures, such as growth and productivity, may be irrelevant or even at odds with this construction.

    1. from Mexico

      Hugh said:

      NAIRU is not to blame but the looters who espoused it. They are afterall the crafters of the conventional wisdom. There were no mistakes. As looting-enabling propaganda, NAIRU functioned exactly as it was supposed to.

      Exactly!

      NAIRU is the perfect example of purpose-driven science, and Milton Friedman et al and NAIRU rank right up there with the German racial scientists and eugenics and social Darwinism when it comes to justifying pure evil.

      1. David Lentini

        I isn’t fair to call NAIRU “science”, since it, like economics, isn’t scientific in any way. Science has enough problems without having to take on charlatans like Friedman.

        Friedman’s work, as exemplified by NAIRU, is pseudo-science used to justify the demands of the industrtialists and financiers to remove governmental economic regulation. It’s an example of what I like to call “Laissez-Faire Lysenkoism“, after the infamous Soviet agronomist who rigged his experiments and data to demonstrate that communism had a biological basis.

        I agree very much with the article’s analysis and conclusions. But I want to add two things:

        1. The idea that there really is no “Gault” in a modern economy is not new. J.K. Galbraith described the inherent interdependence between management and workers in his book The New Industrial State in which he coined the term “technostructure” to describe how modern industry no longer could realistically claim to run by a single person. Instead, the rise of scientific and business specialties made nearly all employees of a business vital. No one, especially the CEO, could really claim to all the profits.

        2. I think the question of economic performance is too narrow. The real issue ultimately is power. At some point, wealth will become so concentrated that the rich won’t care about economic performance; they’ll just make vassals and slaves of the rest of us. At some point money per se will become obsolete, since everything will be owned by a few anyway.

        1. Massinissa

          On number 2, I dont remember Feudalists ever worrying about economic growth, except when it came to how much grain they could extract from their serfs.

          It doesnt matter all that much to the ruling classes how much growth there is or not as long as they control all that there is.

          If low growth means easier control, then they will prefer that. Though I must say im not sure that low growth does mean easier control.

          1. Doug Terpstra

            Dave’s close, but you got it! Neoliberal economics is not interested in a dynamic economy, in optimum output, or in aggregate wealth-creation, and most certainly not in shared prosperity (egad!). It is only relative wealth that concerns our neoliberal elite.

            Relative wealth is the key to power and concentrated wealth to absolute power, the holy grail. Thus inequality is not an unintended consequence at all; it’s the neolibs’ actual goal, a feature not a bug. Power is their ultimate narcotic. And their pursuit of it is relentless and violent.

            I believe this is the elemental nature of our criminal elite that people must understand, first and foremost, before change is remotely possible. Unfortunately it’s difficult for sane people to comprehend such madness, and they continue to believe people like Obama have a conscience, that Congress really seeks the greater good, that our warriors really want to avoid war. They can no more relate to people like Jamie Dimon, Lloyd Blankfien, or Benjamin Shalom than they can to a pedophile or a rapist. They have no common reference with the enemies of humanity.

          2. David Lentini

            Feudalism wasn’t concerned with economic growth and performance. Those ideas came with the Enlightenment and the Modern eras, and the end of monarchy. My point was to use “vassal” in the sense of someone who owe allegiance to a master but is not a slave.

            As for the other points you made, I was trying make those too: At some point the inequality makes modern economics irrelevant.

        2. from Mexico

          David Lentini says:

          I isn’t fair to call NAIRU “science”, since it, like economics, isn’t scientific in any way.

          No true Scotsman, hun?

          I think the indictment of science is far broader than mere economics.

          1. from Mexico

            And by the way, who gets to decide what is science and what is pseudo-science?

            How does the layman tell the difference?

            1. David Lentini

              I’ll assume that you’re not just baiting me. Or are you taking the side of the climate-change deniers?

              Try starting with the basic definitions:

              http://en.wikipedia.org/wiki/Science

              You can also take the time to read the classics of Bacon, Descartes, Newton, et al.

              A succinct definition of “science” is not that easy. But I argue that scientific statements at the least have to be robust—they have to be capable of reliable confirmation i.e., identical conditions should lead to the same observations, in other words “predictability” (Popper’s “falsification” is a useful rule of thumb); a new theory should be able to explain or describe all relevant phenomena described by older theories as well as new phenomena to maintain unified explanation.

              As I’ve argued many times on this ‘blog, economics fails both tests. Instead economists offer statements that ape scientific forms, what I call “pseudo-science”. They do this out of ignorance and a desire to cow the public (including scientists).

              And we’re all entitled to review the facts and make our judgment in light of the definitions and uses of the term “science”.

              I don’t see your point in attacking science, which you of course never define. I believe that humanity needs a view of life that is far broader than provided by science alone. But the scientific view is still vital to our lives. The problem is that far too many have become mesmerized by the usefulness of science in addressing certain types of questions, and have been trying to force their own investigations into a scientific mold rather than admitting that the scientific method cannot address all questions equally well.

              1. from Mexico

                Well for me, the question is still who gets to decide what is science and what is pseudo-science?

                Is it the guy with the most money?

                The guy with the biggest printing press or soap box?

                The guy with the most political power?

                The Nobel Prize committee?

                University professors?

                The person with the most publications?

                The most prestigious and renowned scientist?

                The school of hard knocks has taught us that none of the above are trustworthy or reliable. The historian of science Naomi Oreskes gives a great talk about this phenomenon here:

                http://www.blogtalkradio.com/virtuallyspeaking/2012/04/12/naomi-oreskes-tom-levenson-virtually-speaking-science-1

                This means that one is therefore forced back onto their own lights.

                Which brings us back to the question: How does the layperson tell the difference between science and pseudoscience? I don’t know many laypersons who have read Bacon, Newton or Descartes.

                And what if they’ve read Hume, Kant or Nietzsche? Then they come away with a very different idea of what science is. For example:

                Thus, though metaphysics is an illusion from the point of view of science, science in turn becomes but another state of illusion as far as absolute truth is concerned. In The Birth of Tragedy Nietzche already attacks the scientific optimism of his time under the guise of “Socratism.” The “theoretic man” pursues truth in the delusion that reality can be fathomed, and even purged of evil, by rational thought and its applications. But faith in the omnipotence of reason shatters, for the courageously persistent thinker, not only on the fact that science can never complete its work but chiefly on the positive apprehension that reality is irrational. As Nietzsche writes later, “We are illogical and therefore unjust beings from the first, and can know this: that is one of the greatest and most insoluble disharmonies of existence.”

                –GEORGE A. MORGAN, What Nietzsche Means

                1. David Lentini

                  Mexico, I already answered that question. I really don’t care what Naiomi Oreskes thinks; I think for myself. And I don’t have much patience for people who won’t make the effort to learn enough about science to answer the question for themselves.

                  There’s a world of difference between Oreskes’s writings about the abuse of science to further partisan political positions, and the meaning of science itself and deciding what qualifies as science. Just make the effort to learn and stop quoting everyone else.

                  As for your quote about Nietzsche, all this argument leaves is the usual relativistic confusion. And that just invites abuse. Science and the scientific method can be defined well enough to distinguish reliable claims from charaltanism. If you want absolutes, you might just as well accept what the most powerful tell you to accept.

                  1. from Mexico

                    Oh I get it!

                    You get to decide what science is and what pseudo-science is.

                    It’s like Humpty Dumpty said:

                    ‘I don’t know what you mean by “glory”,’ Alice said.

                    Humpty Dumpty smiled contemptuously. ‘Of course you don’t — till I tell you. I meant “there’s a nice knock-down argument for you!”‘

                    ‘But “glory” doesn’t mean “a nice knock-down argument”,’ Alice objected.

                    ‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

                    ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

                    ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

                    –LEWIS CARROL, Through the Looking Glass

                    1. OldFatGuy

                      Yes, someone does get to decide. Because there ARE universal truths, like it or not.

                      For example, the world is not flat. Period. All the relativism in the world won’t change the fact that the world is NOT flat.

                      Arguing against fact doesn’t make one some sort of relativist intellectual (is that a term??) it makes one WRONG. And the only way humanity can ever transcend chaos is to acknowledge those truths that are universal. We, as a species, are still nowhere near there, and it’s like trying to play a baseball game with no foul lines, basees, umpires, or even a ball. Yes, if life were like a baseball game there are entire groups of people today that argue it can be played without a ball. We’ll never get beyond this chaos and into a peaceful order until we all get on more or less the same playing field, and the only way to do that is to acknowledge truths (or rules, like foul lines, in baseball).

                      Science is but one avenue to identify those truths. There are others.

          2. David Lentini

            Mexico, you made the claim that NAIRU was “purpose-driven science”. I countered with the point that NAIRU was pseudo-science and that economics is not a science. Neither statement has anything to do with indicting science.

            If you argue about flaws in science, whatever that means,n then start a new thread.

            1. Hugh

              Science is a method, but what that method is applied to and how its results are interpreted are not. Science is also a human activity and so must be viewed through the lens of our humanity, not as objective truth external to us.

  5. allcoppedout

    Lord save us! Humans are biological systems and such systems have all kinds of modularity to protect various sub-systems and the overall system from collapse.

    So where is a modular economics?

    Growth? What’s that? A sensible, scientific notion of it would be a system that raises everyone a lot, curtails rich by-products that capture politics and load the many with economic rents, educates to planet level responsibility, reduces work and squalid energy burning and related wars …

    We should be seeking stability and incorporating real well-being and a new understanding of growth. Growth as we have it is a Gucci handbag while others live on a squalid jack tuna boat earning almost nothing for your fish, eaten with a fancy T-shirt on proclaiming ‘save the dolphins’, served with salad picked by migrant workers to keep your figure trim along with the coke you snort.

    What growth should be one of the first questions of economics, followed by how we might create a modular financing of what we should be doing. Without such, no subject.

  6. Aussie F

    In reality all the dynamism is in the state sector – from the internet, to superconductors, pharmaceuticals, biotechnology, containerisation. ‘The market’ just deals with copyright and marketing.

    1. charles sereno

      Sorry, late reply, having ISP problems. When I see NAIRU, I think of Nauru. NAIRU, an unhappy acronym; Naura, an unhappy island since its “discovery.” Nauru, however, has produced perhaps the most complicated, as well as, beautiful string figures known. Google “nauru string figures” to find images and even clickable instructions (they’re not easy!). If anyone is into authenticity, use a string made of plaited human hair.

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