It is High Time to Ditch the NAIRU

8/11/2019 It is High Time to Ditch the NAIRU

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Journal of Post Keynesian Economics /Summer 2007, Vol. 29, No. 4 531

2007 M.E. Sharpe, Inc.

01603477 / 2007 $9.50 + 0.00.

DOI 10.2753/PKE0160-3477290401

SERVAAS STORM AND C.W.M. NAASTEPAD

It is high time to ditch the NAIRU

Abstract:According to the mainstream theory of equilibrium unemployment,

persistent unemployment is caused (mainly) by excessive labor market

regulation, whereas aggregate demand, capital accumulation, and techno-

logical progress have no lasting effect on unemployment. We argue that the

mainstream nonaccelerating inflation rate of unemployment (NAIRU) model is

only a special case of a general model of equilibrium unemployment, in which

aggregate demand, investment, and endogenous technological progress have

long-term effects. It follows that the labor market policy prescriptions (i.e., to

drastically deregulate), following from the standard NAIRU model, can by no

means be generalized. Empirical support for the general model is provided by

an econometric analysis for 20 Organization for Economic Cooperation and

Development (OECD) countries (198497): demand factors are the overriding

determinants of structural unemployment in the OECD.

Key words: demand-led growth, endogenous technological progress, equilibrium

unemployment, KaldorVerdoorn relation, NAIRU.

Over the past 25 years, unemployment has risen dramatically in manyOrganization for Economic Cooperation and Development (OECD)countries, especially in Europe. It is widely believed that an importantpart of the high unemployment rate is caused by labor market rigidities,due to trade union power, strict employment protection, and other labormarket institutions (International Monetary Fund [IMF], 2003; Layard

et al., 1991; Nickell et al., 2005; OECD, 1994). Other potentially impor-tant causes of high unemployment, such as the long-term slowdown ofaggregate demand and of capital formation in particular, have been ne-glected.1This view has its basis in the standard model of the equilibrium

The authors are affiliated with the Department of Economics, Delft University ofTechnology, Delft, the Netherlands, [email protected].

1Among the lonely voices who argue that aggregate demand growth dominates thedetermination of unemployment are Galbraith and Garcilazo (2004), Palley (2004),and Rowthorn (1995; 1999).


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532 JOURNAL OF POST KEYNESIAN ECONOMICS

unemployment rate (also known as the nonaccelerating inflation rate ofunemployment or NAIRU).

According to the standard NAIRU model, the equilibrium unemploy-ment rate does not depend on aggregate demand but is fully determinedby wagepush factors, including long and durable unemployment ben-efits, strict employment protection legislation, generous social securitycontributions and high labor taxes, collective wage coordination, andstrong labor unions. Demand policy is ineffective in the long run: ademand stimulus may temporarily reduce actual unemployment belowequilibrium unemployment, but this will lead to rising wages and prices;inflationary tendencies can only be checked by a rise in actual unem-

ployment (up to the NAIRU level) so as to force workers to accept thepreordained wage share. The NAIRU thus serves as an (distributional)anchor from which the macroeconomy cannot float away. The policyimplications of this NAIRU model are straightforward: To reduce unem-ployment, labor markets have to be deregulated and welfare states haveto be scaled down (IMF 2003; OECD, 1994, 1999, 2003).

The standard NAIRU model is generally considered to beand inmainstream textbooks it is being presented asthe general macroeco-

nomic model of unemployment and inflation. But it is not. This papershowsbuilding on earlier work by Naastepad (2006) and Rowthorn(1995; 1999)that the standard model is only a special case of a gen-eral model of equilibrium unemployment, in which aggregate demand,investment, and (demand-induced) endogenous technological progressdo play a major role, even when it is (rather unrealistically) assumed,as in the standard NAIRU model, that price and wage expectations arefulfilled. We showunder realistic assumptions regarding the technol-

ogy of production and the wage bargaining processthat the (long-run)NAIRU is a function of (autonomous) demand factors. The implication isthat the steady-inflation unemployment rate moves (up and down) withautonomous demand and, hence, that high OECD unemployment is inlarge measure created by the deflationary macroeconomic policy stance,adopted by many governments during the past two decades.

The standard NAIRU model: a critique

Today, the standard NAIRU view that makes the deregulation of labormarkets and increased (downward) wage flexibility the key to reducedunemployment has become a new orthodoxy (Freeman, 2005). Interna-tional agencies, such as the OECD (1999; 2003), the IMF (2003), andmany economists (Blanchard and Wolfers, 2000; Layard et al., 1991;


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IT IS HIGH TIME TO DITCH THE NAIRU 533

Nickell, 1997; Nickell et al., 2005; Nicoletti and Scarpetta, 2003) blameunemployment and sluggish economic growth in the OECD area (par-ticularly in the European Union) on unions and labor market regulationand recommend that governments weaken labor market institutions infavor of market-driven solutions.

The central proposition of the standard NAIRU model is that the rateof inflation is the outcome of a conflict over income distribution betweenworkers (labor unions) and capitalists (firms). This follows from a wagebargaining process in which workers negotiate money wages designedto give them a certain standard of living, while firms set prices as a(exogenous) markup on expected variable costs, which include labor

costs. Wage setting depends positively on the expected price level andexogenous wagepush factors (including employment protection legisla-tion, social security provisions, unemployment benefits, and labor taxes)and negatively on the unemployment rate. Competing income claims byworkers and capitalists are made consistent by means of variations in theequilibrium unemployment rate; in fact, it is the function of equilibriumunemployment to make workers accept the preordained wage share, for ifthey do not, the result will be accelerating and, ultimately, unsustainable

inflation. To explore the NAIRU approach, assume (Rowthorn, 1995)that as the outcome of the wage bargaining process, real wage growth w[is determined by the following equation:2

, , ; ,w u z= + + > 0 1 2 3 0 1 3 20 0 1

(1)

where uis the unemployment rate, {is the exogenously given growthrate of labor productivity (using a hat over a variable denotes its growthrate), andzis a (catchall) variable that stands for all other (institutional)variables that affect the outcome of wage setting. Coefficient 1reflectsthe (negative) impact on the real wage of a rise in unemployment: be-cause higher unemployment weakens workers bargaining power, theyare forced to accept a lower real wage. 2represents the extent to whichlabor productivity growth is reflected in the real wage bargain; if 2=1, productivity growth is fully reflected in the real wage rate. By con-vention, variablezis defined in such a way that an increase in zleadsto an increase in real wage growthhence, the positive coefficient 3.

Suppose that in the long run, real wages must grow at the same rate aslabor productivity, so that

2We assume that price and wage expectations are fulfilled.


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.w= (2)

Condition (2) implies that both inflation and the distribution of incomeacross wages and profits are constant. Combining (1) and (2), the equi-librium unemployment rate u*or NAIRU that is required to achieve thisoutcome is given by

uz* =

( ) +

0 2 3

1

1.

(3)

The standard model generates powerful results (assuming that 1> 0and 3> 0). If 2< 1, faster (exogenous) productivity growth implieslower equilibrium unemployment. But if 2= 1 (which means that laborproductivity growth is fully reflected in the wage bargain), as is gener-ally assumed, equilibrium unemployment is determined only by thewagepush factorz. Accordingly, when the bargaining position of workersis strengthened andzrises, for example, by an increase in labor unionstrength or by the introduction of proworker labor market regulation,u*must rise. The argument is that the strengthened bargaining position

of workers will increase the wage rate demanded by workers at a givenunemployment rate. As a result, the equilibrium unemployment rate willrise so as to bring the wage demanded back in line with the preordainedwage share implied by firms price setting.

The most important implication of Equation (3), however, is that there isno role whatsoever for demand factors in determining equilibrium unem-ployment. Any attempts by fiscal or monetary policy to permanently move(actual) unemployment away from its equilibrium level u*is doomed

to failure. Policy may succeed in temporarily lowering unemployment,thus causing inflation, which in turn will undermine demand and raiseunemployment until the equilibrium or natural rate of unemployment isreached again. Demand will adjust itself to the natural level of output,corresponding to the rate of equilibrium unemployment, either passivelythrough the so-called real balance effect or, alternatively, more activelythrough a policy-administered rise in interest rates (Nickell et al., 2005);in the latter case, actual unemployment is determined by how large thecentral bank thinks the NAIRU is. The implication of Equation (3) is thatemployment policy should focus exclusively on the labor market (and noton aggregate demand and investment), and above all on the behavior oflabor unions and (mostly welfare state-related) wagepush factors. Thepolicy recommendations are straightforward: to reduce unemployment,


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labor markets have to be deregulated; employment protection, labortaxes, and unemployment benefits have to be reduced; wage bargaininghas to be decentralized; and welfare states have to be scaled down (IMF,2003; Layard et al., 1991; Nickel, 1997; Nickell et al., 2005; Nicolettiand Scarpetta, 2003; OECD, 1994, 1999, 2003). However, although theview that labor market regulation explains OECD unemployment hasbecome widely accepted, particularly in policy circles, it is by no meansuniversally accepted. Serious problems remain.

First, even authors working within the orthodox NAIRU approach areunable to explain (changes in long-run) unemployment in terms of onlyexcessive labor market regulation. To explain (changes in) u*, most

empirical studies consider it necessary to include other, additional fac-tors which might explain short-run deviations of unemployment fromits equilibrium level (Nickell et al., 2005, p .10), the most important ofwhich are aggregate demand shocks (i.e., import price and real interestrate shocks) and productivity shocks. The inclusion of such shocks isnot an innocent amendment, because it turns out that a significant partof the OECD unemployment increase during the past three decades mustbe attributed to these shocks (see, e.g., Nickell et al., 2005, p. 22). This

is obviously a dissatisfactory state of affairs: in the theoretical analysis,the impact of demand factors on equilibrium unemployment is definedaway, but in the empirical analysis it has to be brought back in, not as astructural determinant but rather as an exogenous shock. We argue thatthis incongruence points to a misspecification of the NAIRU model.

Second, as argued by Freeman, there are substantive and growingobjections to the evidentiary base on which the new orthodoxy rests(2005, p. 1). In particular, Baker et al. (2005) show that the findings of

several important studies (including IMF, 2003; Nickell et al., 2005;Nicoletti and Scarpetta, 2003) are not robust; the estimated coefficientson labor market institutions disappear or become statistically insignifi-cant when modest changes are made in the measures of institutions,countries covered, or time periods analyzed. Accordingly, Baker et al.conclude that there is a yawning gap between the confidence withwhich the case for labor market deregulation has been asserted andthe evidence that the regulating institutions are the culprits (2005, p.108). The nonrobustness and the lack of uniformity of the empirical

results are related to the misspecification of the orthodox model. Theorthodox model of the equilibrium unemployment rate is not a generalmacroeconomic model of unemployment and inflation, but only aspecial case.


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The general model

Our general model is an extension of the cumulative causation growth

model developed by Naastepad (2006), which can be reduced to tworelationships: aproductivity regime,which specifies how (potential) laborproductivity gains are obtained, and a demand regime,which specifieshow productivity gains (for a given real wage growth) may affect ag-gregate demand growth. We add a labor market regime,which describeshow real wage growth is influenced by unemployment, productivitygrowth, and labor market regulation.

The productivity regime

Ifis the outputlabor ratio, or average labor productivity,xis real output,w(= W/P) is the real wage (the ratio of the nominal wage Wand the ag-gregate price level P), andzis an indicator of the extent of labor marketregulation (the more rigid the labor market is from the point of viewof the firm, the higher isz), then the productivity regime is given by

, , ; . = + + + > < 0that is, the more regulated the labor market,the higher will be the rate of productivity growth. Labor marketregulation will improve labor productivity by promoting workersmotivation and by stimulating investment in human capital forma-tion (on this, see Agell, 1999; Fehr and Falk, 1999; Gchter andFalk, 2002). Supporting empirical evidence is provided by Bucheleand Christiansen (1999) and Gordon (1996).


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The aggregate demand regime

Our specification of the aggregate demand regime follows Naastepad

(2006) and Naastepad and Storm (2006). We assume that aggregateproduction or outputxis determined by effective demand:

x= c+ g+ i+ e m, (5)

where cis aggregate private consumption, gis public current expenditure,iis aggregate investment, eis exports, and mis imports; all variables aremeasured at constant prices. Before presenting the structural equationsdetermining c, i, e, and m, we define the real labor cost per unit of output

or real wage share as follows (Taylor, 1991):

v W P w=( ) = / , 1 1

(6)

where Wis the nominal wage (per hour of work), Pis the aggregate pricelevel, and is the level of labor productivity (or real value added perhour worked). We assume that the real wage w= (W/P) is fixed at anypoint in time, from institutions and a history of bargaining. For later use,we express Equation (6) in growth rates as follows:

.v w= (7)

Unit labor cost growth depends (positively) on the growth of the realwage and (negatively) on the growth of labor productivity.

From Equation (6), and at a given level of labor productivity , it fol-lows that there exists a negative relationship between the real wage rateand the profit share. To see this, note that, by definition, the (real) profit

share is equal to 1 minus the wage share:

= =

1 11W

Pv,

(8)

where is the profit share. Expressed in growth rates, this gives

,

= = = ( ) v v

v

w

(9)

where is defined as (v/) = v/(1 v) > 0. Profit share growth declinesas a result of real wage growth in excess of labor productivity growth.


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Consumption demand is a function of wage income and capital income.Denoting the saving propensity by and using the subscripts wand to refer to wage and profit income, respectively, wage earners consume(1 w) of their income, whereas capitalists average consumption pro-pensity equals (1 ). Suppose further that w 1), the magnitude of which depends, via v, on the distribution

of income and on the real wage and the level of labor productivity, inparticular. Totally differentiating Equation (12) with respect to time,dividing through by x, and rearranging gives us

,

** *x

g

xg

i

xi

e

xe g i eg i e= + + + = + + +

1 1 1

(13)

whereg,i, andeare the (multiplier-adjusted) shares in gross domes-

tic product (GDP) of net government current expenditure, investment,and exports, respectively. Output growth is thus a weighted average ofinvestment and export growth, adjusted for changes in (the magnitude of)the multiplier. The multiplier is endogenous, because any change in reallabor cost per unit of output will directly affect its denominator , which


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equals [ v( w) + ]. Using this expression for , we can deriveits growth rate as a function of unit labor cost growth as follows:

,

= ( ) = ( ) ( )v

v ww w

(14)

where is the positive fraction (v/). Hence, the denominator of themultiplier will decline (and the multiplier will become larger) when realunit labor costs rise. We now turn to investment and export growth.

Consider first investment demand. We assume that the growth rate ofinvestment idepends positively on the growth of the profit share , of

demandx, and negatively on the change in the real interest rate (or costof capital) rk(Naastepad and Storm, 2006):

, , , ,i b x r k= + + > 0 1 2 3 0 1 2 3 0 (15)

where b{represents other factors (mainly animal spirits of entrepreneurs)influencing investment decisions. Coefficient 1is the elasticity of invest-ment with respect to the profit share; the positive effect on investment

of can be justified by reference to the use of corporate retained profitsfor relieving financial constraint on investment. The positive effect ofxreflects the accelerator effect; 2is the elasticity of investment withrespect to demand, and 3is the elasticity of investment demand withrespect to the change in the real interest rate.

Exports eare a negative function of relative unit labor cost and a posi-tive function of exogenous exports e0:

e e

v

vrow=

0

1

,

(16)

where vrowis the real labor cost (in domestic currency) associated withone unit of world exports, 0is the elasticity of exports with respect toworld demand, and 1 is the elasticity of export volume with respectto change in (relative) real unit labor cost. For simplicity and withoutloss of generality, we assume that vrow= 1; linearizing Equation (16) ingrowth rates gives

.e e v= 0 1 (17)

Substituting Equations (9), (14), (15), and (17) into (13) yields the fol-lowing reduced form equation for the aggregate demand regime:


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*

xb g e r i g e i k

i

w i e

= + +

+ ( )

0 3

2

1 1

1

11 2

i

w .

(18)

Note that, for Equation (18) to be economically meaningful, we mustassume that [1 i2] > 0, that is, given that 0 < i< 1, the acceleratorelasticity has to fall within the following range: 0 2< (1/2). Outputgrowth thus depends on five factors:

1. the growth of autonomous investment b{,2. the growth of net public current expenditure g[*,3. the growth of autonomous exports e[0,4. a change in the real interest rate rk, and5. the growth rate of real unit labor cost v[= w[ {.

Even though the impact of autonomous investment, exports, and govern-ment expenditure growth will be positiveunder our assumptionsand

that of real interest rate increases will be negative, the impact of laborcost growth on output growth is ambiguous in sign (Naastepad andStorm, 2006). This is so because any excess of real wage growth overlabor productivity growth (i.e., v[> 0 or w[> l) has two opposing effectson output growth. On one hand, it will reduce investment and exportgrowth, and consequently lower output growth. But, on the other hand, itwill increase the size of the multiplier, because it entails a redistributionof income from profits toward wage income and a consequent decline

in the aggregate savings propensity. To derive the sign of the derivativeof output growth with respect to unit labor cost growth (dx[/dv[) fromEquation (18), recall that [1 i2] > 0, = (v/), i= i/(x), and e=e/(x). It then follows that (dx[/dv[) will be positive and the economy willbe wage led,if

dx

dv

i

x

e

vxw

.= ( ) >

+

0 1 1if

(19)

The labor market regime

The labor market regime determines the real wage rate according toEquation (1).


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Long-run equilibrium: the general model

When we combine the productivity regime Equation (4), the demand

regime Equation (18), and the labor market regime Equation (1), weobtain a system of three equations with four unknownsproductivitygrowth {, demand growthx[, real wage growth w[, and the unemploymentrate u. This means that one additional restriction needs to be imposedto close the system.3We assume that in the long run real wages mustgrow at the same rate as labor productivity, so that

{= w[. (20)

Using Equation (20), we can immediately obtain the reduced-form ex-pression for equilibrium income growthx[*from Equation (18):

.**

xb g e r i g e i k

i

= + +

0 3

21

(21)

Interestingly, as shown by Equation (21), the wage-led or profit-lednature of the demand regime, while being of crucial importance in themedium run (Naastepad, 2006), turns out to be immaterial for long-run

income growth; this is not surprising, however, because we are keepingthe distribution of income between wages and profits unchanged by as-sumption (20). Long-run growth thus depends on (autonomous) invest-ment and export growth, the growth of net public expenditure (i.e., thefiscal policy stance), and the real interest rate (i.e., the monetary policystance). Substituting Equation (21) into the productivity regime Equation(4) gives us the reduced form expression for {*:

*

.**

= + + + + 0

2

1

2

0 3

2

3

21 1 1 1i g e i k

i

b g e r z

(22)

Provided 1> 0, that is, the KaldorVerdoorn coefficient is positive,long-run productivity depends positively on the growth of autonomousdemand and negatively on the real interest rate (assuming that 1 2> 0).In addition, if 3> 0, any rise in the extent of labor market regulation(captured by a rise inz) will raise productivity growththrough a processof labor-saving technological progress.

3In a short- and medium-run context, we could assume that real wage growth isfixed by bargaining. As a result, income growth, productivity growth, and unemploy-ment become a function of real wage growth (and the other exogenous variables,including net public expenditure, exports, and the real interest rate).


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Turning to the labor market regime, we first note that the equilibriumunemployment rate u*, which satisfies restriction (20), is given by

uz

* = ( ) +

0 2 3

1

1

(3)

It follows that, provided 20, 0 < 2< 1, 0 < 1< 1, and 0 2< 1, any increase in the growth rateof autonomous investment, net public expenditure, and exports reducesequilibrium unemployment, whereas a rise in the real rate of interestraises u*:

= ( )

( )

u

z

*

.

1 1

10

2 2 3

1 2

(25)

Assuming that 1> 0 and (1 2) > 0, condition (25) can be restatedas

>( )

>( )

u

z

*

.01 1

3

2

3

2

if

(26)

This inequality has a straightforward interpretation. Its right-hand side is

the impact of an increase inzon labor productivity growth from Equa-tion (22): [({*/z) = (3/1 2) > 0]. Because of the increase in laborproductivity growth, equilibrium real wage growth can also increasewhile keeping the rate of inflation constant. Accordingly, we can define

w[w= ({*/z) = (3/1 2) as the increase in real wage growth warranted

by increased productivity growth. The left-hand side of condition (26)reflects the extra real wage growth demanded by workers in responseto an increase inz. To see this, we rewrite Equation (1) in terms of real

wage growth:

.w u z=

+

0

2

1

2

3

21 1 1 (1)

From (1), it follows that (w[/z) = (3/1 2) > 0; that is, workers re-spond to a rise inzby claiming a higher real wage growth. Let us denotethe additional wage growth demanded by w[D. According to condition

(26), w[D> w

[W; that is, the extra wage growth claimed exceeds thewage growth increase, warranted by the increased productivity growth.

This can only be reconciled by a rise in equilibrium unemployment,which, as shown by Equation (1), forces workers to reduce their wagegrowth demands until, in equilibrium, w[D= w[W= w[

*. But condition(26) need not be satisfied, and hence, it is possible that

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It is High Time to Ditch the NAIRU