The Institute Blog

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

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 labor markets and the consequent wage squeeze and sharp rise in inequality.

Alan Greenspan spoke appreciatively of “traumatized 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 and 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. And 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 that were 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 labor markets deviate from the benchmark competitive labor 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. If the labor market is more regulated, the NAIRU must be higher and potential growth lower.

It follows that if one wants to reduce structural unemployment, the only way to achieve this is by abolishing regulatory interventions in the labor market; the price of a dynamic economy and low unemployment is heightened inequality and “traumatized workers.” A second implication of NAIRU economics is that neither central bank policy nor fiscal policy affects natural unemployment. Macro policy is presumably ineffective.

We argue in our book Macroeconomics Beyond the NAIRU that the NAIRU doctrine is wrong because it is a partial, not a general, theory. Specifically, wages are treated as mere costs to producers. In NAIRU, 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 labor 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. And 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 labor and greater learning-by-doing by firms. Third, higher wages induce firms to step up the pace of labor-saving technological progress. The bottom line is that higher wages raise demand, promote technological progress, and increase labor 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. In other words, macroeconomic policy has permanent effects on structural unemployment and growth – the NAIRU as a constant “natural” rate of unemployment does not exist.

This means we cannot absolve central bankers from charges that their anti-inflation policies contribute to higher unemployment. They have already 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 labor productivity growth is higher in economies that have more regulated and coordinated industrial relations systems. The explanation for this is that the more co-operative the social relations of production are, the more strongly workers will reciprocate by providing higher productivity – which is good for profitability and investment.

For the OECD countries, we find that the net impact of regulation is actually to 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, cooperative, and egalitarian macro-management of our economies. And it has to change if economics is to revive its earlier sense of purpose and worthiness, which it has lost over the past three decades.

Originally appeared on Naked Capitalism.