Saturday, August 8, 2009

This Week in Econ Navel-Gazing, II

In the FT, Roger E.A. Farmer writes:
The economic history of the twentieth century is one of the struggle between classical and Keynesian ideas. Two events have transformed the history of economic thought since 1900. The first was the Great Depression of the 1930s. The second was the stagflation of the 1970s. We are now experiencing a third: the 2008 stock market crash and the ensuing Great Recession.

The economics of the 1920s was the economics of Adam Smith. Markets work well and the business cycle is self-stabilising. The economics of the 1950s was that of Keynes. Markets mess up sometimes and government must get in there and fix them. In the 1980s we had a resurgence of classical ideas with simpler content but harder mathematics.

Each of the two previous transformational events saw the death of a great idea. After the Great Depression it was the demise of Say’s law, the idea that supply creates its own demand. After stagflation in the 1970s, economists ditched the Philips curve; the idea that there is a stable exploitable trade-off between unemployment and inflation.

So far, so good... He continues:

Which great idea will economists topple next? The next casualty of economic history will be the natural rate hypothesis. I make that case in two forthcoming books and in two recent NBER working papers.
Given the various criticisms of macroeconomics that have been seen lately, perhaps I shouldn't be surprised, but it certainly had not occurred to me to think the natural rate might be in trouble. Though it is problematic to pin down empirically (and therefore of limited use as a guide to policy), I had thought it was a pretty useful concept, rightfully enshrined in "textbook" macro.

The original and best explanation is in Milton Friedman's 1968 presidential address [JSTOR] to the American Economic Association:

At any moment of time, there is some level of unemployment which has the property that it is consistent with equilibrium in the structure of real wage rates. At that level of unemployment, real wage rates are tending on the average to rise at a "normal" secular rate, i.e., at a rate that can be indefinitely maintained so long as capital formation, technological improvements, etc., remain on their long-run trends. A lower level of unemployment is an indication that there is an excess demand for labor that will produce upward pressure on real wage rates. A higher level of unemployment is an indication that there is an excess supply of labor that will produce downward pressure on real wage rates. 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 imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.
That idea is part of the problem, according to Farmer:

The fact that central bankers believe this theory is important because it will lead them to conclude that high unemployment after the Great Recession is inevitable. That is why the Obama administration is psychologically preparing the public for the possibility that we will see double digit unemployment. If the natural rate of unemployment goes up by 5 per cent, get used to it. Economists have a name for it: A jobless recovery.

But a jobless recovery is not inevitable. We do not need to accept the immense human misery that goes with permanent job losses. The natural rate of unemployment is not like the gravitational constant. It depends on the confidence of all of us and it can be influenced by policies that we can and should adopt.

A jobless recovery is a real problem, and Farmer is right that we should not accept it (or any theory that says it is inevitable). But the natural rate concept is a strange culprit - I have not heard of anyone interpreting the increase in unemployment as a sudden, massive rise in the natural rate (though probably there is some hardcore new classical economist out there who is).

The natural rate is sometimes taken as synonymous with the "non accelerating inflation rate of unemployment" [NAIRU] - i.e., the unemployment rate consistent with stable inflation. Interpreting it this way, I also do not see any sign that the Fed is acting under the belief that they need to hold back because inflation might take off if the unemployment rate falls.

The problem is that we are struggling to figure out how to get aggregate demand back to the point where we're close to some reasonable equilibrium in the labor market. This does point to some deficiency in our thinking (or policymaking), and I think Farmer's ideas are interesting in this regard, but I'm somewhat befuddled by his framing it as a failure of the natural rate hypothesis. I guess I need to read the book once it comes out.


Roger E. A. Farmer said...

Dear Bill
Thank you for your thoughtful post. Friedman thought that the "Walrasian system of general equilibrium equations" had a unique solution. Keynes never thought about the question. My reading of the General Theory is that there is a continuum of solutions to these equations because unemployment and vacancies are inputs to a search technology that are not priced in markets. You don't need to wait for my books. I explain this idea much more carefully in NBER WP 14866. You can dowmload it from the front page of my website.
Roger Farmer

Bill C said...

Thank you for the response. I'll definitely take a look at the paper.

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Anonymous said...

I think Farmer meant NBER WP 14846.

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