rough draft:

comments welcome.

do not quote, unless

favorably.

by

James G. Devine

Loyola Marymount University.

May 10, 2001

DeLong seems quite uneasy with the lack of acceptance of his assertion by orthodox economists, so it could be said that he is conscious of the contradiction. However, it’s useful to tease out the nature of the problem, i.e., the conflict between the casual empiricism of deLong (or Alan Greenspan) and the official neoclassical party line on this subject. If we address the contradiction, we have to acknowledge that the perceived improvements in the NAIRU are intimately linked with the shift in the distribution of income away from labor and toward capital.

In the below, I want to simply focus on the contradiction. I'll take the acceleration of labor productivity growth for granted (and won't quibble about its causes, e.g., to note that it may be partly because people are working more intensively). More importantly, I'll also initially take as fact the existence of a unique NAIRU (U*) that's independent of the actual unemployment rate; thus I ignore a major issue that deLong avoids until Part II. In tune with the reigning orthodoxy, I also initially treat U* as given by structural conditions in labor markets, i.e., the degree of structural or mismatch unemployment, the amount of frictional or turnover unemployment, and the amount of impediments to labor-market adjustment due to rigidity of real wages (classical unemployment). I also present a clear model, rather than leaving things implicit or referring to the assumed consensus of orthodox economists, the way deLong does. (For people who don't like math, skip to part II.)

The first section deals with the contradiction between deLong’s assertion and the dominant theory, while the second section considers what this all means in terms of policy. Though the first might be interpreted as a criticism of deLong, the second praises his assertion.

In order to understand the contradiction, first state a short-run "Phillips curve" for wages:

Orthodox economics discusses the components of (1) totally in terms of markets (supply and demand), ignoring institutions. I totally disagree. Instead of presenting an argument against that interpretation at this point, I will simply note that the argument developed below indicates that a version of the Phillips curve that incorporates institutional insights helps avoid the contradiction between the productivity growth/NAIRU nexus that deLong posits and the inability of orthodox economics to accept that nexus.

Next, given money wage growth, employers pass on the increased costs to consumers:

(2) p = w - q* + ss

Combining equations (1) and (2) give us a general short-run price-inflation Phillips curve:

More generally, what equation (4) says is that labor-market institutions matter in determining the effective NAIRU (and by "institutions" I mean more than transgressions against market perfection). In other words, we should reject the neoclassical conception that a world without non-market institutions is a good approximation for the real world, as Blanchard and Katz [1997] do in practice.

Where's the contradiction, though? The problem is the introduction of labor productivity growth into the story goes against standard neoclassical presumptions. I have seen a lot of orthodox versions of (3) in which both w* and q* are dropped, so that in the absence of supply shocks:

That means that the trend growth of money wages must be equal that of labor productivity, so that unit labor costs (wage costs/labor productivity) and the organizational part of workers' bargaining power stay constant. Most importantly, this equation also indicates that labor productivity growth plays no role at all, going against deLong’s assertion. This is quite clear when we note that the long-run equilibrium unemployment rate equals:

So the effective NAIRU equals its notional value. Crucially, we can’t use recent productivity growth as an explanation of the falling NAIRU: the U* is assumed to be determined by such issues as demographics, which deLong rejects as an explanation of the falling NAIRU in the 1990s.

On the other hand, if w* - q* is allowed to fall (i.e. if workers’ institutional bargaining power is weak), we can use labor productivity as an explanation of the low NAIRU in the 1990s. But then we have to address the distributional issues, something that neoclassicals would like to leave to references to technologically-determined parameters (such as the marginal product of labor ground out by making the silly assumption of the existence of an aggregate production function).

The rise in the coefficient b (the greater exposure of workers to market forces) implied a steep rise of wages during the late 1990s, but it suggests that wages will fall behind inflation just as steeply in the near future (perhaps in 2000). This raises the possibilities of deflation, something that can be quite disastrous in a country like the U.S., where much of the population is deep in debt. At one point in his ponderings, Paul Krugman rejected the possibility of deflationary depression because wages are sticky downward. The institutional changes in labor markets makes such optimism less apt.

The distributional issues are crucial and encourage us to break with the assumption made above that firms aim to keep a constant mark-up. If they are successful, this assumption implies that the share of profits in national income is constant, something that has been shown to be incorrect in recent years. Instead, it might be argued that businesses aim for a higher mark-up when their profitability is low and are willing to accept a lower mark-up when profitability is high, while they need not always achieve their goals.

Under this alternative conception, when worker organizational bargaining power is low (as in recent decades), real wages lag behind productivity growth, so that profitability rises in the trend. This reduces the need to raise mark-ups and prices, reducing the inflationary potential of the economy. Alternatively, with workers having less organizational bargaining power, less unemployment (a smaller "reserve army of labor") is needed to protect profits. In general, this suggests a negative relationship between profit rates and stagflation (as measured by the sum of unemployment and inflation rates).

This relationship is seen in the graph below, copied from another paper of mine. The profit rate is corrected for changes in capacity utilization, i.e., cyclically corrected, since falling utilization rates discourage inflation. The sum of unemployment and inflation rates is termed "the stagflation potential factor" or SPF. The consumer price index for urban consumers is used to measure inflation. The relationship stands up pretty well when different measures of profitability and inflation are used. In sum, there is a strong relationship between distributional issues and the seeming fall in the NAIRU during the 1990s. 

Though I think that there’s a little bit of truth in the NAIRU theory (i.e., if unemployment equaled 2 percent or lower for a few years, inflation would begin to get worse and worse), the whole theory has severe problems. As seen above, even the presumption of that a unique NAIRU that exists independent of the actual unemployment rate cannot avoid the political issues of distribution. But there is more.

The key issue can be stated as follows. In the late 1990s, was it that the actual notional NAIRU was falling or was it rather that there was a rising willingness to let the actual unemployment rate to fall, which allowed the realization of a lower NAIRU?

The problem is that there are major errors in the estimation of the NAIRU (Staiger, Stock, and Watson, 1997). The O.E.C.D. (2000) tells us that the U.S. NAIRU equaled 5.2 percent in 1999, as do the Office of Management and Budget and the Congressional Budget Office. Unlike most authors, the O.E.C.D. economists state this number plus or minus a margin of error (a standard error) of 1.2 percentage points. That means that the NAIRU could be anywhere between 4 and 6.4 percent of the labor force. This in turn implies that we may see a "fat" NAIRU, as suggested by authors such as Abba Lerner [1951] and Robert Eisner [1997]: the NAIRU (presuming that it exists) represents a range, from "high full employment" to "low full employment" (in Lerner’s terms). Given the quality of the empirical results, we really can’t assert anything else except by imposing an arbitrary assumption.

In this view, the Federal Reserve isn’t simply intuiting the structure of the economy to decide what specific unemployment rate (the NAIRU) should prevail in order to stabilize the inflation rate. Rather, it is choosing among a number of possible NAIRUs (assuming that they really have enough control over demand to do so). Since the desired or target unemployment rate isn’t given by the parameters of the economy, the Fed’s leadership’s political biases can easily creep in.

The Federal Reserve, like most Central Banks, is dominated by the collective interests of bankers and financiers. It pushes for and cultivates its independence from democratically-elected politicians (while the latter are often willing to let it go independent, since they can avoid responsibility when things go wrong). But it is dominated by inflation hawks, whose always emphasize the "worst case" scenarios while emphasizing the false precision of their estimates. (For those who like historical analogies, their attitudes are akin to that of the Committee on the Present Danger and "Team B" toward the late Soviet Union.)

This encourages the Fed to define the NAIRU as on the high end of the possible range while actively fighting inflation even when it isn’t there. (Central Bankers proudly proclaim that their job is to "take away the punch-bowl before the party gets wild," ignoring the impact of their policies on Main Street. Some people benefit only when the party is so wild that the party-goers become generous.) That’s why, for example, the Fed kept on raising interest rates during 1999 and most of 2000, even though inflation wasn’t to be seen. At least for awhile, workers could thank their lucky stars that it didn’t have enough power over the economy to squelch the boom right away, since this is when their cyclical bargaining power rose, counteracting the decrease in their institutional power.

That is, it is quite extraordinary and unexpected that the Fed allowed the unemployment rate to fall to 4 percent of the labor force. What had happened was that events in 1997 and 1998 – the East Asian crisis, the Russian crisis, the collapse of such U.S. speculative organizations as Long-Term Capital Management, etc. – pushed the Fed lower interest rates. Greenspan commented that the Fed was steering on a knife-edge between worsening inflation and deflation – and was pushed to risk the former. This meant that the economy was pushed into a region of low unemployment rates as the Fed dropped the "worst case" inflation scenarios for awhile (until 1999).

Then, with lower unemployment, we see the realization of what seemed to be a lower NAIRU. Not only was there no serious inflation, but low unemployment tends to feed on itself, encouraging the NAIRU to fall (the hysteresis effect). (See Hargereaves-Heap, 1980.) In the late 1990s, Business Week reported that many employers were hiring people they normally wouldn’t hire (because of inadequate skills, wrong location, or poor attitudes) and then training them for the jobs available. This meant that the problem of structural or mismatch unemployment was being attacked. If there’s any truth to the NAIRU theory, then lowering structural unemployment should lower the NAIRU by lowering U* (the notional NAIRU).

Further, abundant demand encourages investment, learning-by-doing in production, the transfer of labor to high-productivity sectors, technological change, greater specialization, and thus labor productivity growth (Verdoorn’s Law). (It should be stressed that this complements rather than replacing the "new economy" story that deLong discusses.) Given the general stagnation of worker bargaining power, the surge in labor productivity growth encouraged the fall in the effective NAIRU.

Finally, note that deLong’s view that a surge of labor productivity growth lowers the NAIRU can help contribute to this process. If he can convince the Fed and other members of the policy-making elite that the "new economy" allows a lower NAIRU, it might allow the unleashing of hysteresis forces and Verdoorn’s Law, producing a virtuous circle. But it doesn’t fit well with neoclassical theory, which should be rejected. Nor does it deal with the distributional impact of the institutional changes that have allowed the effective NAIRU to fall.

James G. Devine

Professor of Economics

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