The NAIRU and inflation myth

Dr Frank Shostak
BrookesNews.Com
Monday 25 February 2008

Many economists are of the view that once the unemployment rate falls to below a certain percentage, the Non-Accelerating Inflation Rate of Unemployment (NAIRU), it sets off an inflationary spiral. This acceleration in the rate of inflation takes place through increases in the demand for goods and services. It also lifts the demand for workers and puts pressure on wages, reinforcing the growth in inflation.

A Brookings Institution study by three scholars, William Dickens, George Perry and George Akerlof, concluded that a rate of unemployment of 4.5 per cent is where the rate of inflation stabilizes. This finding is below the generally accepted view that the rate of inflation tends to accelerate when the unemployment rate falls to below 5 per cent. The writers of the report also argue that eradicating inflation altogether may do more harm than good.

If inflation were to fall to zero, worker productivity would decline, unemployment would rise and the overall economy would sink. According to the research-paper an inflation rate of 3.4 per cent, which is consistent with the unemployment rate of 4.5 per cent, is the ideal situation for the economy. It seems that while too much inflation can destroy your health, a little bit of it could actually be good for you. But does this make sense?

The NAIRU however, is an arbitrary measure, it is derived from a statistical correlation between changes in the consumer price index and the unemployment rate. What matters here is whether the theory “works”, i.e., whether it can predict the future rate of increases in the consumer price index. This way of thinking doesn’t consider whether a theory corresponds to reality. Here we have a framework, which implies that “anything goes” as long as one can make accurate predictions.

The purpose of a theory, is to present the facts of reality in a simplified form. The theory has to originate from the reality and not from some arbitrary idea that is based on a statistical correlation. If “anything goes” then we could find by means of statistical methods all sorts of formulas that could serve as forecasting devices. For example, let us assume that high correlation has been established between the income of Mr Jones and the rate of growth in the consumer price index.

The higher the rate of increase of Mr Jones’ income, the higher the rate of increase in the consumer price index. Therefore we could easily conclude that in order to exercise control over the rate of inflation the central bank must carefully watch and control the rate of increases in Mr Jones’ income. The absurdity of this example matches that of the NAIRU framework. Contrary to mainstream thinking, strong economic activity doesn’t cause a general rise in the prices of goods and services and an economic overheating known as inflation. Regardless of the rate of unemployment, as long as every increase in expenditure is supported by production no overheating can occur.

The overheating emerges once expenditure is rising without the backup of production. This can only occur when the money stock is increasing. Once money increases it generates an exchange of nothing for something, or consumption without preceding production, which leads to the erosion of real wealth. As a rule, rises in the money stock are followed by rises in the prices of goods and services. Here is why. Prices are another name for the amount of money that people spend on goods they buy. If the amount of money in an economy increases while the amount of goods remains unchanged more money will be spent on the given amount of goods i.e., prices will increase.

Conversely, if the stock of money remains unchanged it is not possible to spend more on all the goods and services, hence no general rise in prices is possible. By the same logic, in a growing economy with a growing amount of goods and an unchanged money stock, prices will fall. If the general rise in prices is the outcome of the rising money stock, how could it then benefit the economy if it stabilizes at 3.4 per cent? People’s real income will be eroded year after year by 3.4 per cent, so how could this promote economic growth and stability as the Brookings report suggests?

On the contrary, people’s capacity to save out of their eroding incomes will diminish. With fewer savings less funding will be generated, which in turn will hamper the future of economic growth. Curiously, writers of the Brookings report in suggesting that the rate of inflation of 3.4 per cent is good for the economy imply that a higher figure is bad. However, regardless of how fast it rises, inflation is always bad news, for it sets an exchange of nothing for something, implying an erosion of the real wealth. The only difference between the 3.4 per cent rate of inflation versus 10 per cent is that the larger number will cause greater damage.

Yet both figures undermine people’s well being. Contrary to the Brookings report then, the ideal setup is the complete eradication of inflation. This however, means that the central bank must stop its monetary pumping and the abolition of fractional reserve banking. Ignoring the facts of reality by means of an arbitrary theory is an attempt on behalf of the Brookings report to justify the central bank’s tampering with the economy. This however, can only further undermine people's living standard.

Dr Frank Shostak is a former professor of economics who now works in the private sector