Something I'd Forgotten

If you had to name the factor most responsible for the Canadian recession of the early 90s, some would mention NAFTA and its predecessor, FTA. Some others might mention the deficit (which actually should usually accelerate the economy, but people would blame the deficit nevertheless.) Few would mention NAIRU.

Perhaps one of the greatest gifts of the "new economy" was the speed with which unemployment dropped below 6% in the US. It happened quickly enough that Greenspan didn't have enough time to put the brakes on the economy and throw a few million people out of work. 6%, you see, had been the lowest level most economists believed that unemployment in the US could go without spurring inflation. And not just inflation, but accelerating inflation - a wage-price spiral. Hence, 6% (the safe marker) was the non-accelerating inflation rate of unemployment, or NAIRU.

This wasn't just a concept - it was seen as the edge of the known world: lower than 6%, and the central bankers of the world believed "here there be dragons". For example, in 1995-96 Alan Greenspan raised interest rates precipitously - doubling the fed funds rate in just over a year.

Canada's experience with NAIRU was far, far harsher, as anyone who's read "Shooting the Hippo" by Linda McQuaig can tell you. Canada's central banker at the time - Jim John Crow - believed that we couldn't rest until we'd eliminated not just accelerating inflation, but any hint of inflation. (John Crow's previous experience had been in Latin America, and apparently he never noticed the colder weather in Ottawa.) The result was interest rates among the highest in the industrialized world, which didn't end until Crow was replaced. For one shining moment, Canada actually experienced deflation - at the cost of an economic slump far more pronounced than the one to the south of the border.

Anyway, I'd actually forgotten about NAIRU until I read about it again in Dean Baker's book. James Galbraith (son of the recently-deceased John Kenneth) has an excellent description of it in this book review:

Laurence Meyer is a leading advocate of one of the worst ideas in the modern history of economics.... Meyer's terrible idea is known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU): the notion that there exists a threshold unemployment rate below which inflation increases without limit. The NAIRU was invented, mainly by Milton Friedman in 1968, in dissent from the prior doctrine of the Phillips Curve, the idea that full employment would entail only a modest rise in the permanent rate of inflation. Then, in the early 1970s, high inflation combined with unemployment to shatter the Phillips Curve. The NAIRU doctrine taught that even trying to push the unemployment rate down with monetary policy was futile; and, worse, that if unemployment were to fall for a substantial time below the NAIRU threshold, inflation would not only rise but also accelerate. This would lead over time to hyperinflation--to financial and social disaster....

By the late 1990s, circumstances had changed. Unemployment was falling below established estimates of the NAIRU--and eventually to levels rarely observed in peacetime. Yet prices remained strikingly stable. Meyer was on the Federal Reserve Board. What to think? What to do?

Meyer chose to adhere to the NAIRU concept, while conceding ground, bit by bit, on his estimate of where the threshold of hyperinflation might be: a rationale which unfortunately always made him fear the worst. As unemployment fell, he would argue that inflation was just around the corner. Therefore (although in appointing him President Clinton had clearly hoped for better), he found himself generally favoring increases in interest rates--not because inflation was rising, but only because his model told him that it soon had to.

There's a joke about economists: People who worry about whether something that works in fact can possibly work in theory. It sounds like that joke was invented to describe Meyer.

It's good to remember that for most of my lifespan, the government saw full employment as something to be avoided like the plague. Some of the most powerful institutions in the country were devoted to keeping unemployment high, for ideological reasons. In short, it's a valuable lesson for progressives: The Government is not always our friend.