Dany Lang

Can the European construction really continue relying on the NAIRU?

25 Seiten · 4,42 EUR
(11. Januar 2008)

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Introduction:

Unquestionably, one of the core concepts underlying the European construction since the beginning of the 1990’s has been the ‘Non Accelerating Inflation Rate of Unemployment’ (NAIRU). The core idea of the NAIRU is now very familiar to economists. It is that there exists, at least in the medium run (or even in the short run), a theoretical rate of unemployment (the NAIRU) that constitutes an ‘inflation barrier’. If, for any reason, the current rate of unemployment falls below this theoretical rate, inflation is supposed to increase mechanically. One of the most important associated ideas is usually that the NAIRU is determined only by supplyside factors, and that, if the unemployment rate approaches the NAIRU, unemployment can be reduced only by supply-side oriented policies, and in particular labour market reforms.

These ideas underlie all European treaties signed during recent years, at least since the Maastricht treaty was implemented in 1992. The idea that such a rate truly exists in each country as well as on the European level has deeply taken root in decision-makers’ minds, and has become part of what Keynes would have called the ‘conventional wisdom’ on the European level.

As a result, fighting inflation is seen as the most important economic policy goal for monetary policy on the European level. The fight against inflation has become a major guideline for the policies designed by the major economic policy authority of the union, the European Central Bank (ECB). Bringing down the terrifying ‘inflation monster’ is even the only objective that has been assigned to the ECB by the treaties. Indeed, if, as stated by Friedman (1968), there is no permanent trade-off between inflation and unemployment, monetary policy cannot have long-lasting effects on the unemployment rate. There are plenty of documents edited by the ECB that explicitly refer to the NAIRU, its level, and why it would be a good guide for monetary policy.

As the NAIRU is supposed to be determined only by supply-side factors, the associated idea that the part of the unemployment rate that is below the NAIRU can only be reduced by means of structural policies is central to the European employment strategy, and can be found in many documents edited by the European Commission. The most significant expressions of this view are unquestionably the so-called ‘Growth and Stability Pact’ and the ‘Lisbon Strategy’. This mainstream view is very well explained in a speech made in 2005 by the governor of the ECB, Jean-Claude Trichet:

“A key objective of the Lisbon strategy is to raise the employment rate. To achieve this, some euro area countries have started to implement the needed reforms to reduce the disincentives to work that are currently present in many European labour markets. Unemployment schemes have been amended and early retirement incentives have been reduced. As a result, the countries that have introduced measures aimed at increasing flexibility of the labour market witnessed a fall in actual unemployment rates and consequently in the non-accelerating inflation rate of unemployment – the so called NAIRU.”

For all these reasons, one can say the current European construction unambiguously relies on the NAIRU.

And yet, the NAIRU has come under serious attack during the last twenty years. Amongst others, Cross (1995) and Galbraith (1997) have argued that, given the theoretical and empirical frailty of the concept, it would be more wise to abandon the concept altogether. Apart from the multiplicity of definitions and the haziness of the concept, the most important objection put forward by NAIRU opponents in the second half of the 1990’s is that, for most of the countries, and whatever the definition of the NAIRU chosen, this theoretical rate always followed the current rate of unemployment with some lag. Nonetheless, the rate was also supposed to be determined, at least in the medium and the long runs, exclusively by supply-side factors. Moreover, how the changes of these supply-side factors affect the NAIRU, and when the NAIRU changes with these supply-side factors, was not explained by the models.

As the issues raised were serious, the NAIRU-proponents have started amending their models in order to deal with these concerns. The most important results of this research process are the TV-NAIRU (timevarying NAIRU) and the new NAIRU models based on the so-called ‘New Keynesian Phillips Curve’ (NKPC). This paper sets out to determine, on the basis of a close examination of the NAIRU concept and its limitations, whether the European construction can really continue relying on the NAIRU. This issue includes two main concerns. Firstly, we have to examine the ‘old-fashioned’ NAIRU models in order to recall their most important limits (section 2). Secondly, we need to investigate recent developments in the NAIRU literature to determine whether the theoretical and empirical changes imposed on the NAIRU concept more recently have managed to remedy the most important flaws of the old concept (section 3). Section 4 concludes.