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Wednesday, November 18, 2020

Roger Farmer's Comments On The Natural Rate Of Unemployment

One of my concerns about mainstream economic methodology is the dependence upon hidden variables that are estimated with techniques like the Kalman Filter. The issue is that the resulting methodology is non-falsifiable: it will always end up being consistent with any observed data (admittedly, some outright bizarre behaviour might be rejected). 

Although this might appear to be my own hobby horse, I just want to note that I was not the first person to make such a complaint. Various heterodox authors have levelled similar complaints, but my feeling they have done so in such a long-winded fashion that non-heterodox readers like myself have a very hard time picking out what is a straightforward -- but important -- point. In reading Prosperity for All: How to Prevent Financial Crises by Roger E. Farmer (Amazon affiliate link), he makes the same point with respect to the natural rate of unemployment.

In Chapter 3 (The Demise of the Natural Rate Hypothesis), Professor Farmer writes:

Defenders of the NRH [natural rate hypothesis] might choose to respond to my empirical findings by arguing that the natural rate of unemployment is time varying. But, I am unaware of any theory that provides us in advance [emphasis mine] with an explanation of how the natural rate of unemployment varies over time. In the absence of such a theory, the NRH has no predictive content. A theory like this -- which cannot be falsified by any set of observations -- is religion, not science.

I want to emphasise that this is not purely an issue for the natural rate of unemployment (u*) -- it can be applied to all of the other "star variables": the "natural rate of interest" (r*) and potential output (y*) . (Potential output is used to generate a GDP-based output gap, which is the usual way of framing the hidden variable.)

From a practical perspective, this question of predictive content shadows the mainstream methodology. My impression of recent research is that complexity is being added as a means of distracting away from this basic issue.

As I have written earlier, I will be discussing Roger Farmer's theory in a series of articles, which will likely end up as a chapter in the second volume of my book on recessions. (Link to volume one.) I want to focus on what his theory says, and not his criticisms of New Keynesian theories. As such, I pulled out this particular point as a separate article as it will be of interest to my heterodox-leaning readers. 

(Note: My writing output will be low for awhile. I am still editing my manuscript, and another non-writing project has also popped up.)

(c) Brian Romanchuk 2020

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