Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
I read the headline in the UK Guardian from yesterday (September 15, 2010) – Unemployment claimant count rises unexpectedly which apparently confounded forecasts. The hopes for an export-led recovery as the expectations of the forthcoming public austerity damage private spending plans took a further hammering with the data release showing the “highest balance of trade deficit on record” in Britain and “surveys of the services and construction sectors showing employer sentiment deteriorating sharply”. Why is this surprising? The fact that the so-called analysts and the press are surprised only tells me that they do not understand the way the macroeconomic system works. When there are already severe aggregate demand constraints and the government announces that soon enough they will brutalise public spending what would you expect but a further decline in economic activity? When the rest of the world is easing the fiscal stimulus under the concerted attack by the deficit terrorists why would you expect the balance of payments to dramatically improve? None of this surprises me at all. It is exactly what an understanding of the monetary system would lead one to predict.The reality is that to lower unemployment you need to spend more. There are no surprises in that.
The other salient feature of the UK situation is that underemployment is becoming endemic. The UK Office of National Statistics data for September 2010 showed that part-time employment jumped (now comprising 27.2 per cent of total employment a rise from 25.4 per cent in two years) which suggests that employers wish to maintain as much downside flexibility as they can given their expectations of a double-dip recession are rising by the day.
Conclusion: the new British government are vandalising their economy and lied to the citizens when they said their policy strategy would provide the path out of the malaise they were in. Their strategy is clearly making things worse.
This brings me back to the Trade and Development Report 2010 published by the United Nations Conference of Trade and Development (UNCTAD) which I discussed in yesterday’s blog – Export-led growth strategies will fail.
Today I want to focus on UNCTAD’s analysis of unemployment which begins with Chapter III. In later blogs I will more fully consider their ideas about what governments can actually do.
In 2000, one of the authors of the original NAIRU terminology (Franco Modigliani) showed some contrition when he said:
Unemployment is primarily due to lack of aggregate demand. This is mainly the outcome of erroneous macroeconomic policies… [the decisions of Central Banks] … inspired by an obsessive fear of inflation, … coupled with a benign neglect for unemployment … have resulted in systematically over tight monetary policy decisions, apparently based on an objectionable use of the so-called NAIRU approach. The contractive effects of these policies have been reinforced by common, very tight fiscal policies (emphasis in original
We consider Modigliani’s about face in detail in my recent book with Joan Muysken – Full Employment abandoned.
I particularly liked this section in Chapter III of the UNCTAD Report:
The authorities in the United States may feel more obliged to take countercyclical action to combat unemployment because the welfare system in that country provides much less support than in Europe. But that does not make European welfare systems the cause of high unemployment.
In 2001 to 2003 I did a lot of work on this issue with my Dutch colleague Joan Muysken.
At the time, the influential “macroeconomic consensus” among European researchers as to the cause of unemployment persistence in the European labour markets was characterised by the conclusion that rigidities imposed by labour market institutions and policies dominate all other explanations of the European unemployment crisis of the 1980’s and 1990’s.
This was the central message of the OECD’s Job Study (1994) and later follow-up reports. In the current period, these structural explanations are emerging again as one of the planks that the conservatives are using to attack the use of fiscal policy.
The claim is that the rise in unemployment is actually a structural rise and that aggregate policy (fiscal and monetary policy) cannot reduce it. The argument alleges that structural reforms – that is, deregulation, harsher welfare-to-work rules, cutting of income support – are necessary to resolve the impediments to growth. So push the unemployed closer to starvation and the increased desperation will force them to work.
At the time I wrote a paper – the unemployed cannot search for jobs that are not there – which was subsequently published but you can see a free Working Paper version HERE.
To support the OECD line a host of papers came out from the conservative European and British think-tanks and institutes all purporting to show that these structural variables – like welfare payments and trade union coverage and taxes – were all implicated and driving the unemployment. The policy agenda was clear – free up the labour market and undermine the entitlements and protections that workers had built up over many years of struggle.
We spent a lot of time during those years exploring the econometric models and datasets that the researchers had been using to give authority to the policy conclusions.
Many interesting things emerged. Other than major lapses in econometric technique and convenient use of restrictive samples (that is, shortening or otherwise manipulating the sample of data used in such a way as to bias the estimates towards your own preferred ideological outcome), one stunning result we found related to the veracity of the so-called structural variables that appeared in all these models.
The models effectively deny that aggregate demand matters and that persistently high unemployment is really indicative of a rise in “equilibrium unemployment” driven by structural impediments. So variations in the equilibrium rate of unemployment is allegedly best explained by fluctuations in the tax wedge, the replacement rate, the minimum wage and the user cost of capital.
These are all variables that the government can vary without extra net spending.
But the question we asked – which was ignored by the mainstream literature – was – how structural are the empirical indicators that were being used by this lot in their regression models to show the importance of these impediments?
Using an array of decomposition and spectral analytic statistics tools what we found was that the so-called structural variables (tax wedge, replacement ratio, user cost of capital) were in fact highly cyclical. That is, the business cycle drove significant fluctuations in these variables which explained why they exerted significant influences on the change in the unemployment rates in various nations.
Importantly, once you decomposed (took out) the cyclical component and then ran the OECD-type regressions again to test for the structural effect what do you think happened? Answer: there was no structural effect. All the so-called structural “causation” was being driven by variations in the business cycle and fiscal and monetary policy changes influenced that trajectory in relatively predictable ways (at least in direction – up or down).
So what did that mean? Answer: unemployment is heavily determined by aggregate demand fluctuations which can be managed in a counter-cyclical manner by fiscal policy interventions. Exactly the conclusion that the OECD and all their lackeys had set out to destroy so they could justify the introduction of their neo-liberal supply-side agenda. Pity they didn’t actually establish their results in an honest and/or robust manner.
The literature justified ignoring aggregate demand influences by appealing to the work of Milton Friedman and others who invoke the so-called classical neutrality – that is, in the long-run, real variables cannot be influenced by changes in nominal variables. Which means in English that increased government spending will not increase aggregate demand or employment (in a nutshell!).
This notion had been categorically destroyed of any credibility in the 1930s by the Great Depression and the work of Keynes and others.
The OECD-type studies also always assumed away the fallacy of composition that Keynes and others showed existed when applying classical wage-cutting solutions to unemployment.
Macroeconomics in the 1930s emerged out of the failure of mainstream economics at the time to conceptualise economy-wide problems – in particular, the problem of mass unemployment. Please read my blog – What causes mass unemployment? – for more discussion on this point.
In terms of their solutions to unemployment, they believed that one firm might be able to cut costs by lowering wages for their workforce and because their demand will not be affected they might increase their hiring.
However, they failed to see that if all firms did the same thing, total spending would fall dramatically and employment would also drop. Again, trying to reason the system-wide level on the basis of individual experience generally fails.
Wages are both a cost and an income. The mainstream ignored the income side of the wage deal. The technical issue comes down to the flawed assumption that aggregate supply and aggregate demand relationships are independent. This is a standard assumption of mainstream economics and it is clearly false.
Mass unemployment occurs when there are not enough jobs and hours of work being generated by the economy to fully employ the willing labour force. And the reason lies in there being insufficient aggregate spending of which the net spending by government is one source.
The erroneous mainstream response to the persistent unemployment that has beleaguered most economies for the last three decades is to invoke supply-side measures – wage cutting, stricter activity tests for welfare entitlements, relentless training programs. But this policy approach, which has dominated over the neo-liberal period, and reflects their emphasis on the individual falls foul of the fallacy of composition problem.
They mistake a systemic failure for an individual failure. You cannot search for jobs that are not there. The main reason that the supply-side approach is flawed is because it fails to recognise that unemployment arises when there are not enough jobs created to match the preferences of the willing labour supply.
The research evidence is clear – churning people through training programs divorced from the context of the paid-work environment is a waste of time and resources and demoralises the victims of the process – the unemployed.
The conclusion we came to was that whatever the validity of the theoretical model that relates structural variables to the evolution of the equilibrium unemployment rate, the empirical work that is typically performed to accompany the theoretical development cannot be used as an authority to underpin the theoretical development. In general, the models are mis-specified, contain several untested (and invalid) empirical restrictions which invalidate the resulting inference.
In my recent book with Joan Muysken – Full Employment abandoned – we also provide a thorough critique of the theoretical models that are typically used in this debate. They leave out key variables and rely on very ad hoc assumptions to deliver their theoretical outcomes.
However, all these considerations were largely ignored at the time. Many academic studies sought to establish the empirical veracity of the neoclassical relationship between unemployment and real wages and to evaluate the effectiveness of active labour market program spending. This has been a particularly European and English obsession. There has been a bevy of research material coming out of the OECD itself, the European Central Bank, various national agencies such as the Centraal Planning Bureau in the Netherlands, in addition to academic studies.
The overwhelming conclusion to be drawn from this literature is that there is no conclusion. These various econometric studies, which have constructed their analyses in ways that are most favourable to finding the null that the orthodox line of reasoning (that wage rises destroy jobs) is valid, provide no consensus view as Baker et al (2004) show convincingly.
Further, in the actual real world (outside of the halls of academic research), things starting falling apart for the consensus view about unemployment.
As various governments feverishly implemented the OECD Jobs Study supply-side agenda through the 1990s and simultaneously constrained demand as noted in the quote above by Modigliani by enforcing restrictive fiscal and monetary policy regimes they observed very little improvement in unemployment. By the early 2000s it was clear to anyone who could see beyond their ideological glasses that the policy agenda was a total crock.
Several studies emerged around then that drove the point home. In the last 10 years, partly in response to the reality that active labour market policies have not solved unemployment and have instead created problems of poverty and urban inequality, some notable shifts in perspectives are evident among those who had wholly supported (and motivated) the orthodox approach which was exemplified in the 1994 OECD Jobs Study.
In the face of the mounting criticism and empirical argument, the OECD began to back away from its hard-line Jobs Study position. In the 2004 Employment Outlook, OECD (2004: 81, 165) admitted that “the evidence of the role played by employment protection legislation on aggregate employment and unemployment remains mixed” and that the evidence supporting their Jobs Study view that high real wages cause unemployment “is somewhat fragile.”
The winds of change strengthened in the 2006 OECD Employment Outlook entitled Boosting Jobs and Incomes, which is based on a comprehensive econometric analysis of employment outcomes across 20 OECD countries between 1983 and 2003. The data sample included those who adopted the Jobs Study as a policy template and those who had resisted labour market deregulation. The report provided an assessment of the Jobs Study strategy to that point and revealed significant shifts in the OECD position.
The OECD (2006) found that:
- There is no significant correlation between unemployment and employment protection legislation;
- The level of the minimum wage has no significant direct impact on unemployment; and
- Highly centralised wage bargaining significantly reduces unemployment.
This was not given very much exposure by the press and the policy debate barely picked up on it. But it constituted a serious withdrawal from the previous hard-line position. It means that governments who had relied relied on the previous work of the OECD including the Jobs Study to push through harsh labour market reforms such as the widespread deregulation, retrenched welfare entitlements and attacks on trade unions were now without any real authority.
The OECD retractions make a mockery of the arguments that minimum wage increases will undermine the employment prospects of the least skilled workers.
The OECD (2006) also found that unfair dismissal laws and related employment protection do not impact on the level of unemployment, merely the distribution. In my own work I have consistently pointed this out – in a job-rationed economy, supply-side characteristics will always serve to only shuffle the queue. The most disadvantaged stand at the back of the unemployment queue.
All the punishments (removal of income support), incentives, training and other attacks on those standing in the queue will not alter its length. To reduce the queue you need extra jobs and that requires higher levels of aggregate demand.
This point is dealt with very well in the UNCTAD Report (Chapter III).
They say that all observers now agree that during the period between the early 1990s and 2007 (that is, the growth period between the two major recessions) that:
… labour market outcomes were generally unsatisfactory in this period of accelerated globalization: employment typically grew at much lower rates than output – or in some cases did not grow at all – and the share of wages in national income generally declined in both developed and developing countries.
The growing gap between labour productivity and real wages growth has been one of the hallmark characteristics of the OECD Jobs Study period which really provided a policy framework to implement a neo-liberal anti-worker, anti-welfare recipient agenda.
But the interesting (and sad, given the consequences) aspect is that the success was sowing the seeds of its own destruction.
I have documented this trend and this point in several blogs – for example – The origins of the economic crisis.
If you systematically undermine the purchasing power of the workers by squeezing their command on real output (real wages growth) yet enjoy growing output per worker the question is how does all the stuff get sold and profits realised.
This became especially tricky given that the related agenda over this period was to contract the government contribution to aggregate demand.
As I show in the blog just noted the answer was that the financial sector grew spectacularly and the financial engineers pushed huge amounts of debt onto the workers. Now the capitalist not only got increased profits (and share of real income) by squeezing real wages but also were able to extract additional real income from the workers via the interest payments on the debt.
With inflation falling, it was all advantaging capital.
But at the same time it was unsustainable because the private sector (overall) cannot continuously accumulate debt and spend the funds on consumption and housing.
In this context, UNCTAD note that:
… employment creation and a declining wage share are interdependent, in the sense that if wage growth does not keep pace with productivity growth, the expansion of domestic demand and employment creation will be constrained, and that this constraint can only be lifted temporarily, if at all, by reliance on external demand.
They proceed to debunk the standard mainstream arguments relating to the relationship between real wages and unemployment.
They note that:
Rising and persistent unemployment in many countries has prompted a variety of explanations based on new and old ideas concerning the rigidities and malfunctioning of labour markets and the role of the welfare state in generating such “inflexibilities”. According to neoclassical employment theory, the only explanation for high or rising unemployment is that real wages are too high or are rising too fast because strong labour unions or excessively high legal minimum wages prevent wages from falling sufficiently to absorb an excess supply of labour. This reasoning is based on a microeconomic concept that is transposed to the macroeconomic level.
So refer back to my earlier discussion about fallacies of composition.
UNCTAD say in this regard that if you want to run the mainstream (neoclassical) line then the “supply and demand functions have to be independent of each other” which might hold at the microeconomic level “but is not valid at the macroeconomic level”.
The way they express the compositional fallacy is to note that:
… if the decision of a sufficiently large number of households to buy less bread does not affect the income situation of any of these individual households, the fall in the demand for bread should lower its price and result in new and stable relative prices between bread and other products … [but] … if the income situation of all households depends, directly or indirectly, on the value added that is generated by all producers in an economy, and the latter have to adjust their production downwards in reaction to a fall in household demand, this adjustment itself will feed back into aggregate household income through lower total wage income.
In other words, when you try to cut wages across the board, firms will enjoy lower costs (maybe – depending on what happens to productivity) which is a supply-side benefit. But equally, on the aggregate demand side, workers have lower incomes and so spending falls. There is no reason to believe that the latter effect will be smaller than the former.
Indeed, Keynes and others showed that the standard case is that they two impacts will likely offset each other in typical situations and so there will be no net change in aggregate demand and no improvement in employment overall.
However, if productivity falls (morale problems etc) then the supply boost is not forthcoming and aggregate demand will fall. This will, in turn, lead to a rising pessimism among consumers and investors, of the type we are seeing in the UK at present, and so there will be further contractions in aggregate demand.
You end up with rising unemployment, a race-to-the-bottom with respect to productivity growth, falling standards of living and a thoroughly annoyed working class.
There is nothing by way of consolation that you can say about such a strategy. It is mindlessly destructive.
In terms of the so-called structural explanations of unemployment that I considered before, UNCTAD say:
Although the view that legal employment protection, trade union power and generous unemployment benefit schemes are responsible for higher unemployment has become very widely accepted, it has been shown to be empirically unfounded.
Yes it has been yet it still arises in the public debate. For example, in the US Congress debate about whether the miserly unemployment benefits should be further extended all the mainstream “experts” (who know nothing) are arguing along the standard microeconomic lines – that the benefits are undermining search incentives and prolonging unemployment.
There is no empirical evidence to support any of these mainstream notions.
UNCTAD then provide further analysis to support this proposition. They then turn to what they consider to be the only theoretically and empirically robust explanation of persistent (mass) unemployment.
Generally, in developed countries employment cycles are very closely associated with output growth cycles: employment growth is typically associated with growth of aggregate demand and output … There is also a strong positive correlation between investment in fixed capital and employment creation in developed countries … Once it is recognized that it is not primarily the relative cost of labour but the pace of output growth that is the key determinant of the level of employment, it follows that investment in real productive capacity and the demand expansion that motivates such investment are the drivers of both income growth and employment creation.
So firms form expectations of future demand (and realised sales) and invest accordingly. Fluctuations in investment drive the business cycle and the components of aggregate demand are interdependent via expectations and employment.
So given consumption is induced by faster growth which in turn responds to public spending and investment is dependent on, among other things, expectations of future revenue, you can quickly see the interdependencies.
It is clear that growth builds on itself. But when private spending is stagnant and expectations are very pessimistic what external force will change that? Why will investors once again assume the risk and start building new capacity?
In some of my earlier work (with Joan Muysken) – for example, here is a working paper you can get for free (subsequently published in the literature) – we developed a model based on the notion that investors facing endemic uncertainty make large irreversible capital outlays, which leads them to be cautious in times of pessimism and to use broad safety margins.
Accordingly, they form expectations of future profitability by considering the current capacity utilisation rate against their normal usage. They will only invest when capacity utilisation, exceeds its normal level. So investment varies with capacity utilisation within bounds and therefore productive capacity grows at rate which is bounded from below and above. The asymmetric investment behaviour thus generates asymmetries in capacity growth because productive capacity only grows when there is a shortage of capacity.
This sort of model stands up very well to empirical scrutiny.
Please read my blogs – How do labour markets react to capacity utilisation changes? and Deficits should be cut in a recession. Not! – for more discussion on this point.
UNCTAD then relate the idea that aggregate spending is important for employment growth back to the distributional issue:
Whether or not aggregate demand rises sufficiently to create net employment depends crucially on the distribution of the gains from productivity growth, which in turn is greatly influenced by policy choices. The policies generally adopted over the past 25 years have sought to keep wages low, and have served to translate productivity gains either into higher capital income or into lower prices. They are based on the assumption that the demand for labour will behave in the same way as the demand for most goods (i.e. the lower the price, the greater the demand). But keeping wages low in order to generate higher profits is self-defeating, because without a stronger purchasing power of wage earners, domestic demand will not rise sufficiently to enable owners of capital to fully employ their capacity and thereby translate the productivity gains into profits. A potentially more successful strategy would be one oriented towards ensuring that the gains from productivity growth also accrue to labour: wages rising in line with productivity growth will cause domestic effective demand to increase and nourish a virtuous cycle of growth, investment, productivity increases and employment over time.
The global economies were able to stall the inevitable by increasingly pushing debt onto the private households to keep consumption spending going. But that was never going to last and it came unstuck because the financial engineers had to extend the margin of indebtedness further out into the income cohorts who were not financially viable.
Once the house of cards starting crashing the non-sustainability of this approach was revealed to all. The problem is that we do not seem to have learned from the mistakes.
Neo-liberalism is still dominating the policy debate and essential reforms have not been considered yet. But a double-dip is heading our way and that might provide some scope to reject the fiscal austerity thesis, to reject the export-led growth thesis, and instead to reconsider the basic relationships at the macroeconomic level.
It is very simple – if you want to reduce unemployment you have to systematically provide more jobs. More jobs require more private and/or public spending. If you cut either, then it will never be a surprise to me that the labour market will deteriorate and vice versa.
That is enough for today!