The ideology that caused the problem cannot be its solution

All the economic news at present is bad. Eurostat released its latest labour force data which shows that the Euro area unemployment rate has risen to 10.2 per cent in September 2011 (0.1 rise over the year) which shows how persistent the crisis is in that region and that is is slowly getting worse. The OECD has released a Special G20 Briefing Note which declares the world economic outlook to be gloomy and decisive action is needed although their policy recommendations will make things gloomier. A major financial company (MF Global) has gone bankrupt, partly as a result of their bond market exposure in Europe (haircuts?) and most disturbingly, the ILO has just released a – G20 Briefing – which was co-published by the OECD and predicts a “massive jobs shortfall among G20 members by next year” if the current slow-down in the world economy continues. There is a major demand (spending) shortfall in the advanced economies and only one sector that can do something about it – the public sector. But politicians are being pressured to spend less. I cannot understand how we have been so caught up in an ideology that caused the problem in the first place and is now being seen as the solution despite all evidence to the contrary.

I saw another disturbing Bloomberg article (October 31, 2011) – ‘Generational War’ Seen as Lawmakers Stall on Deficit – which documents the many ways in which the conservative attacks on public spending in the US will ensure that the children of America are the “biggest casualties”. The article says that “lawmakers are sacrificing the U.S.’s future investment in children, education, infrastructure and other programs.”

Which is an interesting way of tackling the so-called ageing society challenge where rising dependency ratios will require the remaining workers to be more productive than ever to ensure that real standards of living continue to be maintained.

Europe is also trashing its youth. Over the twelve months to July 2011, Greek unemployment rose from 12.6 per cent to 17.6 per cent and over the twelve months to September 2011, unemployment in Spain rose from 20.5 to 22.6 per cent, with no end in site to the deterioration.

The Eurostat youth (under 25) unemployment estimates now stand at 21.4 per cent in September 2011 (for the EU27) up from 20.9 per cent in September 2010.

But this masks some disparity with youth unemployment in Spain reaching 48 per cent in September 2011 (up from 42.3 per cent in 2010); Ireland 29.5 per cent (up from 28.2 per cent) and Italy 29.3 per cent (up from 27.7 per cent) among several other nations with very high and worsening youth labour markets.

On October 28, 2011, Eurostat reported that the Euro area Household saving rate had risen to 13.9 per cent in the second quarter 2011 from 11.9 per cent in the first quarter.

Eurostat also reported that the Business investment rate fell slightly in the second quarter 2011 compared to the first quarter.

So there will not be any major stimulus coming from the private sector.

The OECD which has been urging governments to engage in “fiscal consolidation” presumably because they believed private spending would step in to replace the gap left by the fiscal drag are now ringing the emergency bell.

Yet they still are maintaining their mantra that monetary policy should do the heavy lifting (it cannot!) and that:

Strong, credible medium-term frameworks for fiscal consolidation and durable growth are needed to restore confidence in the longer-term sustainability of the public finances and to build budgetary space to deal with short-term economic weakness. Those advanced economies with sounder public finances can provide additional counter-cyclical support.

I remain bemused by the snake-like prose these organisations are using. The IMF also talks about “growth friendly fiscal consolidation”. The rhetoric is that you can have budget cuts yet not damage growth somehow – or that you can promise budget cuts with damaging growth.

The OECD also continue to push the erroneous concept of “budgetary space to deal with short-term economic weakness”. What does that mean? They consider that budget surpluses somehow build a store of reserves that can be used to attack the next crisis.

For sovereign currency-issuing nations such a concept has no application. Such a government can always respond to a private aggregate demand collapse by increasing the public deficit, irrespective of their fiscal position going into the crisis. It is a lie to claim otherwise.

There is also the implication that budget surpluses could reduce public debt which then makes it easier to expand public debt. There are two aspects to this claim. First, the ideological assumption that governments should issue debt to match their deficit spending when it is clear that currency-issuing governments do not have to do this.

That requirement disappeared with the termination of the Bretton Woods agreement in 1971 but conservatives have pressured governments to maintain the unnecessary practice because they know it is a way of “disciplining” government spending.

Second, the claim presumes that there will be a reluctance by bond markets to accept higher public debt ratios. Where is the evidence for that? One cannot use the EMU as an example because that monetary system denies member state sovereignty. But elsewhere bond markets cannot get enough public debt and yields are very low as a consequence.

Moreover, if the bond markets did demonstrate a reluctance to tender for government debt at acceptable yields then the governments can deal them out of the equation via appropriate central bank action (which may in some cases require legislative changes). The government (consolidated treasury and central bank) always has the power in these cases should it choose to use it.

The ILO/OECD Report – Short-term employment and labour market outlook and key challenges in G20 countries – presents daunting empirical information but its policy framework is ideologically tainted by the OECD’s obsession with structural interpretations.

The note: (a) updates the “most recent employment and labour market trends”; and (b) aims to “highlight key structural issues in G20 labour markets and the policy challenges to address them”.

You can see the tension immediately. The empirical update tells us that unemployment is not much different to the peak levels reached during the 2008. The policy proposals presume this malaise to be a “structural” problem.

Therein lies the problem that the world has been in since the OECD released its Jobs Study report in 1994. Despite clear evidence that advanced economies were not producing enough jobs (that is, a systemic demand failure) the OECD chose to construct the problem as a supply-side issue and focuses on trade union power, welfare provisions, worker motivation etc.

After 17 years of that policy agenda they still haven’t worked out that the swings in unemployment are demand-driven.

Please read my blogs – The OECD is at it again! and OECD – GIGO Part 2 – for more discussion on this point.

The ILO/OECD Report says that:

The latest available indicators suggest that growth in world output is slowing. In the major advanced G20 economies the recovery appears to have come close to a halt, with falling household and business confidence affecting both investment and job creation.

As a result, “economic growth in the major advanced G20 economies excluding Japan will remain at an annualized rate of less than 1 per cent in the second half of 2011”.

So the reader would clearly conclude that there is not enough spending and that is driving growth below that necessary to bring unemployment down. Spending equals output which creates the need for employment.

Private confidence is low and that is affecting spending growth.

I agree completely with that assessment.

The labour market implications of that slowdown in spending are then documented:

With economic activity slowing in several major economies and regions, earlier improvements in the labour market are now fading, hiring intentions are softening and there are greater risks that high unemployment …

Once again employment is what economists call a derived demand – emanating from the need to assemble workers to produce goods and services for final sale. Right through the supply chain the demand for labour is derived from the demand for final goods and services.

No matter how cheap labour is, firms will not employ if they do not have sales for the production. That is a fundamental reason why Keynes and others opposed wage cutting as a way of stimulating employment. While across-the-board wage cuts would reduce costs for business, they would also reduce consumption (because workers would have less income) and the net result was uncertain at best. The argument is more complex than that but is the topic of another blog.

The huge pool of idle labour and the lack of employment growth will according to the ILO/OECD Report:

… make it impossible in the near term to close the jobs gap accumulated during the crisis, which amounts to more than 20 million jobs.

Which, in turn, is “exacerbating structural challenges in the form of high and mostly increasing youth unemployment and a rising incidence of long-term unemployment” and is highly deflationary with respect to “consumer demand”.

What are these “structural challenges”?

The ILO/OECD Report (page 4) says:

The large increase in long-term unemployment is of particular concern because of the increased risk that many workers will become structurally unemployed. In previous recessions, this was the main channel through which a cyclical increase in unemployment in many advanced countries was transformed into persistently high unemployment rates that took many years to unwind. There are also serious social costs related to long-term unemployment, as it is associated with an increased risk of poverty, health problems and school failure for children of the affected individuals.

I agree that there are serious social costs related to unemployment which should make it a policy urgency to prevent large increases in joblessness from occurring in the first place. But we have to be careful when it comes to assessing the claim that the long-term unemployed become a structural constraint on growth.

In my PhD thesis I explored the way in which so-called structural parameters or outcomes (such as the NAIRU) were sensitive to the business cycle – that is, the stae of aggregate demand. In other words, the mainstream claim that we can focus on structural matters independent of the state of the cycle is flawed.

Please read my blogs – Redefining full employment – again! and The dreaded NAIRU is still about! – for more discussion on this point.

Increasing NAIRU estimates (based on econometric models) in the 1980s merely reflected the decade or more of high actual unemployment rates and restrictive fiscal and monetary policies, and hence, were not indicative of increasing structural impediments in the labour market? There is no credible evidence to show that that major increases in unemployment are due to the structural changes like demographic changes or welfare payment distortions.

For the technically minded you might like to read the original article (derived from my PhD thesis) which appeared in Australian Economic Papers, December 1987 which has the formal theoretical model and econometric analysis.

The main emphasis of that early work was that structural changes were in fact cyclical in nature – this was called the hysteresis effect. Accordingly, a prolonged recession may create conditions in the labour market which mimic structural imbalance but which can be redressed through aggregate policy without fuelling inflation.

Structural constraints that emerge during a large recession (more about which later) can be wound back by strong fiscal policy stimulation.

Recessions cause unemployment to rise and due to their prolonged nature the short-term joblessness becomes entrenched long-term unemployment. The unemployment rate behaves asymmetrically with respect to the business cycle which means that it jumps up quickly but takes a long time to fall again. But this behaviour has to be seen in the context of the policy position that the national government takes at the time of the recession and the early recovery period.

It is true that once unemployment reaches high levels it takes a long time to eat into it again because labour force growth is on-going and labour productivity picks up in the recovery phase. You need to run GDP growth very strongly at first to absorb the pool of idle labour created during the recession unless you provide a strong public employment capacity that is accessible to the most disadvantaged (for example, this is what the Job Guarantee is about!).

It is also the case that if GDP growth remains deficient then the idle labour queue will remain long and employers will use all sorts of screening devices to shuffle the workers in the queue. They increase hiring standards and engage in petty prejudice. A common screen is called statistical discrimination whereby the firms will conclude, for example, that because on average a particular demographic cohort is unreliable, every person from that group must therefore be unreliable. So gender, age, race and other forms of discrimination are used to shuffle the disadvantaged from the top of the queue.

The long-term unemployed are also considered to be skill-deficient and firms are reluctant to offer training because they have so many workers to choose from.

But to understand what happens during a recession we need to consider the cyclical labour market adjustments that occur.

The hysteresis effect describes the interaction between the actual and equilibrium unemployment rates. The significance of hysteresis is that the unemployment rate associated with stable prices, at any point in time should not be conceived of as a rigid non-inflationary constraint on expansionary macro policy. The equilibrium rate itself can be reduced by policies, which reduce the actual unemployment rate.

The idea is that structural imbalance increases in a recession due to the cyclical labour market adjustments commonly observed in downturns, and decreases at higher levels of demand as the adjustments are reserved. Structural imbalance refers to the inability of the actual unemployed to present themselves as an effective excess supply.

The non-wage labour market adjustment that accompany a low-pressure economy, which could lead to hysteresis, are well documented. Training opportunities are provided with entry-level jobs and so the (average) skill of the labour force declines as vacancies fall. New entrants are denied relevant skills (and socialisation associated with stable work patterns) and redundant workers face skill obsolescence. Both groups need jobs in order to update and/or acquire relevant skills. Skill (experience) upgrading also occurs through mobility, which is restricted during a downturn.

An extensive literature links the concept of structural imbalance to wage and price inflation. It can be shown that a non-inflationary unemployment rate can be defined which is sensitive to the cycle. Given that inflation typically results from incompatible distributional claims on available income by firms and workers, unemployment can temporarily balance the conflicting demands of labour and capital by disciplining the aspirations of labour so that they are compatible with the profitability requirements of capital. This is the underlying reason why inflation targetting uses unemployment and a policy tool rather than as a policy target!

So the failure of our governments to really attack unemployment during this crisis will create conditions that appear to be structural in nature – skills loss or no skill development. This is especially problematic for our youth who will struggle for their entire lives if they are excluded from paid work for the formative period of their lives.

Remember the rule of thumb: real GDP growth has to increase at a rate equal to the increase in labour productivity and the labour force (with average hours worked constant) just to keep the unemployment rate constant.

To make inroads into the huge pool of idle labour left over from the crisis, real GDP growth has to exceed that sum. Every percent it exceeds it will see unemployment rates fall by a percent.

In the 4 years since the crisis hit, growth has been well below that required sum in most nations. ILO/OECD Report observe that:

Over the past year, the unemployment rate has declined in the vast majority of the G20 countries, but often only moderately, leaving the number of job-seekers close to the peak recorded at the depth of the Great Recession

At current rates of recovery and policy efforts it will take years to bring unemployment down.

If you went searching for OECD or IMF research on the costs of unemployment – the losses of income etc – relative to estimates of “structural inefficiency” you won’t find any. They clearly do not want to emphasise that their typical policy approach that focuses on structural adjustments (and hence prolonged unemployment) cause irretrievably huge income losses not to mention all the other personal and social costs that accompany unemployment.

An interesting observation made by the ILO/OECD Report is that “the response of employment to the fluctuations in GDP has also varied significantly across the G20 countries.” This conclusion is highly dependent on the measurement of employment – being classified as 1 hour of paid work per week – and the composition of industry. So a service firm that picks up a boost in demand might create 10 casual jobs whereas another firm in another sector might create 1 full-time job.

The rise in employment for a given real GDP growth rate is thus dependent on the composition of industry and the full-time/part-time mix. That is why we should be very careful when analysing claims that employment is growing. It is best to convert the claim into Full-time equivalents to get a better picture of the underlying strength of the economy.

The ILO/OECD Report is correct in saying (page 5) that “(o)ver the next few years, many G20 countries will be facing significant challenges to create enough jobs to accommodate their growing labour force and/or to absorb the persistent jobs gap resulting from the crisis”.

This is not because we do not know how to create employment growth sufficient to reduce the gap. The reason it will be a challenge is because governments have backed themselves into an ideological corner and refuse to take responsibility and use their fiscal capacity to create work for all.

Unemployment is always a choice of government. Government can always maintain full employment by ensuring its net spending is sufficient to meet the desire to net save by the non-government sector. If there is unspent income in the private sector then only the Government has the capacity to provide the spending necessary to fill the spending gap.

At a minimum the government could (and should) offer a job to anyone who cannot find one.

In Part 2 of the ILO/OECD Report we encounter the denial:

Even before the economic crisis, G20 countries were grappling with a number of underlying structural challenges in the labour market. For most of them, better integrating youth, women and migrants into the labour market were key issues. In the context of rapid technological change and globalization, another priority has been to improve labour market prospects for the low-skilled, especially in the more advanced economies. For many countries, reversing a long-term trend decline in the effective age of exit from the labour market by older workers has also been a key policy aim in order to cope with the fiscal challenge posed by rapid population ageing.

This mantra has been echoing around the world for two or more decades.

It completely misses the point. The government could easily integrate all these cohorts into the productive workforce by employing them.

The latest Eurostat labour force data shows that Norway has an unemployment rate of 3.2 per cent (July 2011) down from 3.6 per cent in September 2010. That is 1/3 of the EU rate. That nation has experienced the demographic and industrial trends common across the advanced world (rising female participation, declining manufacturing etc) but has chosen to use the government sector in a different way.

The rise in public service sector jobs (high skill, secure, well-paid) in Norway is in contrast to the way many other advanced nations have allowed casualised, low-paid and low-skill service sector employment in the private sector to dominate employment growth.

The former approach provides a culture of dynamic skill development the latter leads to de-skilling and poor adaption to structural changes driven by changing spending patterns.

Please read my blog – Norway … colder than us but … – for more discussion on this point.

The ILO/OECD Report does say that it is “absolutely essential to give priority to decent work, and to investment in the real economy, and for this to happen we need determined global cooperation”.

I just did an SBS Radio interview (one of two Australian national broadcasters) on the ILO/OECD Report and concluded that the current political direction is totally at odds with what is required to recover the “estimated 20 million jobs lost in the G20 since the crisis began in 2008”.

It is clear that fiscal austerity will exacerbate the jobs gap. The head of the ILO commented in an accompanying press release that:

Employment creation has to become a top macroeconomic priority …

Which can only mean one thing – there has to be more public spending – which should be targetted at maximising the growth of decent and stable jobs.

There is no other sector that is currently in a position to provide a substantial spending intervention.

The losses involved in enduring this persistent unemployment are so large that such interventions should be a priority. The majority of advanced nations are currently paralysed by the political impasses and/or vehement pursuit of fiscal austerity. There is such a divide between what is needed and what is being done that it beggars belief.

I cannot understand how we have been so caught up in an ideology that caused the problem in the first place and is now being seen as the solution despite all evidence to the contrary (that it is making things worse).

Conclusion

I am travelling today and so I didn’t get time to analyse the new report from the Social Protection Floor Advisory Group (within the ILO) which recommended “the establishment of national social protection floors in every society”.

I would start by introducing a Job Guarantee at a socially-inclusive minimum wage and allow participants (workers) to choose how many hours they wanted to work within the plan up to full-time. There is no better place to start in a quest to stabilise communities than ensuring there is enough work available.

Only the public sector can make those guarantees and fund them appropriately.

I would stress though that a Job Guarantee is the basic intervention and is not a panacea for all ills. It is the minimum safety net that should exist in any society.

That is enough for today!