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Policy failure in Europe scales new heights

I had the occasion to re-read an article published by The American Prospect Magazine (March/April edition 1996, pages 54-59) and written by American institutional economist Lester Thurow – The Crusade That’s Killing Prosperity (reprinted December 19, 2001). It is a fine article about the way inflation-first monetary policy, which was one of the defining macroeconomic characteristics of the neo-liberal era (under the aegis of the NAIRU), deliberately drove unemployment and broader measures of labour wastage much higher than necessary and suppressed the capacity of those remaining in employment to enjoy wages growth in proportion to productivity growth. The article is prescient because it provides some good insights into what happens when policy makers deliberately create unemployment (via monetary and fiscal austerity). It allows one to see that the costs extend well beyond the unemployment that emerges fairly quickly. It also allows one to appreciate how austerity impacts across time and damages the prospects for generations. Each week new data comes out which confirms the view that fiscal austerity has failed. Yesterday, the data suggests that the policy failure in Europe has scaled new heights.

Thurow said:

The great untold story of the American economy in the 1990s is the disguised high rate of unemployment and its direct impact on stagnating living standards. Properly calculated, our rate of joblessness is well into double digits. No wonder workers have no bargaining power to get their share of an increasingly productive economy … The Federal Reserve’s crusade against the ghost of inflation has driven unemployment much higher than the official numbers suggest. It’s not technology that’s keeping down wages — it’s the policy of America’s politically insulated central bank.

This resonates with comments from the original architect of the NAIRU (the non-accelerating inflation rate of unemployment), the late Franco Modigliani who with Lucas Papademos pioneered this terminology in 1975. I should add that Lucas Papademos is now the unelected Prime Minister of Greece!

Later in life (in 2000), as he saw the damage that the inflation-first, fiscal austerity approach that defined neo-liberalism in the 1980s and beyond had wrought he reflected and concluded (Reference: ‘Europe’s Economic Problems’, Carpe Oeconomiam Papers in Economics, 3rd Monetary and Finance Lecture, Freiburg, April 6):

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.

I particularly liked Thurow’s insights into how policy makers reinforce their own position because they become defined by them and do not have a purpose outside of them:

Left to their own devices, those who operate central banks are never going to declare a permanent victory over inflation. The reasons are simple. If the battle against inflation is primary, central bankers will be described as, and actually be, the most important economic players in the game. Without inflation, they run rather unimportant institutions.

We see this over and over again. The IMF lost its purpose in 1971 when the US President abandoned the Bretton Woods system of fixed exchange rates. After that the IMF had to reinvent itself and its own sense of self-importance manifested in the creation and implementation of the penurious structural adjustment programs (SAPs), which imposed harsh austerity on poor nations.

Please see my blog – IMF agreements pro-cyclical in low income countries – which details how the SAPs increased poverty and hardship and how low income countries actually became poorer between 1980 and 2006 as the IMF officials moved through them one by one. The SAPs were responsible for transferring income from resource wealth from low income to high income countries.

We also see it in the Troika in Europe at present. Never before have I witnessed such an damaging decision-making environment which gathers strength from the misery that it inflicts on the citizens subject to the flawed monetary system the elites imposed and oversee.

If the Eurozone was dissolved and nations floated their sovereign currencies again then a whole layer of highly-paid but venal officials would be queuing for work somewhere and there would be less sumptuously-catered for “summits” which only inflict increasingly levels of misery.

I thought about Thurow’s article when I saw the latest Eurostat Labour Force estimates (for February 2012), which were published yesterday (April 2, 2012) – Euro area unemployment rate at 10.8%.

Eurostat note that:

The euro area1 (EA17) seasonally-adjusted unemployment rate was 10.8% in February 2012 … It was 10.0% in February 2011 … 24.550 million men and women in the EU27, of whom 17.134 million were in the euro area, were unemployed in February 2012 … the highest in Spain (23.6%) and Greece (21.0% … youth unemployment rate was 22.4% in the EU27 … the highest in Spain (50.5%) and Greece (50.4% in December 2011).

This is policy failure exemplified. The crisis began in 2007. Unemployment continues to rise in Europe. There is no ambiguity about its origin despite the fact that the Euro elites try to tell anyone who will listen that it is structural in origin.

Modern Monetary Theory (MMT) tells us that state money introduces the possibility of unemployment. There is no unemployment in non-monetary economies.

MMT shows that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

So taxation is a way that the government can elicit resources from the non-government sector because the latter have to get $s to pay their tax bills. Where else can they get the $s unless the government spends them on goods and services provided by the non-government sector?

The imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.

Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector.

The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector.

Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (defined as government taxing and spending) into a non-monetary economy that raises the spectre of involuntary unemployment.

As a matter of accounting, for aggregate output to be sold, total spending must equal the total income generated in production (whether actual income generated in production is fully spent or not in each period).

Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal.

As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment.

In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

MMT concludes that mass unemployment occurs when net government spending is too low.

This reasoning also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the non-government desire to save (accumulate net financial assets in the currency of issue).

It is also clear that if the Government doesn’t spend enough to cover taxes and the non-government sector’s desire to save overall, the manifestation of this deficiency will be unemployment.

Keynesians have used the term demand-deficient unemployment. In MMT, the basis of this deficiency is at all times inadequate net government spending, given the private spending (saving) decisions that have been made at any particular time.

Shift in private spending certainly lead to job losses but the persistent of these job losses is all down to inadequate net government spending.

But the problem is that while unemployment is the most visible aggregate that is impacted by recession, other less visible aggregates also deteriorate.

The great American economist Arthur Okun coined the term “The Tip of the Iceberg” and I borrowed that for the title of a book I co-authored in 2001. The point is that the costs of recession and the resulting persistent unemployment extend well beyond the loss of jobs. Productivity is lower, participation rates are lower, the quality of work suffers and real wages typically fall.

That was the point that Thurow was making in the article I referred to above.

Within this context, Okun outlined his upgrading hypothesis (in the 1960s and 1970s) and the related high-pressure economy model, which provided a coherent rationale for Keynesian demand-stimulus policy positions. Two references are Okun, A.M. (1973) ‘Upward Mobility in a High-Pressure Economy’, Brookings Papers on Economic Activity, 1: 207-252 and Okun, A.M. (1983) Economics for Policymaking, Cambridge, MIT Press.

Okun (1983: 171) believed that:

… unemployment was merely the tip of the iceberg that forms in a cold economy. The difference between unemployment rates of 5 percent and 4 percent extends far beyond the creation of jobs for 1 percent of the labor force. The submerged part of the iceberg includes (a) additional jobs for people who do not actively seek work in a slack labor market but nonetheless take jobs when they become available; (b) a longer workweek reflecting less part-time and more overtime employment; and (c) extra productivity – more output per man-hour – from fuller and more efficient use of labor and capital.

The positive side of this thinking is that disadvantaged groups in the economy were considered to achieve upward mobility as a result of higher economic activity. The saying that was attached to this line of reasoning was “all boats (large or small) rise on the high tide”.

Okun’s (1973) results are summarised as follows:

  • The most cyclically sensitive industries have large employment gaps, and were dominated by prime-age males, offered high-paying jobs, offered other remuneration characteristics (fringes) which encouraged long-term attachments between employers and employees, and displayed above-average output per person hour.
  • In demographic terms, when the employment gap is closed in aggregate, prime-age males exit low-paying industries and take jobs in other higher paying sectors and their jobs are taken mainly by young people.
  • In the advantaged industries, adult males gain large numbers of jobs but less than would occur if the demographic composition of industry employment remained unchanged following the gap closure. As a consequence, other demographic groups enter these ‘good’ jobs.
  • The demographic composition of industry employment is cyclically sensitive. The shift effects are in total estimated (in 1970) to be of the same magnitude as the scale effects (the proportional increases in employment across demographic groups assuming constant shares). This indicates that a large number of labour market changes (the shifts) are generally of the ladder climbing type within demographic groups from low-pay to higher-pay industries.

The evidence is that when the economy is maintained at high levels of employment, workers in low paying sectors (or occupations) also receive income boosts because employers seeking to meet their strong labour demand offer employment and training opportunities to the most disadvantaged in the population. If the economy falters, these groups are the most severely hit in terms of lost income opportunities.

Upgrading also focuses on the mapping of different demographic groups into good and bad jobs. The groups who experience the greatest relative employment gains when economic activity is high are those who are stuck in the secondary labour market, typically, teenagers and women.

While these groups are proportionately favoured by the employment growth, the industries with the largest relative employment growth are typically high-wage and high-productivity and employ mostly prime-age males. Expansion is therefore equated with ladder climbing whereby males in low-pay jobs (as a result of downgrading in the recession) climb into better jobs and make space for disadvantaged workers to resume employment in their usual sectors. In addition, favourable share effects in predominantly male industries provide better jobs for teenagers and women.

So there are many benefits from growth which spread out across rising participation, rising wages, rising hours of work, rising employment and falling unemployment.

But the downside is that the iceberg takes a long time to melt if (a) it is large; and (b) if the recovery is not robust enough. Recovery alone is not sufficient. Real GDP growth has to be consistently strong for some years before the iceberg melts and the upgrading bonuses accrue.

The other side of this is that the longer the recession persists the more the damage penetrates the future.

It is also clear that 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.

The impacts of the persistently high unemployment that will remain for years to come will not only impoverish those directly involved but also is setting up the conditions for intergenerational disadvantage. The extant research is clear – children who grow up in jobless homes inherit the disadvantages of their parents. They suffer poor work histories and transit between one poorly paid job after another interspersed with lengthy periods of unemployment.

Once growth returns, it takes a long time to reduce unemployment because labour force growth is on-going and labour productivity picks up in the recovery phase. A nation needs to enjoy very strong GDP growth at first to absorb the pool of idle labour created during the recession.

That is, in the absence of a Job Guarantee.

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

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 as outlined above (under Okun’s updgrading hypothesis).

Training opportunities are typically 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!

Why is all that important? Answer: because the long-run is never independent of the state of aggregate demand in the short-run. There is no invariant long-run state that is purely supply determined.

In the blog – The Great Moderation myth I presented the following diagrams which also bear on the point.

Hysteresis theories purport permanent losses of trend output as a consequence of the disinflation. The following diagram shows that the real GDP losses are much greater than you would estimate if you used the mainstream macroeconomics approach that assumes (withouth evidence) that the “long-run” ius supply-determined and invariant to the demand conditions in the economy at any point in time.

You can see that potential output falls after some time (as investment tails off) and actual output deviates from its potential path for much longer. So the estimated costs of the disinflation (and fiscal austerity supporting it) are much larger than the mainstream will ever admit.

But the point of the diagram is that the supply-side of the economy (potential) is influenced by the demand path taken. Hysteresis means that where you are today is a function of where you were yesterday and the day before that.

Those who advocate austerity and the massive short-term costs that accompany it (as evidenced by the latest Eurostat) data fail to acknowledge these inter-temporal costs.

While unemployment is clearly the most visible pathology that is providing evidence of the European policy failure, there are a number of other manifestations that are emerging as the crisis extends. Typically, unemployment impacts disproportionately on the most disadvantaged workers first. But, as a recession endures, the costs penetrate into the better-off cohorts of society and more generally undermine prosperity.

When there is 6 per cent unemployment, there are still 94 per cent employed. When there is 10, 90. When there is over 20, less than 80. And while this process is going on, those who remain in employment are also experiencing changing circumstances of the type Lester Thurow discussed above.

Full-time work collapses into part-time work. Pay growth is suppressed. And – we observe increased poverty among those employed. That is we see a rising working poor emerge as the penetration of the policy failure deepens.

There was an interesting article in the New York Times (April 1, 2012) – Ranks of Working Poor Grow in Europe – which bears on this discussion.

The article reports on the “rising tide of workers” who have been pushed by the economic crisis “into precarious straits in France and across the European Union”:

Today, hundreds of thousands of people are living in campgrounds, vehicles and cheap hotel rooms. Millions more are sharing space with relatives, unable to afford the basic costs of living.

These people are the extreme edge of Europe’s working poor: a growing slice of the population that is slipping through Europe’s long-vaunted social safety net. Many, particularly the young, are trapped in low-paying or temporary jobs that are replacing permanent ones destroyed in Europe’s economic downturn.

Please read my blog – The aftermath of recessions – for more discussion on this point.

Lester Thurow’s observations in 1996 were very insightful and are playing out again in Europe (and elsewhere).

Even advanced nations such as France, the scale of the crisis and suppression of wages growth is generating “the steady increase in working people who do not make enough to get by”.

The NYTs article says that:

The trend is most alarming in hard-hit countries like Greece and Spain, but it is rising even in more prosperous nations like France and Germany.

The penetration deepens within and across nations.

The article quotes a French macroeconomist who said:

France is a rich country … But the working poor are living in the same condition as in the 19th century. They can’t pay for heating, they can’t pay for their children’s clothes, they are sometimes living five people in a nine-square-meter apartment – here in France!

Eurostat has developed as part of their EU Statistics on Income and Living Conditions (EU-SILC) data on what they term “In-work poverty”. They have published a series – In-work poverty (ilc_iw) – since 2003 with the latest data being 2010.

There is a very good research paper published by Eurostat – In-work poverty in the EU (published October 2010) – which provides insights into how concepts such as the working poor can be measured.

The data shows that “In-work poverty” in the Eurozone rose from 7.3 per cent to 8.2 per cent between 2006 and 2010. These proportions will have risen since then.

The NYTs article says that:

In 2010, the latest year for which data were available, 8.2 percent of workers in the 17 European Union countries that use the euro were living under the region’s average poverty threshold of 10,240 euros, or about $13,500, a year for single adult workers, up from 7.3 percent in 2006, according to Eurostat. The situation is nearly twice as bad in Spain and Greece.

The other aspect of the problem is the wage inequality, another topic that Lester Thurow wrote about in the article cited above.

The NYTs article notes that while France “seems to exude prosperity … half the nation’s workers earn less than $25,000” (that is, USD equivalents).

Further, France is better off than most of the European nations where the “median monthly paycheck is $2,199, 26 percent above the average for the entire European Union”.

There is now an accelerating trend for French people to live permanently in camping grounds and “even some people with middle-class jobs are living on the edge”.

There was a related story from last year in the Greek newspaper (November 22, 2011) – Crisis-hit Greeks leave the cities for a new rural life – which documents how Greeks who have lost “their jobs, incomes and pensions … are now returning to their families’ rural past in search of a future”.

The ABC News ran a story today (April 3, 2012) – Spanish youth hit by unemployment crisis – which documents how Spanish youth (who are enduring above 50 per cent unemployment rates now) are migrating to richer European nations in search of work.

Each day, I hear news reports about such things as how arts funding is being cut severely in the Netherlands and undermining music education and suppressing the cultural side of life; about how young Irish tradespersons are migrating in droves to Australia in search of work; about how migrants who went to Europe from the colonies are now moving back – reversing the population patterns that have stood for a century or more.


All these trends and anecdotes tell me about the long-term costs of austerity. They tell me that the cultural landscape in Europe will be diminished which bears on the capacity of societies to be tolerant to minorities and suppress criminality.

They tell me that potential real GDP growth paths are being undermined as skilled labour leaves for a better life. The massive “skills drain” out of Europe at the moment – which has taken years to build up (through formal education and then more technical skills development) – will leave a massive growth gap.

So even if Europe begins to grow again, its capacity to generate income growth will be highly constrained for years to come, which means that the costs of the recession will reverberate over the generations.

It is almost impossible to construe how any government (much less a large number of them) could standby and conspire to maintain a policy framework that allows 50 per cent of their youth to sit idle in unemployment while another proportion are underemployed. The intergenerational damage that the current policies will cause is beyond measure.

The evidence is clear. If teenagers do not become engaged in the labour market at the time they leave school, then they will typically have highly unstable work histories into their adult years – and be prone to poverty and alienation.

The costs of the policy folly in Europe are mounting daily.

Lester Thurow can have the last word:

… if policies are to change it will require a change in political perceptions. Rising inequalities and falling real wages have to come to be seen as more important problems than the ghost of inflation when it comes to getting elected or reelected. Social welfare programs for the poor are not politically viable as long as the poor do not vote for the politicians who support the programs that benefit them. Tight labor markets are equally politically unviable unless voters reward the politicians who are willing to reverse the macroeconomic policies that have been in place for the past 25 years.

Citizens of the world unite!

I have been reading some interesting papers from the US Federal Reserve today which I might report on tomorrow.

That is enough for today!

This Post Has 5 Comments

  1. Austerity and all that preceded it will weigh on Southern Europe for more than a generation. It is disgusting that these people must endure the consequences of ongoing government failure. This is how wars start.

  2. about how migrants who went to Europe from the colonies are now moving back – reversing the population patterns that have stood for a century or more.

    That’s great news!

  3. They have stopped training police in Ireland these past few years… to save money , a concept……what a absurd little country.
    Have you heard of any advanced country that stopped recruiting police forces. ?……… petty crime & break ins is exploding……
    From a national economy perspective the real cost is a Bicycle , pen & notebook imports.

  4. petty crime & break ins is exploding Indeed. And that should just be considered as the government guaranteeing les miserables a crappy job as a petty thief, with their takings the wages. And simultaneously imposing a tax on the victims, to the amount of their damages. And JG, FF, MMT opponents really “think” that the government can’t find better things to do, better taxation and spending than this for the victims and the thieves and everyone else.

  5. @
    Some guy
    We have been dealing with bouts of deflation in Ireland since the 80s (we departed from the Sterling zone in 79)
    The 80s recession was all about us integrating with the continent……….. the domestic economy never did – the multinationals & european fiscal transfers kept the lipstick on the pig.
    We have moved from mid 1980s unemployment deflation to post 1987 credit inflation to post 1995 credit hyperinflation –to post 2007 unemployment deflation / wage deflation to a possible future hyper deflation.

    Its a crazy system – the Irish culture has been completly destroyed during this post 1979 era…….. having a few pints down at the local with the lads is gone………. everybody now stays at home in their little cocoons to save money.
    Meanwhile the entire built envoirment is a product of credit hyperinflation – the energy input costs needed to just move around are now enormous.
    Its been a epic disaster movie.
    We never really had a sov currency (post 1979 we were given a pretend CB as long as we integrate)……at least during the Sterling years British wage money went back into the domestic system ….. now …
    The absurdity has reached new heights now with perhaps 1000+ less police which from a national currency perspective would not cost much if they were on foot & Bike.
    Ireland is a sort of Frankestein monster – a product of monetory madness.

    Northern Ireland appears to be doing a little better…….with some evidence of good substitution & lower unemployment –
    I am a rail buff and so follow rail passenger numbers.
    Northern Irish railways passenger numbers have reached record numbers while southern Irish transport figures in all areas including rail are in a deep depression.
    We simply are not getting a positive monetory growth that would at least provide the tokens for good & service substitution.
    Its crazy down here………they believe currency is a physical good .so they must save it while the economy burns…………..
    I am of a more Austrian bent with concerns for resourse extraction but this is madness.

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