The possibility of mass unemployment – Part 1

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text by the end of this year. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

Chapter 11

11.1 Introduction and Aims

In Chapter 10, we discussed issues relating to labour market measurement. In this Chapter we will focus on theoretical concepts that underpin the measurement of economic activity in the labour market and the broader economy.

The Chapter has five main aims:

  • To explain why mass unemployment arises and how it can be resolved.
  • To develop the concept of full employment.
  • To consider the relationship between unemployment and inflation – the so-called Phillips Curve.
  • To develop a buffer stock framework for macroeconomic management (full employment and price stability) and compare and contrast the use of unemployment and employment as buffer stocks in this context.
  • To more fully explore the concept of a Job Guarantee (employment buffer stock) approach to macroeconomic management.


11.2 Categories of Unemployment

Economists have long used taxonomies to organise their thoughts about unemployment. Two often used categorisations focus on the distinction between frictional, structural, cyclical (demand-deficient), and seasonal categories, on the one hand; and, the distinction between voluntary and involuntary unemployment on the other hand.

These taxonomies can cut across each other and neither one is better than the other. The categorisation system depends on the purpose of the analysis. In general, economists have married these categorisation frameworks into broader theoretical discussions which seek to explain why unemployment arises, whether it is a problem or not, and what can be done about it via policy interventions should we consider it to be a problem.

The most popular typology used to describe unemployment distinguishes between frictional, structural, cyclical (demand-deficient), and seasonal unemployment.

Frictional unemployment – it is recognised that the labour market is in a constant state of flux. Jobs are continually being created and destroyed, which means that workers who have been laid-off or quit are moving between jobs while firms are seeking workers for new jobs created or to fill existing jobs where the previous incumbent has left.

Further, new entrants into the labour force seek work while retirees leave jobs. Frictional unemployment arises because the matching of these demand and supply flows is not instantaneous. It takes time for workers and employers to gather relevant information and move between labour force states. Frictional unemployment is considered to be a short-term phenomenon and part of normal functioning of the labour market. While it is debatable, this category would comprise around 1 to 2 per cent of the labour force.

Seasonal unemployment – arises when certain occupational skill groups and industry sectors experience fluctuations over the course of the year, which is of a systematic (seasonal) nature. For example, in certain regions, workers who are engaged in harvesting of agricultural crops will experience seasonal unemployment as they move between crops and localities. This category is considered to be small in magnitude when assessed on a macroeconomic scale. It is also difficult to distinguish it from frictional unemployment.

Structural unemployment – is said to arise then there are enough jobs available overall to match the total pool of unemployment but that there are mismatches between the skill demanded and the skills supplied and/or between the location of the jobs available and the location of the unemployment. This category of unemployment is often discussed in the context of industrial restructuring (for example, the decline of the manufacturing sector or deindustrialisation). Changes in the composition of industry create jobs losses in declining sectors and new job opportunities in emerging sectors.

Further, given that industry is not spread evenly across regional space, the decline of a major firm in one region will have significant implications for the local labour market.

Changes in technology are also considered to have structural impacts in the sense that new skills become relevant while old skills cease to be in demand by firms.

All of these disruptions to the pattern of employment take time to resolve. The relocation and re-training of workers displaced by structural change is sometimes a lengthy process. It is the changing pattern of required skills, the changing location of jobs and the extended time taken to resolve the resulting demand and supply imbalances that distinguishes the concept of structural unemployment from frictional unemployment.

However, there are two important qualifications to the normal conceptualisation of structural unemployment, which is not often considered in the mainstream textbooks.

First, the concept of a skills shortage is a relative concept, implying some distance from an optimal state, which begs the question: according to whom. Unsurprisingly, analyses of skills shortages by industry and governments invariably consider the issue from the perspective of business and profitability, which places the emphasis on containment of labour costs both in terms of wages and conditions, and hence, whenever possible, externalising the costs associated with developing the skills firms require in their workers.

Within this context the notion of structural unemployment arising from “skills mismatch” can be understood as implying an unwillingness of firms to offer jobs (with attached training opportunities) to unemployed workers that they deem to have undesirable characteristics. When the labour market is tight, the willingness of firms to indulge in their prejudices is more costly. However, when labour underutilisation is high firms can easily increase their hiring standards (broaden the desired characteristics they demand from workers) and the training dynamism driven by labour shortages is lost. Then we observe, in a static sense, ‘skill mismatches’ which are really symptoms of a ‘low pressure’ economy.

Second, the fact that hiring standards and the willingness of firms to offer training slots to correspond with job offers varies with economic activity means that the concept of structural unemployment is difficult to distinguish from the next category of unemployment we define, which is related to a lack of aggregate demand in the economy.

In other words, there is a significant overlapping between these categories, which reduce their capacity to provide a definitive decomposition of total unemployment.

Cyclical (demand-deficient) unemployment – arise when there is a shortage of jobs overall relative to the willing supply of labour resources (persons and hours) at the current wage levels. This category is termed demand-deficient unemployment because it relates to a deficiency in aggregate demand. Unemployment thus varies over the economic cycle – rising when aggregate spending falls below the level needed to fully employ the available workforce and falling when aggregate spending moves closer to the level needed to full employ the available supply of labour.

Cyclical unemployment is also known as mass unemployment and arises because of the macroeconomic system fails to generate enough jobs to match the preferences of the available workforce. It is also related to the concept of an output gap, which measures the percentage deviation of real GDP from the potential production levels at any point in time.

During an economic downturn (which may become a recession), cyclical unemployment will be the dominant proportion of measured unemployment. When economic activity improves as a result of increased aggregate demand, cyclical unemployment falls.

In Chapter 10, we saw that the costs of unemployment (associated with output gaps) are enormous, which makes the elimination of cyclical unemployment a policy imperative. The solution to cyclical unemployment is thus to increase the growth rate of aggregate demand to close any output gaps.

11.3 Why does mass unemployment arise?

In this Section, we consider the concept of cyclical unemployment in more detail, which will then allow us to understand what the achievement of full employment requires. We seek to develop a conceptual understanding of why mass unemployment occurs, why it persists and what policy solutions are available to alleviate it.

11.3.1 A simplified economy

We start with an incredibly simple economy to fix the essential idea. This economy is populated by two people, one being government, which issues the currency, and the other, being the private (non-government) sector, that uses the currency that the government issues.

In addition to be the sole issuer of the currency, the government also demands that all tax obligations to the state are relinquished in that currency. Government spending is designed to move private activity into the public sector – that is hire private productive resources and utilise them for public purposes – to fulfill the government’s socio-economic goals.

As is the case in the real world, the vast majority of government spending and taxation is accomplished by electronic transfers (via computer systems) between public and private bank accounts.

If the government runs a balanced budget (for example, spends 100 dollars and taxes 100 dollars) then the private accumulation of fiat currency (saving) is impossible (that is, it is zero) in that period and the private budget is also balanced.

The other observation is that in order to pay the 100 dollar tax liability, the non-government person has to accept payment from the government for their services (perhaps in the form of a wage or a sale of a commodity). The non-government sector does not have dollars until the government sector spends them. That is a defining feature of a fiat currency system, as was explained in Chapter 3 Governments and Money.

Say the government spends $120 and taxes remain at $100, then the private sector can save a maximum of $20, which allows it to accumulate financial assets denominated in the currency of issue up to that amount.

In other words, the government has increased its expenses by $20 and is now running a deficit of that amount. It had no financial constraints in increasing spending by $20 above its tax revenue because it issues the currency and can credit private bank accounts for sums of its choice. Clearly, the extra volume of spending would only be possible if it elicited that much extra economic activity from the private sector.

The government deficit of $20 is exactly the private saving of $20. Now if government continued in this vein, accumulated private savings would equal the cumulative budget deficits.

The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not have to do this to finance its deficit. The introduction of a bond merely gives the private sector a chance to diversify their financial wealth (the accumulated flows of its saving). In other words, the private sector can choose to hold its wealth as cash or bonds and in Chapter 14, which examines monetary policy, we will consider the factors that influence that choice.

What would happen if the government decided to run a surplus (say spend $80 and tax $100)? Then the private (non-government) sector would owe the government a net tax payment of $20, given that the private sector’s income would be $80 and its tax liabilities would be $100.

Where would the private sector get the funds to meet this shortfall? It would either draw down its cash savings and/or sell a bond back to the government back to the government to get the needed funds. Given that it is typically preferable to hold one’s financial wealth in the form of an asset that generates a return as opposed to non-interest bearing cash, then the shortfall will be covered by the government buying back some bonds it had previously sold to the private sector.

Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus.

The government surplus has two negative effects for the private sector:

  • The stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and
  • Private disposable income also falls in line with the net taxation impost. In this context, there is less economic activity than before and less employment. The economy has no “unemployed” resources, given that the private sector were willing to supply productive resources up to $120 in the previous period.

You might respond by saying that the government bond purchases provide the private wealth-holder with cash and so the transaction involves a portfolio shift. In the first instance, that is true. But why would the private sector need that cash? In this instance, the liquidation of wealth is driven by the shortage of cash in the private sector arising from the tax liabilities exceeding private income. The cash from the bond sales pays the Government’s net tax bill and so net financial wealth falls.

The result is exactly the same when expanding this example by allowing for private income generation, a banking sector and diversifying the non-government sector into a foreign and domestic sector.

The simplified (unrealistic) example just serves to make the accounting clearer and helps us to understand why mass unemployment arises.

11.3.2 The possibility of unemployment

In this Section we are considering unemployment that arises from a shortage of aggregate demand. It is the introduction of “state money”, which we discussed in Chapter 3, that raises the possibility of unemployment. If we could conceive of a non-monetary economy, we would quickly realise that there would be no possibility of unemployment arising.

In Chapter 3, we understood that a government that issues its own currency does not have to raise taxes or issue a financial asset (bond) in order to spend. So the government in a fiat monetary system is not said to be “revenue-constrained”.

The idea of a government that is not revenue-constrained is hard to grasp when we are initially confronted with it. Intuitively this is hard to accept because we are so wedded to the idea that the purposes of taxes is to raise money so that the government can spend. In our simple economy, it was clear that the private capacity to pay taxes post-dated the decision by the government to spend. The private sector required the government to spend dollars into existence before it could honour its tax liabilities.

You will be asking: if taxation is not required to raise revenue, which permits the government to spend, then what function does it serve?

In Chapter 3, we explored the concept of functional finance, which considered government spending and taxation to be tools by which the government achieved its goals of full employment and price stability. That is, fiscal policy should be functional and not seen as an end in itself. In the modern era, we observe governments espousing aims that are specified purely in terms of financial ratios, which of themselves are not functionally important.

In the context of functional finance, we learned that government should seek to maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.

So taxation is what we consider to be one spoke in the macroeconomic steering wheel that the government uses to regulate economic activity.

In a famous article – The Economic Steering Wheel – written in 1941 by US economist Abba Lerner (who coined the term functional finance), which was reproduced as Chapter 1 of his 1951 book, we read:

Our economic system is frequently put to shame in being displayed before an imaginary visitor from a strange planet. it is time to reverse this procedure. Imagine yourself in a Buck Rogers interplanetary adventure, looking at a highway in a City of Tomorrow. The highway is wide and straight, and its edges are turned up so that it is almost impossible for a car to run off the road. What appears to be a runaway car is speeding along the road and veering off to one side. As it approaches the rising edge of the highway, its front wheels are turned so that it gets back onto the road and goes off at an angle, making for the other side, where the wheels are turned again. This happens many times, the car zigzagging but keeping on the highway until it is out of sight. You are wondering how long it will take for it to crash, when another car appears which behaves in the same fashion. When it comes near you, it stops with a jerk. A door is opened, and an occupants asks whether you would like a lift. You look into the car and before you can control yourself you cry out, “Why, there’s no steering wheel”. Want a ride?

In other words, macroeconomic policy-making is all about “steering” the spending fluctuations in the economy, which drive variations in production and employment. Fiscal policy is the steering wheel and should be applied for functional purposes, which includes to eliminate cyclical unemployment. Conversely, Abba Lerner considered laissez-faire (free market) capitalism was akin to letting the car zigzag all over the road. His work emphasised the fact that if the government desired the economy to develop in a stable way then it had to control its movement with fiscal and monetary policy.

There are other functions of taxation that governments may focus on. For example, it might desire to alter the allocation of resources such that people spend less on harmful products (such as tobacco or carbon-intensive products). Taxes on these type of products pushes their price up and discourages spending on them. While important we will not consider these microeconomic functions of taxation any further in this text book.

You will be now thinking about the functions or purpose of taxation in a different light, rather than considering it to be a source of revenue for government that permits it to spend.

We extend this thought process to see how taxation and the incidence of mass unemployment are intrinsically related in a monetary economy. In such an economy, 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. This involves the direct offer of labour to the public sector (to allow public production to take place) as well as privately-produced goods that are purchased by the government to advance its socio-economic programs.

An example of the latter might be the purchase of construction services from a private construction company to facilitate the building of a new public hospital. It might manifest as the supply of stationary to the public schooling system or the supply of technology to a public broadcaster. The private sector supplies a myriad of goods and services to the government every day and in return, as well as generating income it gains the capacity to relinquish its tax liabilities.

This train of thought leads to the insight that taxation is a way that the government can elicit productive resources and final goods and services from the non-government sector that it needs to advance its political mandate.

It is clear that the non-government sector has to get the dollars before it can pay its tax bills. Where else could the non-government sector get the dollars from to meet its legal liabilities to the government, if the latter did not purchase goods and services provided by the non-government sector or make transfers to that sector?

So the reality is the opposite of the intuitive view that conceives of taxation as providing revenue to the government, which permits it to spend. In fact, government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending.

Extending that logic leads to a further insight, which we introduced in Chapter 3. 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.

So in our 2 person economy, the government person would be able to purchase labour from the non-government person as long as the tax regime was legally enforceable. The non-government person will also accept the government money because it is the means to get the $s necessary to pay the taxes due.

This insight allows us to see another dimension of taxation which is typically not well understood. 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 government spending, which amounts to a transfer of real goods and services from the non-government to the government sector.

While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.

Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue.

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.

Generalising this discussion, makes it 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 creates the possibility of mass unemployment.

As we saw in Chapters 7 and 8, where we developed the expenditure-income framework and the concept of effective demand, it is a matter of accounting that if all the aggregate output produced in a period is to be sold, then total spending must equal the total income generated in production (whether actual income generated in production is fully spent or not in each period).

The obvious conclusion is that unemployment occurs when net government spending is too low to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets).


10.4 The concept of involuntary unemployment




Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.

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