In 1978, during my postgraduate studies at the University of Melbourne I came up with…
Even though the US government has shutdown, the BLS is still open for data downloads. That is something. More on that data another day. Today I have been working on a formal academic paper (to be presented at a conference in December) which examines the concept of “capacity-constrained” unemployment. This concept says that capacity constraints may create bottlenecks in production before unemployment has been significant reduced (this would be exacerbated if there are significant procyclical labour supply responses). In this case any expansion in government demand may have insignificant real effects – that is, the real output gap is not large enough to allow all the unemployed to gain productive jobs. This argument is often use to attack the Job Guarantee. It can be shown that while private sector investment, which is government by profitability considerations can be insufficient (during and after a recession) to expand potential output fast enough to re-absorb the unemployed who lost their jobs in the downturn, such a situation does not apply to a currency-issuing government intent on introducing a Job Guarantee. The point is that the introduction of a Job Guarantee job simultaneously creates the extra productive capacity required for program viability.
The 1980 book – Profitability and Unemployment – Cambridge University Press) was the product of a series of Marshall Lectures that French economist Edmond Malinvaud presented at Cambridge University in 1978.
At the time, there was a robust debate about the rising unemployment rates around the world, following the OPEC oil shocks and the contractionary fiscal reaction by governments to the rising inflation that followed.
Malinvaud’s work is highly technical as was most of the debate.
The first issue was to ascertain the impact of aggregate demand and income rationing in a monetary economy on the product (goods and services) and labour markets. In other words, consumers could face binding rations by having their income constrained (by unemployment) and firms by facing sales constraints (due to a lack of demand).
One of my early articles (1985 with M.E. Burns) contributed to this literature – see Real Wages, Unemployment and Economic Policy in Australia. You can access a PDF version HERE.
In that paper, we considered the arguments of the orthodox economists who urge governments to restrain their expenditure and to wait for a prophesied supply-side recovery and stimulate that recovery by cutting real wages.
We rejected these arguments on two grounds. First, while the way in which a real wage reduction would actually take place is never really outlined in orthodox theory (bearing in mind that the real wage is the ratio of money wages set in the labour market and the price level set in the goods market – two separate arenas, each subject to its own influences and power relations), even within an orthodox framework, a real wage cut can damage employment given asymmetries in substitution responses. This related to the fact that firms will not immediately scrap existing capital (to increase the labour to capital ratio) if labour becomes cheaper. Why would they do that.
Second, more fundamentally, we showed that it is actual and expected aggregate demand that is the strongest influence on the level of activity and employment.
As a consequence, and running against the mainstream at the time, we made the case for demand expansion against real wage cuts as a solution to the growing unemployment. We showed that “whatever the level of wages relative to the general price level, providing spare capacity exists a ceteris paribus increase in expected demand would lead to a similar percentage increase in output and permanent employment”.
We noted two problems that might hinder expansion.
The first, (following Malinvaud’s book noted above) is that “it may be that capacity constraints will create bottlenecks in production before unemployment has been significant reduced (this would be exacerbated if there are significant procyclical labour supply responses). In this case any expansion in government demand may have insignificant real effects and the crowding out argument has some validity”.
Note, we were referring to “physical” rather than financial crowding out here. Modern Monetary Theory (MMT) clearly acknowledges that an economy could be pushed to the point that all real resources are in use and so if one sector (say the government) wants to increase its share of total resource use then it must come at the expense of another sector.
The second, related to the “profitability of investment”. We argued that “(w)hile recovery need not be investment led it must quickly stimulate new investment so that its durability is guaranteed. the urgency of this depends on how much capital has been lost in the downturn through shedding, on the utilisation rates and the state of health of the retained capital. The thorny issue here if higher rates of return are required for new investment to occur, is whether careful expansion will guarantee this (via a cyclical recovery in profit margins) or whether higher profit rates must necessarily precede expansion”.
At the time, we concluded that neither issue was likely to be an important constraint on government expanding employment (and reducing unemployment) via stimulus spending.
Later in that paper (pages 18-20) we concluded that “a significant government budget deficit is involved, it would even be if stimulatory initiatives were not to be pursued because of a decrease in revenues and increase in expenditure consequent on the recession”.
We also noted that the “whole subject of the antagonism towards the budget deficit is interesting in its own right, particularly in a historical context … it should be made clear that the issue of government involvement has always had a political and moral component in addition to (and sometimes, in the absence of) economic considerations”.
Which one would suggest some 26 years later still is the case – for example, the closure of the US government!
We noted that “part of the deficit would be financed through monetary expansion and here would be less concerned than the Treasurer, who dismissed all opportunity of reasoned academic debate on matter with his characterisation “a source of world inflationary policy of having a non-financed deficit, that printing money …'”
Our final paragraph noted that:
… there is an onus on economists to choose which of the tools available is appropriate to a given situation. Thus there may be a simple and useful framework of analysis whereby doctors in the Antarctic on the basis of discolouration of extremities, can usefully be guided as to whether frostbite has occurred and a limb requires to be amputated. We would be critical of a doctor in the tropics of applying the same discolouration test to sufferers of sunburn. Perhaps the economic doctors who prescribed real wage decreases rather than demand stimulation would have been less willing patients if they made clear that the diagnosis rested on the beliefs ceteris paribus , the expected volume of sales has no independent effect on employment decisions and accordingly, at the current time with the current wage-price structure firms would not respond to a maintained increase in their orders received.
One could conclude that the same sort of reasoning still holds. First, before one starts dishing out remedies it is best to understand the nature of the system that is malfunctioning. So claiming that the US is heading down the Greek path is clearly nonsensical given the two nations operate within different monetary systems – the latter uses a foreign currency (the Euro) and the former issues its own currency.
Second, when proposing policy solutions a basic grasp of the evidence is required. A most basic principle in macroeconomics is that spending creates (and is equal to) national income, which in turn, requires inputs to generate it (via output) and that means employment.
In this blog, I consider the capacity constraint issue raised by Malinvaud (in the book noted above). He argued that it is possible that there will be insufficient capital available after a recession to allow the workers who are involuntarily unemployed to be subsumed back into the productive workforce.
This brings into consideration the way in which investment responds to a fall in aggregate demand. In turn, it requires us to consider questions of profitability, given that firms will not invest unless they expect the new productive capacity will generate an acceptable rate of return.
It is clear that extra investment occurs if firms see that the cost of providing an extra unit of capacity will be less than the expected revenue that flows from selling the extra output. Firms have to factor in both the likelihood that demand for the specific products involved will be sufficient in the future and that they can hire the extra labour to work on the new capacity to produce the output necessary to satisfy the expected increase in demand.
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 work in 2002 (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, firms 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. Thus, 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.
This is also the focus of Malinvaud. He showed that even with real wage flexibility (the Classical case) the economy can reach a stalled equilibrium (where nothing will change) with mass unemployment.
His book also attempted to outline how low investment during and after a recession reduces the capacity of economies to reabsorb the unemployed back into productive employment. So instead of there being demand-constrained unemployment, which is sometimes called Keynesian unemployment, Malinvaud claimed that mass unemployment could become capacity-constrained unemployment.
In the current environment, fiscal austerity may exacerbate this problem by eroding productive capacity. This has clearly been the case in many of the European nations.
The resulting shrinkage in productive capacity poses the question: is the existing idle capacity sufficient to allow the unemployed and the hidden unemployed (those that left the labour force as a result of a lack of job opportunities) to be re-employed.
If the answer to this question is no, then it is clear that any stimulus has to focus on increasing investment, that is, augmenting the productive capacity of the economy.
Capacity Constraints and the Job Guarantee
The issue of capacity constraints is often raised as an objection to the introduction of a Job Guarantee – where the government provides an unconditional open offer of a job at a fixed wage to anyone who desires to accept the offer.
The Job Guarantee, is thus demand-determined (the limits set by the last person to walk through the door in search of a job) rather than supply-determined (by budget constraints).
Many critics of the scheme claim that there is not sufficient capital available to facilitate such a scheme given that millions are now unemployed around the world.
In this blog – Investing in a Job Guarantee – how much? – I discuss the way in which we can assess the resource impact of introducing such a program.
One temptation when calculating whether a Job Guarantee is a viable part of a full employment strategy is to:
1. Calculate the real output gap – that is, the difference between potential real output (what the economy can produce given given capacity, including capital) and actual real output.
2. Make an assumptions about the productivity of the existing pool of unemployed – that is, how much extra real output each one would add if employed.
3. Calculate the extra output that would be generated if the unemployed were re-employed (allowing for a small percentage of frictional unemployment – say 2-3 per cent at most).
4. Compare that output with the real output gap (which reflects capacity constraints).
5. Conclude that the extra output that would be forthcoming exceeds the real output gap and that the economy has capacity-constrained unemployment that cannot be solved by a short-run stimulus package but requires longer-term investment in productive capacity (particularly in the private sector).
6. In other words, the Job Guarantee is incomplete as a solution to mass unemployment and traditional Keynesian stimulus of private investment is required.
My response will be outlined in a formal paper that will be delivered at this year’s – 14th Path to Full Employment Conference/19th National Unemployment Conference – which will be held in Newcastle, December 4-5, 2013 and all are encouraged to attend our annual gathering.
The calculation sequence outlined above is really about a generalised Keynesian-style stimulus that attempts to increase employment by hiring at market wages in the private sector.
As noted above, my work with Joan Muysken on investment irreversibility clearly shows that firms will be reluctant to invest in new productive capacity in the early stages of recovery if they are unsure that the demand growth will be robust and enduring and capable of supporting the extra productive capacity created.
It is thus entirely possible that the private sector can become capacity-constrained, which limits the scope for private sector employment expansion in the short-run after a deep recession.
Our work on hysteresis, where potential real output falls in a lagged fashion with declining real GDP is also consistent with this conclusion. The longer a recession is allowed to endure the more likely these impacts will be.
But in the case of a Gob Guarantee the situation is entirely different. The spending capacity of currency-issuing governments is not constrained by expectations of future aggregate demand in the same way that pessimism erodes the spending decisions of private firms who are guided by profitability considerations.
In other words, the Job Guarantee creates its own productive capacity as job is taken up by an unemployed person. As we show in various papers (see link to blog above for a summary), we have developed a fairly detailed understanding of the type of jobs that could be created under a Job Guarantee and we also have researched (in very practical ways) the extent of additional equipment (protective clothing etc) required; standard training resource requirements; the ratio of supervisory to operational staff required; purchase and rental costs of additional equipment, outlays on standard raw materials for given job descriptors; and extra administrative and operational outlays that would be required.
In short, a massive amount of very fine-grained information has been assembled by our research group on what resources would be required to mount a Job Guarantee program in Australia.
I (and others in the MMT camp) have also been involved in actual employment generation programs in various countries and have gained a massive amount of operational experience and knowledge of these sorts of issues.
There is also a detailed international literature on the topic that allows one to ascertain realistic parameters for capital and training costs and we have cross-matched this information with the data we gleaned from research in Australia.
The upshot is that we have devised three stylised JG employment categories, differentiated by their labour intensity and wage to non-wage cost rules:
- Low capital intensity – 75/25 rule;
- Medium capital intensity – 60/40 rule; and
- High capital intensity – 50/50 rule.
For example, a 75/25 rule says that 75 per cent of total costs will be absorbed by wages with the remaining 25 being classified as “non-labour costs”. All other costs are included in non-labour costs, which take into account the wages of supervisors, administrative costs, materials used and capital depreciation.
These categories can then be linked to the range of jobs that are identified to meet unmet community need and which would be accessible to the most unskilled workers.
From our research, the majority of jobs identified as being suitable for low skill workers were in the low capital intensity areas of work, although this varied across the specific need areas (transport amenity; community welfare services; public health and safety; and recreation and culture).
The upshot is that the capital requirements are entirely realistic and would not involve even medium-term lags in implementation.
The government has both the financial and real capacity to invest in and procure the required capital in a timely manner. Pessimism, which constrains private sector investment in productive capacity in the early days of recovery, doesn’t enter the picture.
The issue then relates to the demand impacts of the extra employment on the economy and whether that would be inflationary. As I have shown in numerous blogs – (which just report in a less formal way on the academic research we do), there will always be a buffer employment ratio (proportion of total jobs that are in the Job Guarantee pool) which stabilises inflation.
While a private sector expansion may be capacity constrained, this issue does not apply to the introduction of a Job Guarantee, which can be designed to accommodate a range of viable capital-labour ratios.
The offer of a Job Guarantee job thus simultaneously creates the extra productive capacity required for program viability. More about this in December in the form of a formal paper.
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.