The big issues in macroeconomics: unemployment
Following up my previous post, I want to look at the main areas of disagreement in macroeconomics. As well as trying to cover the issues, I’ll be making the point that the (mainstream) economics profession is so radically divided on these issues that any idea of a consensus, or even of disagreement within a broadly accepted analytical framework, is nonsense. The fact that, despite these radical disagreements, many specialists in macroeconomics don’t see a problem is, itself, part of the problem.
I’ll start with the central issue of macroeconomics, unemployment. It’s the central issue because macroeconomics begins with Keynes’ claim that a market economy can stay for substantial periods, in a situation of high unemployment and excess supply in all markets. If this claim is false, as argued by both classical and New Classical economists, then there is no need for a separate field of macroeconomics – everything can and should be derived from (standard neoclassical) microeconomics.
The classical view is that unemployment arises from problems in labor markets and can only be addressed by fixing those problems. Within the classical camp, Real Business Cycle theory allows for cyclical unemployment to emerge as an voluntary response to technology shocks and changes in preferences for leisure – hence Krugman’s snarky but accurate quip that, according to RBC, the Great Depression should be called the Great Vacation. More generally, on the classical view, long-term unemployment has to be explained by labour market distortions such as minimum wages, unions, restrictions on hiring and firing, and so on.
The RBC school mostly treated the Great Depression as an exceptional case, to be dealt with later, and they have been no better on the Great Recession. While some have tried, it’s obviously silly to explain the current recession as the product of technology shocks in the ordinary sense of the term. If you treat the financial sector meltdown as a technology shock, RBC amounts to little more than the observation that opium makes you sleepy because of its dormitive quality. Since financial sector booms and busts are clearly driven by the the general business cycle, you get the theory that the business cycle is caused by … the business cycle.
Looking at the broader classical view, there are two big problems. First, over the past twenty or thirty years unions have got weaker nearly everywhere, minumum wages have generally fallen in real terms, or at least relative to average wages, and labour markets have been ‘reformed’ to become more flexible. So, you would expect low and falling unemployment. The low rate of US unemployment in the 1990s and (to a lesser extent) 2000s was indeed taken as a vindication of this prediction. So, sharp increases in unemployment are the opposite of what was expected. The even bigger problem is that, since 2008, unemployment has risen sharply in many different countries, with very different institutions. Many of these countries have reacted by cutting social protections (here’s Latvia, for example) but unemployment has remained high.
The main alternative to the classical view is a “sticky wage/price” interpretation of Keynesianism. The basic idea is that the aggregate economy is subject to demand shocks, which result in prices and wages being too high. But reducing wages and prices is difficult, because of co-ordination failures. Reducing wages and prices in one sector, or reducing wages but not prices doesn’t help. In fact, cutting wages on a piecemeal basis depresses demand even further. So the economy stays under-employed for a long time.
If you accept the sticky wage story, then you get the kind of policy line supported by the New Keynesians in the current debate. This says that, under normal conditions, monetary policy can be used to avoid deflation. In the current “liquidity trap” case where interest rates are at zero, and expanding the money supply has no effect, it’s necessary for governments to create demand directly through fiscal policy.
Lots of Keynesians (including me) and other critics of the classical view aren’t satisfied with the sticky wage interpretation, or at least regard it as incomplete. There isn’t a single well-developed alternative, however, so I’ll give some thoughts of my own, and invite others to comment. The big problem with the the sticky wage story is that it implicitly assumes a unique general equilibrium with an associated distribution of real wages. But in reality, there’s a lot of room for political processes/class struggle to influence wages and unemployment is part of that struggle (the “reserve army of labor”). So cutting real wages in a depression may produce a new lower-wage equilibrium, which leaves existing wages still “too high” to clear the labor market. Obviously, there are limits on this process, but they may not be relevant.
In empirical terms, the sticky wage story implies that real wages should be countercylical (higher in recessions). The alternative versions of Keynesianism generally imply the opposite. The empirical evidence, sadly, is indecisive.
But the disagreements among Keynesians, or between Keynesians and various heterodox schools, are less important than their collective disagreement with the classical view. According to classical economics, a global recession like the one we are observing, occurring simultaneously in many very different countries and lasting for many years, should be impossible, or at least highly improbable. For the classical view to work, lots of separate and differently organized labor markets must have simultaneously gone haywire, and stayed that way for a long time. But the improbability of this hypothesis hasn’t shaken the faith of classical supporters.
fn1 The linked NY Times story is the most striking example of the body contradicting the lead that I have seen in recent times. After proclaiming Latvia a success, the story notes that, in addition to 14 per cent unemployment, 5 per cent of the population has emigrated, poverty is worse than anywhere in the EU except Bulgaria, and output is far below the pre-recession level. The concluding comment The idea of a Latvian ‘success story’ is ridiculous,” ought to be the opening.