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)[1] 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.

30 thoughts on “The big issues in macroeconomics: unemployment

  1. Fortunately this thread has been free of the tired old platitudes concerning the plight of the unemployed and others at the mercy of the neoliberal revised welfare system. I have come to the conclusion that those who spout the well-worn century-old canards, such as stop whining, or get a second job, must either be fellow poor people who are terrified that others might have a slightly easier time of their lives, or solidly middle class people who have no idea what it is like to come from a lower-class family. Surely no-one who had to work hard to escape the entrenched social class system would have anything but sympathy for the most vulnerable.

  2. Most Keynesian economists are convinced that something exists called involuntary unemployment and people can be unemployed through no fault of their own.

    Involuntary unemployment is like saying you are involuntarily unmarried. You could marry the first person you meet, if they will have you, but few would say that is wise. search and matching costs are real.

    In the late 1970s, Modigliani dismissed the 1969 Lucas-Rapping paper on the U.S. great depression as the great vacation theory where the mass voluntary unemployment of the 1930s is explained, in Modigliani words, as a congenital attack of laziness.

    An increased preference for leisure is another name for voluntary unemployment.

    As Prescott pointed out, the USA in the Great Depression and France since the 1970s both had 30% drops in hours worked per adult. That is why Prescott refers to France’s economy as depressed.

    Others such as Blanchard attribute the much lower labour force participation in the EU to their greater preference for leisure in Europe.

    An unusual left-right unity ticket emerged to explain the great depressions in the 1930s and the depressed EU economies after the 1970s: the great vacation theory.

    p.s. on “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”, Finn Kydland and co-authors have spent 20 years writing on international real business cycles. They showed that real economic activity tends to move together across industrialised economies over the business cycle.

    The result was the Backus–Kehoe–Kydland consumption correlation puzzle. It is one of the six major puzzles in international economics. Read the wiki!

  3. Jim Rose,

    If a business shuts down laying off, say, 100 workers, even if it takes only one week for those workers to find new employment, those 100 workers are involuntarily unemployed for one week. That represents 500 man days of involuntary unemployment. Now if those workers did 30% overtime in their last fortnight of “employment” and were subsequently unpaid for their last fortnight’s work, an outcome not uncommon from Libertarian employers who seek to obtain maximum advantage at minimum cost, then effectively that period of involuntary unemployment is now 3.6 weeks per person totaling 1800 man days of involuntary unemployment.

    I think that it is conclusively proven that the Keynesians are correct, involuntary unemployment not only exists, but is by far the most common form of unemployment. And I have to say that was a very lame attempt at labeling the unemployed as being rent seekers at the public expense.

    Similarly any population gender mismatch will potentially provide a percentage of people who are involuntarily unmarried. Myth Busted.

    Now it is also true to say that there is voluntary unemployment. Anyone on unpaid leave is voluntarily unemployed. Not all women chose to seek employment some preferring to be totally immersed parents. But it is similarly false to claim that a 30% drop in hours worked in, your example France since the 70’s, represents a “lazy” community seeking leisure over work. For starters what certainly is the case is that their was a greater workforce participation over time as more women entered the work force. The 35 hour week did not arrive in France till the year 2000, and in the 1970’s French workers put in slightly longer hours than Americans. Furthermore European communities are far more efficient than American communities as they are more compact and distances for all aspects of people and product movements are far shorter. There is a claim that Europeans were less productive during the last several decades of the last century, and that may well be the case as the US had maintained the position of having the highest degree of automation in the world, a position that they have now lost.

    So I think that in short Prescott’s claims are dubious and based on an artificial selection of criteria.

    As for the Backus–Kehoe–Kydland consumption correlation puzzlement, the answer is simply wastage, false accounting, distribution inefficiency, corruption and theft.

    “……….it fell off the back of a truck”

  4. @BilB Suppose you are divorced, but remarry a week later. (Were the grounds adultery?)

    For one week you were involuntarily single. You could have gone from the court to a singles bar to try you luck but true companionship is rarely found in one night stands.

    The concepts of marriage and divorce and of employment and unemployment are much the same analytically and in welfare terms too. Many recently divorced are unhappy and striving for new fulfilment.

    The economic concept of unemployment was rather primitive until Hutt write his hard to read theory of idle resources in 1939, Stigler’s paper in 1962 and the Phelps book in 1970.

    see http://www.american.com/archive/2010/july/labor-pains showing that French hours per adult aged 15 to 64 dropped by 1/3rd between 1960 and 2000. US hours per working age adult rose; hours per working age Australian dropped trivially. The differential changes between the United States and France is more than 45 percent.

    Those countries with higher marginal income tax rates have systematically lower employment in activities with good non-market substitutes such as home production. The European services sector is much smaller than in the USA.

    Time use studies find that lower hours of market work in Europe is entirely offset by higher hours of home production, implying that Europeans do not enjoy more leisure than Americans despite the widespread impression that they do.

  5. thanks Bilb, suppose you are divorced, but remarry a week later. (Were the grounds adultery?)

    For one week you were involuntarily single. You could have gone from the court to a singles bar to try you luck but true companionship is rarely found in one night stands.

    The concepts of marriage and divorce and of employment and unemployment are much the same analytically and in welfare terms too. Many recently divorced are unhappy and striving for new fulfilment.

    The economic concept of unemployment was rather primitive until Hutt write his hard to read theory of idle resources in 1939, Stigler’s paper in 1962 and the Phelps book in 1970.

    see http://www.american.com/archive/2010/july/labor-pains showing that French hours per adult aged 15 to 64 dropped by 1/3rd between 1960 and 2000. US hours per working age adult rose; hours per working age Australian dropped trivially. The differential changes between the United States and France is more than 45 percent.

    Those countries with higher marginal income tax rates have systematically lower employment in activities with good non-market substitutes such as home production. The European services sector is much smaller than in the USA.

    Time use studies find that lower hours of market work in Europe is entirely offset by higher hours of home production, implying that Europeans do not enjoy more leisure than Americans despite the widespread impression that they do.

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