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The big issues in macroeconomics: unemployment
Crooked Timber ^ | 1/3/13 | John Quiggen

Posted on 01/03/2013 6:28:19 AM PST by ksen

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.


TOPICS: Business/Economy; Government; Politics
KEYWORDS:
So does new classical/classical economics have anything to say about the current depressed employment we're seeing worldwide right now?

Anyway, I think talking austerity in the midst of a liquidity-trap, demand recession is very counterproductive.

1 posted on 01/03/2013 6:28:22 AM PST by ksen
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To: ksen

Counterproductive in what way? Increasing employment? Reducing debt? Increasing wages/hours worked? Spurring “growth” (which may or may not actually result in economic improvements)? Clearing mal-investments from the system? Clearing bad debt from the system? Removing price bubbles (which are everywhere, and large)? Undoing the affects of those price bubbles?

We are at the tail end of a massive debt-supercycle. The political class, and their macro-economic enablers, know that they cannot allow this debt to be cleared organically. To do so would spur an unprecedented demand for lampposts and rope. They cannot print their way out, because the resulting spike in liquid, globally traded commodities (without a corresponding rise in wages) would crush the private sector. Their only “solution” is to keep doing what they are doing (a mixture of cheap money, asset purchases, and expanding government spending), in the hopes that economic growth suddenly appears and saves the day.

“Austerity” is a joke. To clear the economic distortions from the system would require a level of real austerity that can simply never happen politically. People may talk about austerity, but I don’t think they have any idea what that word really means.


2 posted on 01/03/2013 7:43:55 AM PST by jjsheridan5
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To: jjsheridan5

JJ, you are 100% right!


3 posted on 01/03/2013 7:46:03 AM PST by NeoCaveman (Let it burn, let it burn, let it burn)
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To: jjsheridan5
Counterproductive in what way? Increasing employment? Reducing debt? Increasing wages/hours worked? Spurring “growth” (which may or may not actually result in economic improvements)? Clearing mal-investments from the system? Clearing bad debt from the system? Removing price bubbles (which are everywhere, and large)? Undoing the affects of those price bubbles?

Do you have examples of those things happening when austerity measures have been enacted during other liquidity-trap/demand recessions?

Right now the government succumbing to austerity hysteria is the absolute worst thing that can happen. And in fact the austerity measures were the real danger of falling off the fiscal cliff not the tax increases.

4 posted on 01/03/2013 8:08:16 AM PST by ksen
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To: ksen
Do you have examples of those things happening when austerity measures have been enacted during other liquidity-trap/demand recessions?

Those questions were not examples of things that happen during "austerity". I wanted to get a better sense of what you meant by "counterproductive". In other words, what exactly (in your opinion), is austerity trying to accomplish? Is it one of those things listed above, or something else?

While we are clearly in a liquidity trap, and are also in a demand recession, those are symptoms, not causes. Cheap money and other assorted forms of stimulus don't stimulate investment, they stimulate speculation and price bubbles (at a minimum -- they also create all sorts of ways to game the system). This is one of the fundamental problems with the seawater school. Real investment doesn't occur when the real economy is contracting. You have to let the contraction play out. If you give me $100 in this environment, I will put it into treasuries, oil futures, the stock market -- something liquid and speculative. I am not going to be building a factory with it. In other words, all stimulus stimulates is price bubbles (in everything but wages!) -- which has the effect of crushing the private sector.

The problem is not the liquidity trap. The problem is debt, and, since this debt bubble has been ongoing for decades, enormous economic distortions that have resulted from that debt. The demand recession is simply a result of these distortions, coupled with the fact that we are successfully crushing real investment in our attempt to avoid making painful decisions.

Right now the government succumbing to austerity hysteria is the absolute worst thing that can happen. And in fact the austerity measures were the real danger of falling off the fiscal cliff not the tax increases.

Austerity hysteria??? Nobody is even considering austerity. What are you referring to? Real austerity would involve raising the cost of capital. Real austerity would mean forcing banks to take their losses. Real austerity would mean ending the non-productive ecosystems found in most American cities and universities. Real austerity would mean allowing multiple cities, states, pension funds, etc. to go bankrupt. The "austerity" involved in the fiscal cliff negotiations??? How can something that doesn't exist be considered "the real danger"?
5 posted on 01/03/2013 8:39:45 AM PST by jjsheridan5
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To: ksen
Which leads me to say that Keyne’s theories are unmitigated hogwash advanced by one of the leading Fabians of that era.

There are so many problems with his theories one hardly knows where to begin. For starters IF there is a multiplier effect it cuts both ways, something that Keynsians conveniently omit.

Essentially in a perfect world without government interference there should normally be 100% employment over the long haul. Of course there might be some debate over “voluntary” unemployment. A skilled professional for example, finding that in the short term there isn't an opening for his line of work, may voluntarily not take up employment beneath his skill levels.

6 posted on 01/03/2013 12:13:51 PM PST by Sam Gamgee (May God have mercy upon my enemies, because I won't. - Patton)
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To: Sam Gamgee
Essentially in a perfect world without government interference there should normally be 100% employment over the long haul.

:unsure:

Overall unemployment among people aged 15 to 64 is estimated at 54 percent in Somalia, up from 47 percent in 2002

7 posted on 01/03/2013 12:21:14 PM PST by ksen
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To: Sam Gamgee
There are so many problems with his theories one hardly knows where to begin. For starters IF there is a multiplier effect it cuts both ways, something that Keynsians conveniently omit.

What do you mean "IF" there is a multiplier? That's kind of like saying "IF" there was a moon landing.

What is the other way it cuts that Keynesians conveniently omit?

8 posted on 01/03/2013 12:34:28 PM PST by ksen
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To: ksen
The multiplier assumes perfection. It assumes no government waste. It assumes that government can allocate money as efficiently as the private sector.

Keynians claim that spending on a project will have a multiplier effect, as in for $1.00 spent on a damn project, you will get $1.25 of economic growth. They ignore the fact that the $1.00 had to come from somewhere. If they taxed the $1.00 from private enterprise the multiplier effect also means that $1.25 is removed the other side of equation. The $1.00 the baker would have used to upgrade his oven is now no longer available and the economy will contract by $1.25 on that side of the equation.

In fact the presumption is the government could have made an equally good choice or better choice than the baker.

Keynsians just love to pretend that fixing our ills are just as simple as helicopter Ben Bernake thinks things can be solved. Toss some excess money around and all will be well. Keynsianism is a complete and utter farce pushed by radicals like the late John Kenneth Galbraith, who incidentally are major champions of the welfare state.

9 posted on 01/03/2013 1:02:38 PM PST by Sam Gamgee (May God have mercy upon my enemies, because I won't. - Patton)
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