Tuesday, May 1, 2012

The master teaches us about involuntary unemployment

All modern economists owe a great debt to Lord John Maynard Keynes.  I have just started rereading Keynes' classic, The General Theory of Employment, Interest and Money ("General Theory"), from which much of modern macroeconomics has its founding.  It is hard not to see that many of the modern schools of macroeconomic thought have their roots firmly planted in Keynes.  Even those who adopt a "non-Keynesian" position find their definition in their criticism(s) of Keynesian economics.

The master kicks off the General Theory with a discussion of the classical theory of employment, as described by Sir Arthur Cecil Pigou (originator of the "Pigouvian Tax") in his treatise, Theory of Unemployment.  In a way, this discussion is quite similar to those of Professor Paul Krugman in How Did Economists Get It So Wrong?, Mr. Noah Smith in I shall now debunk the "Great Vacation" in one sentence and Wages and the Great Vacation: Casey Mulligan responds, and, most recently, by Professor Simon Wren-Lewis in Microfoundations and Evidence (2): Ideological bias (please excuse for, no doubt, many omissions).  In short, John Maynard Keynes argues that involuntary unemployment is a fact: that not all unemployment is traceable to either frictional or voluntary unemployment. Years later, the Real Business Cycle theory (at least its simplest manifestations) ignore Lord Keynes' insight and good economists are made to point out the obvious: it's not that pleasant to be unemployed and people generally do not want to be, when they can avoid it.

Lord Keynes states that the classical theory is based upon two postulates, namely: (1) "The wage is equal to the marginal product of labor" and (2) "The utility of the wage when a given volume of labor is employed is equal to the marginal disutility of the amount of employment." He points out that these define the demand and supply curves for labor, respectively. Basically, firms are interested in employing labor up to the point where they break even on the last unit and that workers seek employment because of the benefits that they derive from it. He mentions that obviously collective bargaining have been admitted as a means that limits the ability of these markets to "equilibrate".

J.M. Keynes questions whether the actual wage indicates the marginal disutility of labor. He said that although a cut to nominal wages would reduce the amount of labor supplied, a reduction in real wages would not necessarily, if it were due to an increase in the price level, rather than a reduction of nominal wages. Here he indicates that workers suffer from "money illusion".  He does not argue that workers do not respond to real wages, but that, "within a certain range the demand for labour is for a minimum money-wage and not for a minimum real wage." He states that this "breaks down entirely" the classical theory of employment, leaving employment "indeterminate."  Lord Keynes emphasizes something that has been frequently been commented upon since, that there is downward inflexibility in wages. He points out that while wage cuts tend to cause workers to withdraw labor from the market, price hikes do not have the same effect. Relating this issue to depressions, Keynes says that the contention that the refusal of labor to accept wage reductions is the cause of a depression is not "supported by the facts."

I find this argument persuasive, particularly that changes in the real wage should be responsible for changes in the supply of labor, but inflation does not have the same degree of effect as increases or decreases to the nominal wage. I am somewhat skeptical of the assertion that depressions could not be caused by a reduction in the real wage consistent with full employment without a corresponding decrease in real wages in the labor market. I'm not sure that any depression has actually been caused by such a perturbation, but I would not say it's impossible at this point.

Update: I followed up on the issue of real wage v. nominal wage in the post "Are workers employed for nominal or real wages?"

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