The paradox of toil

Both main parties agree that benefit claimants should be - ahem - encouraged to look for work. A new paper, however, suggests that this might prove counterproductive:

Under particular assumptions, and in a particular environment, if everyone tries to work more, this in fact, reduces aggregate employment in equilibrium. This is the paradox of toil.

So writes Gauti Eggertsson, an economist at that hotbed of loony lefties, the New York Fed.
His reasoning is quite straightforward. If labour supply rises, wages tend to fall. Companies therefore want to hire more workers. The conventional thinking stops here. But how can firms sell the extra output which these additional workers produce? By cutting prices, that’s how. However, if prices are falling anyway, and if interest rates are at their zero bound, such cuts raise real interest rates, which choke off aggregate demand. This causes employment to fall.
In deflationary conditions, then, encouraging people to look for work can be do real economic damage.
Now, you might object here that firms needn’t cut prices as their workforce expands, because in moving from benefits to work, people’s incomes will rise and so demand will grow. This objection, however, runs into two counter-objections. First, incomes might not increase much, if replacement ratios are high, as they can be. Secondly, the output produced by these extra workers must exceed the wages paid to them - otherwise it would not be profitable to employ them. On both counts, demand increases less than output.
A more coherent objection is simply that benefit reform will occur under inflationary conditions, not deflationary ones. And in these circumstances, anything that helps prices fall is a good thing.
However, politicians aren't offering welfare reform as merely a response to inflation, but are doing so as a state-independent policy. Eggertsson’s paper shows that this attitude is just stupid.

Comments

[Luis Enrique]

hmm ... can't firms hire workers to do things that make their products & services more attractive, rather than just cut prices? Also, if firms experience meaningful recruitment costs, then increasing "search effort" on the behalf of workers might cut those costs.

I'm not sure it's that stupid to regard these policies as state-independent. Mainstream monetary policy is such that deflationary environments aren't much of a worry. I know the US just had its first downwards dip in decades, but this does not strike me as a terribly strong argument against these policies. You have offered stronger arguments before, such as these policies just end up pushing people into jobs they don't keep.

I do think it's rather unfair to regard these policies solely as harassing the unemployed. You should at least consider their proponents arguments that they are trying to help the unemployed.

http://www.dwp.gov.uk/policy/welfare-reform/legislation-and-key-documents/realising-potential/

[Matthew]

Surely though (especially is replacement ratios are high) the government can cut taxes/increase other spending?

[Calum]

The problem I see with this is it is assuming a closed economy. In practice - let's take Britain - halving the number of unemployed workers doesn't greatly affect our capacity to consume, since most of it is provided by the billion odd souls in China, not to mention our other trading partners.

[Ralph Musgrave]

A thoroughly trite argument by Eggertsson.

I’ve just invented the “Paradox of oil price reductions”, which is this. Crude oil price cuts under the right conditions (Eggertsson’s conditions) might lead to more unemployment for exactly the same reasons as more people wanting to work might lead to increased unemployment. Yawn Yawn.

As Matthew (just above) correctly points out, where there is excess unemployment, governments can just cut taxes or increase spending to cure the problem.

[ortega]

You are explaining that is better that some workers remain jobless. But that has nothing to do with give them any benefit. We well could let them starve with the same result.

[Gaw]

Under particular assumptions, and in a particular environment...

...most things might be made to happen.

Anyway, why assume an increase in output is the consequence of an increase in employment? Production isn't resource-constrained, it's demand constrained. What would most likely happen if wage rates fell and employment rose is an offsetting decrease in capital intensity per unit of production.

[Andrew Sales]

Why do classically trained economists think that highly interconnected disequilibrium systems (or even equilibrium ones) can be analyzed by looking at a change in one factor and following, in a linear manner, its downstream effects on a sequence of other factors? It's moronic.

How can an increase in produced good possibly imply a decrease in "aggregate demand"? If there are more valuable things produced, then the system has more to bid for goods and services with.

Is there really anything wrong with the Austrian school's point that production (of desired goods) creates demand? As can be seen by considering a barter economy.