Unemployment & the free market

Bryan Caplan deserves praise for calling on free market economists to pay more attention to the "grave evil" of unemployment. I fear, though, that he overstates what free market policies can contribute to solving the problem.

My chart shows the problem. It shows the UK unemployment rate between 1855 (when data begins) and 1914. You can see that the jobless rate was often high - it averaged 4% - and volatile.

And this was during a period of as free markets as one could practically get.

This undermines at least three "free market" explanations for unemployment:

- "Welfare benefits mean the unemployed have little incentive to get work." In the 19th C, though, the only state support the unemployed got was in the Workhouse - and even as late as in my lifetime, this was spoken of with terror.

- "Big government and taxes deter job creation." But public spending in this time averaged only around 10% of GDP, and labour market regulation except for a few Factory Acts was nugatory by modern standards.

- "Wages are too rigid". But wages fell in nominal terms in 13 of the 59 years here, and in real terms in 12 of these years. Average nominal wages fell by 9% between 1874 and 1879, which is consistent with some sectors seeing very large falls.

There is, though, an alternative theory that fits these data. It's that a free market will see large swings in aggregate demand and employment, and that unemployment cannot be prevented by wage reductions alone. This was pointed out most famously - well famous in my house anyway - by Michal Kalecki in 1935:

One of the main features of the capitalist system is the fact that what is to the advantage of a single entrepreneur does not necessarily benefit all entrepreneurs as a class. If one entrepreneur reduces wages he is able ceteris paribus to expand production; but once all entrepreneurs do the same thing - the result will be entirely different.
Let us assume that wages have been in fact generally reduced...and in consequence unemployment vanishes. Has depression thus been overcome? By no means, as the goods produced have still to be sold...A precondition for an equilibrium at this new higher level is that the part of production which is not consumed by workers or by civil servants should be acquired by capitalists for their increased profits;in other words, the capitalists must spend immediately all their additional profits on consumption or investment. It is however most unlikely that this should happen...It is true that increased profitability stimulates investment but this stimulus will not work right away since the entrepreneurs will temporise until they are convinced that higher profitability is going to last...A reduction of wages does not constitute a way out of depression, because the gains are not used immediately by the capitalists for purchase of investment goods. (Selected Essays on the Dynamics of the Capitalist Economy, p26-28).

There's a good reason why almost all major economies abandoned free market economics. It's that such economies didn't and couldn't avoid mass unemployment.

I'll concede - much more than most lefties - that there's a big place for free market economics. But the labour market ain't it. 

Note: data comes from the Bank of England.

Comments

[Luis Enrique]

in addition to Kalecki's argument why lower wages won't erase unemployment, what else do you think free market economists like Caplan should add to their mental model of the labor market to explain unemployment?

an answer that free market leaning economists seem comfortable with is search frictions exacerbated by mismatch (something like this
http://www.newyorkfed.org/research/economists/sahin/USmismatch.pdf ) but I suspect you'd think that only a partial answer.

what other reasons might there be for demand for workers being substantially lower than supply?

[chris]

One set of models I like is Akerlof-style gift exchange. Firms won't want to cut wages, even for new hires, in a recession for fear of damaging goodwill among existing staff.
There's also a signaling problem; a worker who offers to work for a low wage might be signaling that - whatever his CV says - he is of below-average quality, and firms might not want to risk hiring him.
And don't forget good old Leontief production functions, which imply zero substitutability between capital and labour; economists like Cobb-Douglas productino functions coz they are differentiable, not because there's abundant evidence they exist in reality.

[Luis Enrique]

gift exchange and signally both sound like wage rigidity to me, isn't Kalecki's point downward wage flexibility wouldn't help?

I don't immediately understand why lack of substitutability between capital and labour would lead to persistent unemployment

[Nick]

4% ain't bad at all by today's standards and with a more sensible macroeconomic policy than the 19th century gold standard, unemployment could be much more stable too.

Of course, it was even better post-war but arguably that was due to low-hanging fruit that allowed a particular spur to growth.

So the lesson could be something like grab economic growth wherever you can, and have generally free labour markets. Now we are richer than in the 19th century, we can afford more of a safety net for the 4% unemployed too.

[Ralph Musgrave]

Herewith a wonkish point: falling wages actually would raise employment, and for a reason pointed out by Pigou. Falling wages and prices increases the real value of the monetary base and national debt, which in turn equals a rise in private sector net financial assets. That would increase spending in real terms which would cut unemployment.

However, I’m not suggesting, and nor did Pigou, that it would be realistic to rely on that effect to deal with unemployment.

[Ben Brennan]

@Ralph - For that to be correct the MPC of those who hold financial assets would have to be at least as strong as the MPC of the wage earning class. Not to mention that the rise in financial assets would also have to be 1:1 to the drop in wage income.

[Dave Lewis]

Freeing the flow of funds from the bottleneck of TBTF financial firms would be, I believe, a good place to start. Public sector subsidies to these firms due to fear, if not inspired at least reinforced by these same firms, of total economic collapse rewards incompetence and stifles competition.

Finance isn't rocket science (I'm a retired FX options risk modeler and trader) unless leverage is too high. In that case, fiance requires more than rocket science skills, it requires the ability to time travel.

[Kaleberg]

Why do all economists assume that business owners are infinitely stupid and that they will produce goods and arrange for services for which their is no perceived market? Well, maybe they don't assume it, but they seem unable to speak about markets without sounding as if they assume it. Look at the quote above "By no means, as the goods produced have still to be sold..." Good grief. As soon as a business owner realizes that wages have gone down he will cut production, either that or go out of business in short order. Real business owners know this. Economists seem less clear on the concept.

[Adam]

@Kaleberg: but that is the point exactly. They will cut production and reduce staffing, reducing employment and therefore demand for goods, so they will cut production...

[rogerh]

Is there an implied suggestion that dirigism might have a better outcome? Feedback and control systems are fairly well understood but the thought of a ministry somewhere with an accelerator and a brake pedal does not fill me with confidence. I suspect a big difficulty is connecting said pedals in any solid way to the real economy. My fear at present is we are trying to re-connect linkages to parts of the economic machinery that no longer exist and necessary new parts have not even been ordered or are out-of-stock.

[Ralph Musgrave]

Ben, The reasoning behind the Pigou effect is as follows, I think.

A recession starts because of a small decline in demand, caused, let’s say by wage earners and entrepreneurs cutting their spending by the same percentage. Once the recession has started, wages, prices and profits all drift downwards in nominal terms and continue drifting downwards.

Assuming they all drift downwards by the same percentage, there will be no change in REAL demand for goods by wage earners because prices fall as quickly as wages. So MPC doesn’t come into it.

In addition, there is a continual UPWARD drift in the real value of the monetary base and national debt. And that induces the relatively well off to spend more.

[Ben Nader]

Chris,

1. If wage rigidity isn't a big deal, then the stability of AD isn't a big deal, because wages can just adjust to equilibrate with any level of AD. Wage rigidity if the key nominal rigidity in the New Keynesian model that means AD matters at all. It's true that there are other nominal rigidities (is Kalecki trying to point to them in a roundabout way?) but they aren't nearly as difficult to overcome.

2. Average unemployment seems lower 1855-1914 then than post-1919 peacetime, especially if we nerf 1945-79 employment for make-work jobs driven by unions & state industries. With better monetary policy it could conceivably have been kept very low indeed.

[Alex]

The problem with the Pigou effect is what happens next. At time t+1, you feel richer, but assuming that nothing else has changed, you will expect to be richer at time t+2, because your cash is gaining in value relative to goods (and services). Therefore you will sit on your money.

Once you incorporate even really crude expectations (naive, or adaptive) into this idea, it just becomes a deflationary spiral.

[Nina]

Can any idea be more cruel and wrong then buying and selling labour on the open market, just as if they were not people, but fruits or vegetables for someone to consume. Now talk to me about freedom in the society where the majority is treated no better then slaves!

The idea of a self-regulating labor market is wrong both morally and theoretically. Suppose the price of some commodity goes up or down.That allows the commodities market to self-adjust by producing and consuming different quantities and redtoring the equilibrium. The labor market can not do the same because quantities can not be immediately adjusted once prices go down or up. It takes a couple of decades to produce more labor force and the existing labour can not just immeduately disappear because the market no longer requires it. It still needs to be housed, fed, dressed, etc. whether the market wants it or not. And if we do the market survey to find out what is it hat the abour market wants what result would we get? Most likely the market jyst wants healthy young maleswith some super-exceptional-abilities that allow them to compete. Niw everyone else goes to waiste. Older, less healthy people - the market does not want them. Women of child bearing age - no, not unless they are model to attract more business. Newly graduated students, with no polished specialised skills - no, we do not hire those, they are not competitive, a waste of time to train.

Allowing labor market to self-regulate is the fundamental error of Thatcher's policy and a plague of capitalist system. Labor market can not self-regulate without destroying human lives and putting the human race on the verge of exinction.

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