VIII. Macroeconomics
1. How the Macroeconomy Works: Plan of Action
The single, most important conclusion from the Institutionalist macro analysis is that the economy does not automatically create enough jobs for everyone who is willing to work. This will be explained in two steps:
1. the establishment of the possibility of involuntary unemployment using the labor market diagram;
2. the establishment of the likelihood of involuntary unemployment in a mature capitalist system using the investment-capital cycle.
Mixed in with the Institutionalist/Keynes analysis will be Orthodox views of the various phenomena.
2. The Labor Market
The Classical economists (the original branch of the Orthodox school, extant from 1776 to 1930's) did not believe that involuntary unemployment was possible, at least not for an extended period.(14) One way to show how they came to this conclusion is by using a labor market diagram. This diagram represents graphically the behavior of potential workers and of firms. On Figure One, the horizontal axis represents the level of labor services (N). This can be measured in hours, number of workers, or however. The vertical axis is the average level of wages (W) in the macroeconomy. The curve on the graph, labeled Nd, is the demand for labor by firms. Its negative slope can be explained as follows.
Firms are rational, greedy, and they like to trade. Their primary goal is to produce just enough output for sale to maximize their profit given demand (i.e., given the price they can charge and the volume of sales they will have). If they produce too much (or sell at a lower price), then the costs they incurred in the production of those goods and services they did not sell have reduced their profits needlessly. If they produce too little (or sell at a higher price) then they have foregone profit opportunity because they could have sold more. To avoid either of these unpleasant possibilities, firms try to set output at the level that will maximize profits.
The model of the labor market is set in the short run. This means that firms can change the amount of labor they hire, but the time period in question is not long enough to both begin the construction of new capital (machinery, buildings, etc.) and have it contribute to production by the end. Thus, the only way for firms to expand output in the short run is to add new workers. There is not time enough to expand output by expanding capital. So, for the firms, the decision to expand output is the decision to hire more workers (and vice versa).
So, the reason for the negative slope of the labor demand curve is this: given that the production and hiring decision are the same, and given that firms' production decision is based on their goal of profit maximization, as wages rise the potential for profit falls, forcing firms to cut back on production and therefore employment. As wages rise, the demand for employees falls, so the slope of the line is negative.
Note that every point on the labor demand curve would represent profit maximization if the wage rate across from it were the prevailing one.
That is the labor demand curve. Now the labor supply curve must be explained. The labor supply curve explains the behavior of potential labor force participants (those who are employed and those who would work under different labor market conditions). As you can see from Figure Two, the slope of this line is positive. The simplest way to understand this is that as wages rise, the willingness of laborers to work rises. As the wage rises, more and more people in the economy are willing to work. So the labor supply curve shows the number of people willing to work at each possible wage rate and the labor demand curve shows the number of people firms wish to hire at each possible wage rate.
Figure Three shows the complete labor market. The interaction of the labor supply and labor demand determine the wage rate (W0) and the actual level of employment (N0). If the wage were at a level lower than the intersection, then, at that wage, there would be fewer people willing to work than the number demanded by firms.
This would lead to firms competing with one another for workers, followed by a rise in the wage rate, which would eventually move up to the intersection (where the number willing to work equals the number firms wish to hire). If the wage were at a level above the intersection, then there would be more people willing to work than firms wish to hire (see Figure Four). The workers would be competing with one another for employment and firms would be able to lower wages. Wages would fall until the are at the intersection, where the number of people willing to work exactly equal the number that firms wish to hire.
All this discussion of the labor market was raised in the context of the Classical school's belief that involuntary unemployment was not possible except for short periods of time. The above description of the labor market is a Classical one. They believe that the situation created by involuntary unemployment is an unstable one, meaning that it cannot last for long. The very conditions that create it tend to destroy it (the excess of willing over openings causes wages to fall, eliminating the excess).
Of course, that was a little hard to swallow
in Britain in 1936 when the rate of unemployment had not fallen below 9.7%
since 1920 (from 1921 to 1935 unemployment averaged 14.6% in the United
Kingdom). Classical economists were at a loss to explain the chronic unemployment,
but John Maynard Keynes was not. Formerly a Classical himself, he slowly
but surely abandoned more and more of that school of thought's perspective
as the crisis in Britain dragged on. The culmination of Keynes' changing
view was The General Theory of Employment, Interest and Money, published
in 1936. Keynes tried to retain as much of the Classical model as possible
so that his task of convincing other economists of his view would be easier.
Keynes thought that convincing other economists was far more important
than convincing the public or government officials because it was his view
that economic theory was a major determinant of economic policy. From page
383 of the General Theory (all editions are paginated exactly the
same):
...the ideas of economists and political philosophers, both
when they are right and when they are wrong, are more powerful than is
commonly understood. Indeed the world is ruled by little else. Practical
men, who believe themselves to be quite exempt from any intellectual influences,
are usually the slaves of some defunct economist. Madmen in authority,
who hear voices in the air, are distilling their frenzy from some academic
scribbler of a few years back. I am sure that the power of vested interests
is vastly exaggerated compared with the gradual encroachment of ideas.
Keynes, in explaining the existence of chronic involuntary unemployment, accepts all the basic tenets of the Classical labor market model but one: he says that, in the event that the wage rate is above the intersection, there exists no automatic tendency for it to move toward the intersection. When there exists an excess supply of labor (involuntary unemployment), there is no competition among workers that lowers the wage. The economy can remain in a position of involuntary unemployment indefinitely.
Perhaps the easiest way to understand the distinction between Keynes' and the Classicals' view is this. The Classicals' see two groups involved when involuntary unemployment exists: firms and potential workers. Keynes sees three: firms, employed workers, and the involuntarily unemployed. That subtle distinction ends up making a big difference.
For a situation to be unstable, it must create conditions that cause at least one group to wish to change those conditions and that group must have the power to do so. To Classicals, when involuntary unemployment occurs, that group is potential workers. Firms always want wages to fall (it helps profits), so they certainly will not resist a decline in wages. But they don't necessarily actively seek it. Potential workers are in a bind, however. There are more willing workers than jobs, which means that someone will not get hired. Rather than go without work, job applicants are likely to offer to work for less than the going wage (this is clear since we can already see on the graph that the current level of employment could be sustained at a lower wage rate). It is in their best interests to do so if they want to be employed. So the wage starts to decline because a) potential workers have both the desire and power to lower them and b) firms have no reason to oppose it. This process continues until the market clears (i.e., until the quantity of workers demanded equals the quantity of workers supplied).
Keynes didn't see it this way. He thought only one group had any incentive to see wages fall, and no one asked them! Firms, to start, are already on the labor demand curve. They are therefore profit maximizing (given the current wage rate) and are not unhappy. Furthermore, it is quite possible that they might even resist lowering wages, even though there is the excess supply of labor. The reason is that lowering wages of existing workers (a group not considered by the classicals) tends to lower morale and productivity. Why risk that when you are already profit maximizing? There is little to be gained. So firms sit tight.
Existing workers would have been willing to work for less, just as the Classicals indicated, but not now! Not once they already have jobs! Offering to work for less makes sense only if there is some advantage in it, and that is the case in the Classical explanation because no one has a job yet--offering to work makes it easier to find employment. But if you are already working, it makes no sense to offer to work for less. It won't happen!
It turns out that the only group that would like to see wages fall is the involuntarily unemployed. For them, offering to work for less might be an advantage...except for one thing: firms aren't hiring! So they can offer all they want, but no one is asking. Firms have their workers, and except for replacing retirees, etc., they aren't looking for new workers. So the fact that the involuntarily unemployed are willing to work for less does not mean that the wage rate will fall.
That's the critical difference in Keynes' view. When you think about the fact that people aren't re-hired every day, suddenly the vision of the masses of potential workers competing with one another, driving wages down, doesn't make sense. Firms have their employees and they are content. The existing workers would be willing to offer to work for less if it meant gaining employment, but they already have jobs. The unemployed would gladly offer to work for less so that they could find work, but no one is hiring. Involuntary unemployment is not an unstable situation. We could remain there forever.
There are other reasons why the Classical version does not make sense. Think about it for a minute. Under what circumstances would a fall in the wage rate make sense as an answer to the problem? One possibility is that the wage rate is not realistic. There simply does not exist enough output in the macroeconomy to pay everyone that much. The wage rate is out of line with the standard of living the economy is capable of providing. For example, what if there were 100 "things" to be had in an economy, and 50 people in the workforce. If the going wage rate was 4 things/person, only 25 people could be employed. Even if all the others wanted to work, they couldn't. There isn't enough output to pay them. But if the competition among the potential workers drives the wage to 2 things/person, everyone could be hired. Why was there unemployment? The wages were too high given the other circumstances in the economy.
This could happen if minimum wage laws or unions drove wages to a point too high for the economy to accommodate, or if there were a natural disaster that reduced our number of "things" from 200 (which could allow 50 employees at 2 things/person) to 100 (where wages must either fall or we will not be able to employ 100 people any more). Which one sounds like the Great Depression? NEITHER! Labor power was minimal (wages were quite flexible) and, while output certainly fell, it wasn't because we couldn't produce enough output for everyone. We had experienced no natural disaster. There was no reason whatsoever, from a productivity standpoint, that we could not have continued to produce as much output as ever. The conclusion: WAGES WEREN'T TOO HIGH DURING THE GREAT DEPRESSION! That wasn't the problem.
What was? Demand for labor was too low. What occurred was a leftward shift in the labor demand curve. As firms laid off workers in the sectors that were nearing saturation, so unemployment climbed. Productive capacity existed, but the demand necessary to make the operation of the factories profitable did not. More on that later.
There's one more issue to consider with respect to the Classical position. Not only was wages being too high not the problem, lowering them could cause considerable economic damage. Contractual agreements are a cornerstone of business in specialization-market economies. Contracts reduce uncertainty for the participants because they set prices, wages, and/or quantities over some specified period of time. Consumers purchase homes, cars, boats, health club memberships, lawn care, furniture, and more with contractual agreements (the list grows larger very quickly when considering the use of credit cards). Some are very long term (house and car) and others are very short (credit cards). The problem is this: lowering wages, even if wages were lowered simultaneously with all current prices, still leaves contractual payments fixed. These cannot be changed, and lowering wages makes it very difficult (if not impossible) for workers to meet the payments. This causes problems throughout the financial sector, first for workers, then for financial institutions, and then to rest of the economy as the weak financial sector is unable to provide funds for further purchases.
So, according to Keynes, in the event that the wage rate is above the intersection and involuntary unemployment has occurred, there is no reason to expect the market system to automatically correct the situation. Nor should moves be made to encourage the wage to fall, either.(15)
Thus far, Keynes has established the possibility of involuntary unemployment, but certainly not the likelihood of it.
3. Shifts in the Labor Demand Curve:
Introduction
The above sections introduce the possibility that involuntary unemployment could take place if the labor demand has shifted left. What causes the labor demand curve to shift? Firms' expectations of sales. To simplify this stage of the analysis, it will be assumed that only two kinds of firms exist, those selling consumption goods and those selling investment goods (this excludes the government sector and the import-export sector). Using the variable Y to represent the total output produced (which would be equal to GDP) this gives
Y = C + I.
This simply means that the sum of final goods and services produced in the consumption-goods industry and the investment-goods industry yields all the goods and services produced in the economy. So the firms in these two industries must determine how much they believe they can sell and then produce, and hire, accordingly.
As the composition of demand in each industry varies considerably, each will be discussed separately.
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NOTES:
14. It is important to remember with the Orthodox school that, in large part, the superiority and efficiency of market solutions in general is something that is assumed at the outset, not "discovered" after a particular market has been studied. This tendency can be traced back to their Newtonian roots and the belief that natural laws are benevolent.
15. Notice the difference between Keynes' approach to the market and the Classicals. The Classicals made a model assuming that the market was perfect and best, and then had a difficult time understanding what had happened when real-world events did not agree. They decided on how the market worked before they studied the actual economy. Keynes went in the other direction, studying the real economy before building his labor market model. Of course, what the classicals did was consistent with their emphasis on nature, since, if the market is a natural phenomenon and not a social one, then they all would be the same.
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