Unemployment – Morality, Money and Increasing Returns

Returns to Scale in Frankfurt's business district
Returns to Scale in Frankfurt’s business district ©DWP

The causes of unemployment make it a moral issue. Radical solutions are required.

In an earlier post I noted some features of unemployment from a UK perspective. The main thrust was that a fairly constant proportion of the population in employment (around 72% of those of working-age) hides a serious decline in the availability of adequate work, due mainly to the increase in women in the workforce and the fall in the ratio of full-time to part-time work. In a paper I wrote and referenced here on welfare I hinted at a moral dimension to the issue of unemployment in a capitalist economy (by which I simply mean an economy where physical means of production tend to belong in more or less concentrated hands).

I have now written a rather more formal paper (pdf 198kb) which I presented to the Post-Keynesian Study Group annual workshop in May this year in which I expanded on why we have a persistent problem with unemployment, and why this has a significant moral implications in our attitude to the unemployed. In this light of this I review the inadequacy of current policy and look at some of the more radical solutions proffered. The following is a non-technical summary of the paper.

Resource Use Failure
The failure to make the best of our human resources is not only a failure to make the best of our welfare, but in a society which explicitly assumes that we ‘get what we deserve’, condemns millions to needless poverty, social exclusion, humiliation and increasingly near-criminalisation for the sin of being unable to persuade firms to employ them at a liveable wage.

Standard Thinking
Standard economic thinking about employment holds that it can be increased by lowering the cost of employing labour for firms, sharpening the cost-benefit separation between low-paid work and unemployment for labour-market participants, and weakening links between labour demand and nominal price rises by reducing workers’ bargaining power and by increasing market competition. The approach of many ‘Keynesian’ economists shares this basic view but tends to see these features that lead to unemployment as being so ingrained and so sustained that since ‘in the long run we are all dead’ direct government action is often required.

The Radical View
Other economists hold a more radical view of Keynes’s insights. They argue that unemployment generally arises due to the interaction of money and uncertainty – uncertainty in the sense that ‘we do not know’ rather than that reducible to probabilities. Money greatly expands the opportunities for exchange, for wealth accumulation and for varying the timing of transactions. The result is an economy more complex, more productive, more prone to fluctuations in activity levels and more unequal than one relying on barter and trust. Money provides a buffer for uncertainty for individuals but acts as a magnifier of uncertainty for the economy as a whole. (See previous posts for discussion of the particular nature and problems of monetary economies.)

Increasing Returns to Scale
Yet there may be something missing even from this account. Once it becomes clear that firms have made expectational errors and that supply and demand of goods are at less than full capacity, why do not the unemployed simply fill the gap – employing themselves and capital at the going rate of return? Harvard economist, Martin Weitzman, more recognised these days for his work on the economics of climate change, argued in the 1980s that firms’ exploitation of the phenomenon of increasing returns – unit production costs that fall as output is increased – can explain both why the unemployed usually cannot compete with established firms at any acceptable return – and why firms may have little incentive to employ unused resources to increase their output.

Weitzman argued that because most goods produced by firms are purchased with wages paid by other firms, there is a built-in barrier to firms increasing output and employment. Since the advantages of scale mean that firms can tailor their output to maximise their profits – and do so given the current level of consumers expected to purchase their goods – any change in their own production involves an immediate fall in profit. This combined with the fact that in most areas of business, an unemployed worker cannot simply set up on his own with a small portion of a factory and produce a small portion of output at the same price per unit as a firm, means that left to its own devices the economy can bump along at more or less any level of unemployment.

Combined with the fluctuations that a monetary economy leads to, this tendency to inertia by firms and the inability of unemployed individuals to counter it, can lead to the persistent inability of large numbers of the population to obtain work and thus a decent income.

Why is there Unemployment?
Unemployment is not an issue in primitive societies. It becomes one as soon as land and its product, physical capital, are unequally or inadequately distributed. If everyone had access to an area of land adequate to provide subsistence (directly or reliably through exchange of essentials) for their families, it would not be unreasonable to regard those of sound mind and body who failed to work hard enough to maintain themselves as entirely responsible for, and even willing, their own misfortune.

With his famous description of a pin factory in ‘The Wealth of Nations’, Adam Smith cogently explained how the specialisation in tasks and access to capital greatly raises efficiency of production. The complexity that results, however, creates greater scope for debate over what should count as a fair or unfair allocation of capital and income, with feedback effects from unequal skills to unequal distribution and vice versa. So it becomes much more difficult to distinguish between those that suffer lack of work and poverty because of circumstances that are largely not within their reasonable control and those whose situations are more self-willed. Moreover, with the benefits of such specialisation most of the work that needs to be done to provide the basics of life for the population can be done using a small proportion of the available labour. Providing employment for the rest depends therefore on demand for non-essentials – which is likely to be both fluctuating and often highly uncertain.

How NOT to Tackle Unemployment
If unemployment results from a combination of the incentives of firms benefiting from their scale advantages and the large-scale vagaries of a monetary economy then most attempts to increase Labour Market ‘flexibility’ are largely misguided, probably welfare reducing and actually pretty morally dubious. Most of these reforms have the effect of reducing the bargaining power of labour, with the result that real wages fall. The Weitzman increasing returns mechanism supported by considerable empirical evidence suggest that wages, demand and output will move together. Reduction in wages thus tends to lead not to greater employment but to less.

What is more, the existence of unemployment is a consequence of the unequal distribution of a limited quantity of land and manufactured capital exacerbated by the efficiency of large-scale production technology and a monetary system from which the majority benefit greatly. In a developed economy there is actually a trade-off between a huge general welfare advantage and the possibility of undeserved individual deprivation. Apart from its unfairness, the prevailing punitive approach to the unemployed can do little more than induce greater churn in the labour market with little impact on resource utilisation and output, so such an approach reduces the welfare of the unemployed with no benefit for the employed. It is most surely a political strategy rather than an economic one.

What Policies Then?
Monetary policy in the form of lowering lending costs for banks has a role to play in minimising negative shocks that frighten banks, firms and individuals about the future, with the result that new loans are hard to come by and existing loans cannot be repaid. Government spending can boosts firms’ revenue under the same conditions. These are short-run fixes that do not address the core causes of unemployment but they can prevent a bad situation becoming worse by persistent lower unemployment from otherwise temporary shocks.

‘Better’ Credit Creation
What approaches have been suggested that get to the root of the unemployment problem as analysed here? Richard Werner of Southampton University argues that only productive economic activity associated with new money creation represents genuine additional aggregate income. He argues that attempts to stimulate a sluggish economy must ensure that new money is created if it is to be effective, and that moreover that the credit issued to create this money must be for genuine productive activity rather than speculative trading or pure consumption. He further argues that government expenditure funded by taxation actually has a net neutral effect on the flow of money through the economy. Unfortunately, while much of this analysis makes sense, some of his proposals, such as government borrowing from the private sector, betray some confusion about the working of a modern monetary system.

The ‘Job Guarantee’
Another non-mainstream proposal for tackling unemployment much-discussed among some economists is the ‘Job Guarantee’ (sometimes referred to as Employer of Last Resort or ELR) approach. In essence, the government always stands ready to provide employment, at or around the minimum wage, to those who cannot find employment elsewhere. The argument is in part a monetary one; it is argued that since sovereign currencies such as the US dollar or UK pound can be issued costlessly by the government this power should be used to eliminate unemployment. The wage-cost of providing the guarantee would be at least partly offset by the social and health benefits, by the existence of a better-prepared and better-equipped workforce and by the fact that the additional demand from the otherwise-unwaged will encourage increased private-sector output and employment – eventually shrinking the pool of government employees. This latter point is clearly linked to Weitzman’s and could perhaps be seen as a way in which the bargaining power of the unemployed is increased. Under a Job Guarantee, when demand for firms’ sales dries up instead of a shift from private employment to unemployment there is a shift from private to government employment. Since government jobs are at the minimum wage the average wage falls, reducing any inflationary pressure.

The obvious mainstream objection to such a scheme is that it is likely to involve long-term deficit spending by the government, even allowing for some of the off-sets mentioned. The scheme’s proponents point to the accounting relationship between private saving and public debt – the mechanism for which is described above – to demonstrate that there should be no objection to deficit spending in itself. The assumption would be that with higher levels of employment and demand, saving and the demand for government bonds would also be higher. There seems a caveat to this response however which is that unless the demand and saving increase exactly offset the cost of providing the wage guarantee (or at least boost growth enough), the policy will lead to an increase in the annual deficit. In this case government liabilities may rise continuously faster than GDP. This would be regarded in mainstream economic circles as unsustainable at least for countries whose currency was not a major reserve asset – and may have problematic consequences.

On the other hand, particularly if other under-utilised resources exist, there is scope for these government-employed workers to carry out welfare-enhancing work where private-sector supply is poor. The problem then becomes how this is monetised. If this cannot be done in the market, then taxation must rise with all the political implications this brings; if it can be done in the market then the question arises as to whether it might not have been a better policy to persuade or enable the private sector to employ the relevant factors and create the relevant output. This brings us to Martin Weitzman’s solution to his own analysis of the problem of unemployment; the concept of ‘profit-sharing’.

‘Profit-sharing’
Profit-sharing is based on a simple theoretical observation. A firm that is operating at the profit-maximizing point where marginal revenue matches marginal cost (ie: the extra income from producing one further unit of output is exactly matched by the cost of doing so) will not want to take on another worker at a fixed wage. If, on the other hand, workers were paid not a fixed wage but compensation that varied at least in part with the revenue of the firm, then the employment of an additional worker would reduce the average cost of output, allow prices to fall and production to expand. The additional demand from the employed worker has a knock-on increase in demand for the products of other firms with the result that a balanced expansion can ensue until genuine full employment is reached. In this case there are no concerns about the correct setting of monetary policy, the timing of fiscal interventions, government deficits or taxation increases since all the corrections are occurring at the level of the firm. Inflation should not be a significant problem, argues Weitzman, because if current workers obtain higher wages the firm has the option to employ new workers so that share portion of remuneration falls. Even should intervention be necessary, the use of monetary policy will be much better targeted on prices and wages rather than employment.

There is much to be discussed about how such a policy might be implemented – in terms of what it means for employees’ role in the direction of firms; in terms of the increased fluctuation of incomes and so on – but it is the only policy proposal that directly goes to any of the root causes of unemployment and so merits renewed examination now that unemployment has been revealed as an intractable problem.

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