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As part of my Mises
Academy class Keynes, Krugman, and the
Crisis, I have reread large portions of The General Theory. In his masterpiece,
Keynes erects an impressive framework on one crucial assumption: left to its
own devices, the free market can get stuck in an
equilibrium with very high unemployment.
Although Keynes's whole edifice and
critique of the "classical economists" rests on this belief, he
devotes surprisingly little time to supporting it. In the present article
I'll point out the weakness in his view. If it turns out that the free market
does naturally move toward full employment in the labor market, then
the entire Keynesian "general theory" falls apart.
Keynes's
"General" Theory Versus the "Special Case" of the
Orthodox Economists
Keynes called his framework a general
theory to contrast it with the "special case" handled by the
orthodox, free-market economists (whom Keynes somewhat confusingly called the
"classical economists"). The analogy here was with the tremendous
advancement in physics, where Albert Einstein's relativity theory explained things (such as
the behavior of clocks at high velocities) that the classical Newtonian
framework couldn't handle. However, Einstein wasn't completely throwing out
Isaac Newton, because at low velocities (relative to the speed of light), the
equations of relativity "reduced to" the more familiar Newtonian
mechanics.
Keynes claimed that there was an
analogous situation in economics. While he agreed that the classical
economists (as epitomized in the work of David
Ricardo and J.B. Say) and their modern disciples had
accurately described the principles of income distribution and the tradeoffs
between consumption and savings for an economy at full employment,
Keynes was offering a more general theory — one that could model
the economy even when it was operating well below capacity with "idle
resources."
Modern Keynesians believe that one of the
crucial contributions of The General Theory was to provide a coherent framework
that explained how the economy could be stuck for many years at less than
full employment. The "classical" economists believed that a free
market would quickly eradicate a glut in the labor market (i.e., a situation
of high unemployment), but Keynes apparently showed that their arguments were
specious.
If one reads The General Theory
cover to cover, this theme is frequently mentioned: The Keynesian system
handles the fact that the economy can have varying levels of employment. It
won't do to talk of "the" equilibrium
rate of investment or saving, because these are endogenous
variables that are influenced by the total amount of employment and income.
Therefore the classical views on government spending and the function of the
interest rate are (allegedly) erroneous. The classical economists falsely
focus on the special, limiting case of full employment, while not realizing
that their views are wrong, in general.
Therefore, it is absolutely critical to
the Keynesian framework that the free market in fact can be stuck at
less than full employment for long stretches. For if the classical wisdom of
J.B. Say and others is correct — and the economy naturally moves to
clear markets and achieve "full output" — then it is the
Keynesian policy proposals that will lead to disaster, not the orthodox
free-market ones.
Why the
Orthodox Economists Thought Unemployment Was Voluntary
In chapter 2, Keynes takes on the twin
postulates of the Classical School. The first is that (in a competitive
equilibrium) the wage rate equals the marginal product of labor. Keynes has
no problem with this.
However, it is the second postulate that
causes controversy. It is the claim that (in a competitive equilibrium) the
utility of the wage rate will just balance the disutility of labor.
If this second postulate is true, then
all unemployment is "voluntary." Workers may be in between jobs,
it's true, but they are deliberately withholding their labor, seeking
better offers than the ones on the table. They could take a job at the
prevailing market wage rate, but they choose not to. Thus, the second
postulate is upheld, because the "disutility of labor" (all things
considered, including the opportunity cost of ending a job search
prematurely) is high enough to offset the advantage of taking a job and
earning the market wage rate.
"In the real world, there definitely
is 'involuntary unemployment,' but this is due to government, union, and
central-bank distortions."
But hold on a second. Surely the
orthodox, free-market economists could open their eyes and see that there was
widespread unemployment during the early 1930s. Did they really think
that this was just a Great Vacation, as some modern critics of Real Business Cycle theory claim of their
free-market colleagues?
Keynes thought so, and explained how they could reconcile their
"second postulate" with the widespread unemployment staring them in
the face:
Is it true that the above categories are
comprehensive in view of the fact that the population generally is seldom
doing as much work as it would like to do on the basis of the current wage?
For, admittedly, more labour would, as a rule, be
forthcoming at the existing money-wage if it were demanded. The classical
school reconcile this phenomenon with their second postulate by arguing that,
while the demand for labour at the existing
money-wage may be satisfied before everyone willing to work at this wage is
employed, this situation is due to an open or tacit agreement amongst workers
not to work for less, and that if labour as a whole
would agree to a reduction of money-wages more employment would be
forthcoming. If this is the case, such unemployment, though apparently
involuntary, is not strictly so, and ought to be included under the above
category of 'voluntary' unemployment due to the effects of collective
bargaining, etc.
Now we can quibble over how
"voluntary" it is if, say, an unemployed person can't get a job
because union picketers threaten to beat up any "scabs" who show up
at a factory. In any event, the important point is that the orthodox
economists thought that widespread unemployment was due to wage rates being
held above the market-clearing level. If unions would simply agree to wage
reductions, then the quantity demanded for labor would rise, the quantity
supplied would fall, and the market would once again be at full employment.
Ah, but Keynes didn't think things were so simple as the naïve classical economists argued.
Why Keynes
Thought the Labor Market Could Be Stuck in a Glut
Keynes rejected the notion that, left to its own devices (and without union
interference), the labor market would clear, such that anybody who remained
unemployed was doing so as a voluntary choice. He had two main arguments, one
empirical, and the other theoretical.
First, Keynes thought the workers adhered
to "money illusion" (though Keynes thought they had rational
justifications for doing so). In other words, workers did not respond
merely to the "real" (price-inflation-adjusted) wage rate, but
cared about the absolute money (nominal) wages they received in their
paychecks:
Now ordinary experience tells us, beyond
doubt, that a situation where labour stipulates
(within limits) for a money-wage rather than a real wage, so far from being a
mere possibility, is the normal case. Whilst workers will usually resist a
reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of
wage-goods. It is sometimes said that it would be illogical for labour to resist a reduction of money-wages but not to
resist a reduction of real wages. For reasons given below … this might
not be so illogical as it appears at first; and, as
we shall see later, fortunately so. But, whether logical or illogical,
experience shows that this is how labour in fact
behaves.
This is the standard "sticky
wages" argument for monetary inflation: If real wages are too high, so
that there is a surplus of labor being offered on the market, then the
solution is for real wages to fall. But because workers resist cuts in their
nominal money-wages, the only answer is for the central bank to inflate the
money supply, driving up prices faster than wages, so that workers end up
earning less in real terms.
The problem with such a diagnosis of
"the free market" is that money-wages are sticky in large part because
of government intervention, including the possibility of central-bank
inflation. As I document in my book on the Great Depression, average money
wages fell very sharply in the depression of 1920–1921, in contrast to
the much more modest decline during the early years of the Great Depression.
Perhaps the change was due to enhanced union power, or to Herbert Hoover's
pleas with business to maintain wages. Whatever the cause, the "sticky
wages" of the first phase of the Great Depression were not inherent to
the market economy, because wages were much more flexible a decade earlier.
More generally, government programs such
as unemployment benefits obviously give workers an incentive to hold out for
better offers before going back to work.
Could Labor
Accept Wage Cuts Even If They Wanted to?
Besides his empirical observation that
wage earners tend to resist cuts in their money-wages, Keynes provides a more fundamental and theoretical
objection to the orthodox view that the labor market can quickly return to
full employment with flexible wages:
The classical theory assumes that it is
always open to labour to reduce its real wage by
accepting a reduction in its money-wage. The postulate that there is a
tendency for the real wage to come to equality with the marginal disutility
of labour clearly presumes that labour
itself is in a position to decide the real wage for which it works, though
not the quantity of employment forthcoming at this wage.
The traditional theory maintains, in
short, that the wage bargains between the entrepreneurs and the workers
determine the real wage; so that, assuming free competition amongst
employers and no restrictive combination amongst workers, the latter can, if
they wish, bring their real wages into conformity with the marginal
disutility of the amount of employment offered by the employers at that wage.
If this is not true, then there is no longer any reason to expect a tendency
towards equality between the real wage and the marginal disutility of labour.…
Now the assumption that the general level
of real wages depends on the money-wage bargains between the employers and
the workers is not obviously true. Indeed it is strange that so little
attempt should have been made to prove or to refute it. For it is far from
being consistent with the general tenor of the classical theory, which has
taught us to believe that prices are governed by marginal prime cost in terms
of money and that money-wages largely govern marginal prime cost. Thus if
money-wages change, one would have expected the classical school to argue
that prices would change in almost the same proportion, leaving the real wage
and the level of unemployment practically the same as before, any small gain
or loss to labour being at the expense or profit of
other elements of marginal cost which have been left unaltered.
Before criticizing him, let's be clear
what Keynes is saying. Yes, unemployed workers might be willing to take jobs
at significant pay cuts (in terms of the absolute dollar amount of the
paychecks). Even currently employed workers would have to follow suit, lest
they get laid off.
But we can't assume that everything else
would remain the same, with the only difference being lower money-wages.
Keynes points out that with reduced labor costs, businesses would pass along
those savings to their customers in the form of lower prices. Because labor
accounts for such a large fraction of total costs, firms might find that just
about all of their savings in wages was offset by drops in revenue. Thus,
real wages would still be too high, and there would still be too many workers
looking for jobs compared to the amount of positions employers wanted to
fill.
There are several problems with this
analysis. For one thing, labor costs are a large fraction of total expenses,
but they are hardly the whole thing. According to this article, labor's share of national
income in the United States has varied between 52 and 60 percent in the
postwar era.
"Keynes was simply wrong when he
argued that the workers didn't have the power to accept lower real
wages."
So even if we mechanically assumed that a
fall in labor's money-wages would translate into a proportional fall in
retail prices, labor would nonetheless have the power to reduce its real
wages. For example, if laborers received a cut of 10 percent in their
money-wages, then the prices of the goods they produce would only fall
between 5 and 6 percent. Labor would be cheaper, even in real terms, and
employers would move out along their demand curve and hire more workers.
But there are other problems with Keynes's
analysis. Consider: What is the actual mechanism through which falling costs
lead to falling retail prices? We start in an initial equilibrium, where
workers earn (say) $10 per hour, and the retail good sells for $100. Firms
are happy with the number of workers they have employed at $10 per hour, and
the amount of goods they can sell at $100 each.
Now, because unemployment is very high,
the firms can get away with cutting their workers' pay to $9 per hour.
Holding everything else constant, they are making more profit than before.
What would induce them to lower their retail price from $100?
The obvious answer is that they want to capture
a larger share of the market. That is, they want to sell more units of
the retail good to their customers. They can't do this with their
original labor force. No, in order to make it profitable to cut their retail
price, they need to hire more workers and boost output. Then,
in order to move the larger quantity of product, they cut prices from $100 to
(say) $98. Even though they make less revenue per unit, they nonetheless make
more total profit.
Other firms do the same thing, of course,
until the new equilibrium settles down with wage rates at $9 per hour and the
retail price at (say) $95 per unit. Thus a large part of the workers' wage
cuts have been passed along to the consumers in the form of lower retail
prices. Nonetheless, in the new equilibrium, each firm is producing more
units, and thus is carrying a larger workforce than before the wage
reduction.
One final point: The Keynesian could
object to the above analysis by saying, "Murphy, you are overlooking the
fact that the customers will reduce their demand for the firm's
products, because many of them are workers themselves who are experiencing
cuts in their money-wages. If workers go from earning $10 per hour to $9 per
hour, then they will have to cut back on their purchases of goods and
services. So the firms will need to lower their prices not to expand output,
but just to keep sales from dropping."
But this too repeats the mistake of
assuming that all customers consist of wage earners. As we've seen,
workers (at least in the postwar years in the United States) only earn about
50–60 percent of total income. Capitalists, landowners, and others earn
the remaining 40–50 percent. So although it is true that the demand for
retail products would fall off from the wage earners, it's also true that (a)
the falloff wouldn't be one-for-one with the reduction in wages, and (b) it
might even be completely offset because the other groups would see their
incomes go up initially.
For example, consider the firms the
moment after the workers accept pay cuts from $10 down to $9 per hour.
Holding everything else constant, the shareholders of the firms are now
reaping extra profit. If they chose to spend their higher incomes on exactly
the same items where the wage earners were now cutting back purchases, then
the demand for retail goods wouldn't change at all.
More realistically, the shareholders of
firms probably would spend their higher incomes on different things. So some
industries (yachts, fancy restaurants, capital goods, housing, etc.) would
expand, while others (movie theaters, low-scale restaurants, beer industry)
would contract.
Someone might object to this change in
the distribution of income as immoral or unfair. The point, however, is that
Keynes was simply wrong when he argued that the workers didn't have the power
to accept lower real wages.
Another consideration is that there are
more workers receiving wages once firms expand output. For example, if wages
go down from $10 to $9, but total employment rises from 90 million to 100
million wage earners, then labor itself has the same
amount of "total income" with which to buy goods and services, so
there is no reason to expect a collapse in business revenue.
Conclusion
The entire system of John Maynard
Keynes's General Theory rests on the claim that under laissez-faire,
the labor market could be stuck in an equilibrium
with a large glut, for years on end. But Keynes devoted only a few pages to
this proposition. His argument fails on both empirical and theoretical
grounds. Absent government intervention, wages and salaries would adjust to
clear the labor market. In the real world, there definitely is
"involuntary unemployment," but this is due to government, union,
and central-bank distortions.
Robert P. Murphy
Essay originally
published at Mises.org
here. With permission
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