Economy and Society

Unemployment Equilibrium: Keynesianism 103

The failure of economics in the runup to and aftermath of the Great Recession has generated a lively debate about how to reform economics and more specifically about the renewed relevance of Keynesian economics, which had fallen out of favor since the 1970s. The Keynesian message, so important in this latest round of political wrangling over the increase in the US debt ceiling, is that cutting government spending in a slump will only worsen the unemployment problem. The role of expansionary fiscal policy, according to Keynesianism 101, is to provide demand for goods (and thus for employees to produce those goods) when the main sources of demand in a capitalist economy — households and businesses – are not providing a level of demand necessary to generate a socially acceptable level of unemployment.

Keynesianism 102 is about the multiplier effect of changes in spending. This is the notion that an increase in demand (from any source, not just government but certainly including government) will impact employment and incomes with a ripple effect. This includes a direct impact and then a secondary impact when the direct incomes are then spent (in some fraction) and an additional fraction of that is spent, etc.

There are two corollaries to the lesson of Keynesianism 102 that are worth mentioning because they have been raised in the current policy debate. The first is about the differential multiplier effect of a spending increase compared to a tax cut. Empirical studies show that the multiplier effect of the former is greater than the multiplier effect of the latter. The second is about the differential multiplier effect depending on the income of the recipients. Since the poor are more likely to spend a higher percentage of additional disposable income than the rich, a tax cut that benefits low-income people will have a bigger multiplier effect than a tax cut that benefits the rich.

These lessons have not been integrated into current economic policy in the US, where deficit spending and progressive tax reform and expanded benefits for the poor and unemployed have been successfully resisted by the Republican congress. Nonetheless, they are well-established lessons of Keynesianism that most professional economists would accept.

The argument against Keynesianism 101 revolves around the psychology of investor confidence in the face of a rising fiscal deficit. The argument is that business people will reduce their investment spending when they see the government deficit becoming very large because it signals the likelihood of some detrimental future adjustment – either in interest rates, tax rates or government outlays – that will be detrimental for future profits. There is simply no empirical evidence to support this theory compared to Keynesianism 101.

But all this is sideshow in comparison to the lesson of Keynesianism 103.  The fundamental economic point of Keynes’s 1936 General Theory of Employment, Interest and Money was not about fiscal policy or the multiplier or income distribution.  It was about the fact that economic equilibrium (a stable condition from which no economic change would occur without external impetus of some sort) will not necessarily be characterized by full employment. Economists prior to (and some subsequent to) Keynes thought that free market economies would naturally adjust to full employment, as an excess supply of labor would lead to a lowering of wages and a corresponding increase in the amount of employment. Keynes explained that the natural state of a capitalist economy is “unemployment equilibrium,” and without a shock to aggregate demand conditions, there was no reason why the economy would not stay at this unemployment equilibrium. Keynes’s insight implied that the wage reduction strategy was not just theoretically wrong but, if implemented, would likely make the situation worse, since it involved a reduction in household buying power and thus would reduce business confidence.

A prospect as disastrous as the second “dip” that the American economy is about to experience is that of a long period of high unemployment that has no natural tendency to reverse itself. We should not stop our analysis at Keynesianism 101 and 102, since the great social problems facing America are understood best by Keynesianism 103.

So what is to be done? Paul Krugman has been a superb critic of the politicians’ focus on the deficit and the debt rather than on job creation. But he has been relatively quiet about what could be done if in fact the political winds were to shift. Robert Reich has been more explicit. His proposals for job creation include:

  1. An additional cut in the payroll tax on employees and employers
  2. An increase in infrastructure investment

My guess is that President Obama’s speech this evening will address these issues. If it does, it should be understood as not just a political maneuver, but as a serious attempt to tackle our economic problems.

7 comments to Unemployment Equilibrium: Keynesianism 103

  • This piece explains the fundamentals of our economic situation and suggested the way the President’s speech should be evaluated. Using these fundamentals as a guide, it is clear that Obama’s speech, and more significantly his economic strategy, are on the mark. This was good economics and also good politics. I think the power of his presentation changes the political landscape.

  • Michael Corey

    Will raises the issue as to why do businesses reduce investment spending? In the practical world of running businesses, there are numerous short-term and longer- term factors. Operating decisions are heavily influenced by short-term factors such as: lack of sufficient demand and the cost and availability of human, material, energy resources. Investments are longer-term commitments that are based upon whether or not the value of the businesses will be adequately enhanced above investment objectives as measured by changes in net present values and through discounted cash flows. Small, short-term, temporary incentives do not lead to large, long-term investments that are major drivers of economic growth and more jobs.

    Cash flow projections take into account the length of time it takes to get things done. Regulatory and other roadblocks extend payouts, reduce returns and reduce the number of projects that can be financed. All cash flows are on an after tax basis. If effective tax rates are not competitive, then the other revenue and cost factors must be exceptional to carry them. This is one reason why uncompetitive tax rates have led to increased investments outside of the United States. The resultant cash flows outside of the United States infrequently come back to the United States due to the high tax costs of bringing them back.

    Uncertainty raises the hurdle rates for longer-term investments. Higher risks require higher rewards. Uncertainty in most the elements used to construct projected cash flows is causing most businesses to hibernate.

    In the short-term, most businesses can use existing workforces and unused capacity to deal with short-term increases in demand that is viewed as temporary in nature. This is one of the reasons why governmental stimulus rarely yields the desired effect. Creating more sustainable jobs requires businesses to make longer-term investment commitments.

    Longer-term business investments require commitments from investors and bankers. If projected after-tax returns are inadequate in one country, then investors will try to find adequate returns in others. If paying dividends is no longer an efficient way to reward investors, then dividend payouts may be reduced in favor of things that enhance the value of the business. Businesses may use this cash to invest in themselves through investments such as acquisitions and share buybacks.

    I really don’t think that most policy proposals take into account how businesses work.

  • Anonymous

    This is the perfect piece for the moment and, as Jeff notes, for use in evaluating Obama’s speech. There is an encouraging op-ed in the NYTimes by Krugman as well. I think that Obama’s speech was tremendous. Now what we need is follow through— he needs to really put the pressure on Republicans to focus on unemployment and not let up on that pressure. Maybe even name names—- I, like many liberals, are energized by the presentation but reluctant to get too excited ….

  • IrisDr

    No one is saying that the economy will all of sudden grow substantially with the kind of Keynesian proposals Obama is making. But certainly everyone should see the benefit of hiring more teachers, policemen and firemen as well as giving unemployed construction workers something constructive to do. Those people likely otherwise would be a drain on government and not be paying taxes, nor have money to spend on goods and services that businesses want to supply. Large corporations might be hedging their bets on the long term, but community businesses need customers for their goods and services. Not only are students better off having the attention of their teacher, but their teacher might decide to make household improvements and hire a local carpenter. The local hardware store might not have to go out of business, etc. Same goes for the construction worker. Not only does the community benefit from better infrastructure, but the workers now have buying power in their local communities. Bridges are having to close due to cracks, http://www.courier-journal.com/article/20110909/NEWS01/309090090/Sherman-Minton-Bridge-closed?odyssey=tab|mostpopular|text|FRONTPAGE and others have fallen while in use. These investments should be no-brainers. All this nay-saying that “it won’t do this and it won’t do that” is missing what it would mean to those people who would not otherwise be employed, and the benefits that their employment would have on our communities, while at least keeping our economy from sliding further.

    I have not heard any Republican economic proposals (that Obama has not also proposed) that would not further increase the income disparity in this country, which is very destructive, or take us back to the environment that got our economy into this mess in the first place.

  • Michael Corey

    There is a significant difference between addressing causes and effects. Much of what is coming out of Washington is temporarily addressing effects. These moves probably will not yield the desired results. In my view, one of the major problems we face from a policy making standpoint is not adequately identifying root causes. There is a much better chance of correcting long term issues that are hurting us today why engaging them. There is a huge difference between proposing programs supported by visions, values and compelling reasons; and offering up projects which frequently fall short of what they are intended to do.

    The biggest part of the projects offered are the infrastructures spending and the continued suspension of the payroll taxes which fund Social Security, a program which its auditors say already has serious actuarial shortfalls. My guess is that many of the infrastructure spending projects will take much longer than expected to initiate; and a rush to do them may fund may be suboptimal. An alternative approach on infrastructure spending would be to identify infrastructure spending that yields the most value to the economy and the functioning of the nation. I’m not at all sure that the best ones will be chosen.

    Some of the other proposals will have little or no effect. Businesses will not hire people because there is a small, short-term tax incentive. When additional people need to be hired, most employers look for the people they think will do the best job for them. All others things being equal, then they might be influenced to hire veterans or the long term unemployed.

    To deal with veteran unemployment and the long term unemployed begs correctly identifying the reasons. I haven’t studied the situation, but I have a few guesses. Veteran unemployment may have to do with relatively few people serving in the military, and being out of the workforce for awhile. Couple this with the high incidence of PTSD, and we are starting to approach root causes: deploying people who serve less often, finding more ways for people to serve, and training people while in the military for post military careers.

    It is difficult to deal with the long term unemployed without helping bring back manufacturing to the United States. The loss of manufacturing jobs for decades has destroyed the life chances of millions of people. This means we need to incent manufacturing to be done here and trade opportunities need to be opened up. This means helping fast track business expansions. It also means using the valuable resources we have in a responsible way. Whole communities, for instance, in the Northwest have been destroyed when the Forest Service has withheld public lands from sustainable forestry. Many of the same problems exist with our energy resources, depletable and renewable.

    Unemployment among minorities in inner cities is far too hard and has created a devastated underclass. This is an intractable problem, but it is worth exploring tax incented redevelopment, enterprise zones with trade preferences. The most humane thing that we can do is deal with structural issues and strive for full employment in my opinion. We need to take advantage of our strengths.

  • IrisDr

    Schools need repairs, and could be done quickly. Teachers need to be in the classroom. We need police and firefighters. Tax loopholes need plugging, and in time, real tax reform needs to happen. You sound like you’re with Perry who says not one job was created with stimulus money.

  • Michael Corey

    Putting measures in place to help bring about a “full/fuller” employment economy will do more to help the life chances of everyone over longer periods of time. Temporary fixes are seductive, in my opinion, and distract us from addressing the bigger issues. There are only a limited amount of resources available to accomplish what needs to be done; therefore they need to be used judiciously. There are numerous things that the Federal government is responsible for; are not being done; and; could create worthwhile jobs for a broad spectrum of people.

    They all involve science and technology. Going from the grandest to the mundane, they include things like: engineering and putting in place a planetary defense system to protect the Earth against probable asteroids strikes; engineering and putting in place a electromagnetic pulse defense system to prevent the destruction of the infrastructure that is the basis for all of our economic and social systems; designing and putting in place a deep water port system which will be needed to sustain imports an exports and be secure; participating in cross state programs to deal with the effects of long term drought and thereby protecting our food production system; putting in place a cyber security system to protect the systems which are the basis for virtually all knowledge and transaction systems; etc. We could keep peeling the onion back and examining worthwhile things that affect the viability of the country; and then establish priorities based upon our abilities to get them done. Each institution (state, local, public and private) needs to seek out and select the best opportunities they have to make a difference.

    As for Perry’s claim, I’m not sure what he said; and I don’t really know how many jobs have actually been created. I doubt that anyone really does. The raw aggregate numbers period to period taken as a whole are very worrisome.

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