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Business cycle and growth policy

Chapter 2: The aim of the full employment continuation

Outline:

01st Restriction to the production factor labour

02nd The different dimensions of the employment level

03rd Full employment in the sense of equilibrium

04th Full employment in the sense of a certain level of employment

05th The problem of the long-term unemployment

06th Ascertainable versus necessary economic data

07th Self-affirmation and self-refutation of prognoses

08th The problem of a differentiating economic diagnosis

09th On the problem of the leading indicators

10th The economic barometer of the council of experts

11th Socio-political reasons

12th Growth policy reasons

13th State political justification

14th Conflicts between full employment and monetary stability

15th Conflicts between full employment and income distribution

11th Socio-political reasons

There is a high intrinsic value of the aim of full employment. There occur welfare losses due to unemployment, namely. Unemployment leads among others to:

- lower income,

- lower career opportunities,

- a loss of prestige in the family and neighbourhood.

An employee receives indeed unemployment benefit while unemployed. This is, though, much lower than the regular wage income; it must also be taken into account that unemployment benefit is not paid indefinitely, the individual employee must have been employed regularly for a certain period in order to have any entitlement to unemployment benefit. If these conditions are not fulfilled, the unemployed person will still receive support within the social assistance (known as Hartz IV), but this is even lower than the normal unemployment benefit.

But the reduction of income is not the only fact that an unemployed person has to face. The opportunities to ascend to qualifying jobs throughout his life and thus to increase income are lost in most cases. When a worker becomes unemployed for an extended period of time and especially when this lot hits him several times, then all of the prospects of an upswing in the hierarchy of jobs disappear mostly.

12th Growth policy reasons

Unemployment means wasting of scarce resources. An elimination of unemployment could increase the level of growth. With increasing employment, however, it has to be expected that the labour productivity to decreases. According to the law of diminishing marginal revenue, the total revenue can be increased with increased work effort, but the growth of earnings, the so-called marginal revenue declines. The following graphic shows the course of the revenue function. We draw the employment on the abscissa and on the ordinate the respective marginal revenue:

This decline in the marginal revenue has several reasons:

Thus far an economy approaches the state of full-employment the performance incentives diminish. If enough jobs are offered by the entrepreneurs, the employee can be broadly confident that he will still find a job even if he does not perform outstandingly. As long as an employee is afraid that he gets nothing because of too few jobs, he has a strong incentive to put in great efforts in order to find employment, though.

But the labour productivity also depends on whether an entrepreneur succeeds in deploying the "right worker" in the "right job". We cannot assume that an employee can deliver a similar performance at every workplace. An employee's performance capability always depends on several factors; one employee may render a specific performance better than another employee, but this one in turn may possibly have better qualifications to perform other tasks. The required skill of an employer is precisely to distribute the individual workforce to the individual positions the way that a maximum of performance can be provided.

Thirdly, it is necessary to consider that the average efficiency decreases with increasing employment. If an entrepreneur employs only a small number of workers, he can hire the most skilled workers. The more workers are already employed, the more the entrepreneurs feel compelled to employ lower-skilled workers as well.

Productivity can be increased not only by putting each individual employee in the right job, but also by ensuring that it is headed for the optimal composition between the number of employed workers and the capital expenditure.

If we assume a given technique, then there is a very specific intensity of labour (a very particular numerical ratio between work effort and capital). The applied technology determines the ratio of labour to capital in order to achieve the optimal combination. If more or fewer employees are employed at existing production capacity, then this results in suboptimal combinations. Thus, if production is extended or reduced above this optimal (cost-minimised) point, the productivity declines in both cases.

13th State political justification

Furthermore, there is a correlation between political and economic stability: economic instability leads to political instability. The unemployed persons are more likely to care for radical thoughts than employees. An example provided the Weimar republic. High unemployment and bankruptcies, thus an economic depression, led to a large number of voters turning to radical parties, workers to a greater extent to the Communist Party, craftsmen and traders more to the National Socialist party. Therewith, the conditions were created that the democratic order could be smashed by the National Socialists.

The right to vote has also favoured this development. The USA was politically more stable than Germany during the Great Depression, as the plurality voting system is more sensitive to dissatisfaction. Within the framework of a plurality voting system, voter disaffection leads much faster to a deselection of the candidate than in a proportional representation system. Precisely because with a proportional representation a deselection of the government presupposes a very high loss of votes, there is the danger here that more and more voters turn to parties that are not based in the least on the ground of the existing democracy and that in this way the overthrow of the constitution occurs.

Up to what extent the existing order is unstable depends finally also on the material protection of the unemployed persons. Since employees in the post-war era were entitled to unemployment benefits that were only slightly lower than the regular wage income, there was less danger that the unemployed would tend to the slogans of the radical parties from left and right. The democracy was despite partially high unemployment in the post-war period more stable than in the Weimar Republic, because the unemployed persons were protected materially by the unemployment insurance in contrast to the time of the Weimar Republic.

14th Conflicts between full employment and monetary stability

To begin with, it is necessary to ascertain that there are no logical determined conflicts of aims. Both aims (that of full employment and monetary stability) require the realisation of equilibrium, thus it is possible to achieve both aims at the same time by way of heading for equilibrium. Mass unemployment is prevented if it succeeds to avoid excess supplies, while vice versa monetary stability is guaranteed when excess demands are reduced. Both aims can be realised if supply and demand correspond. In the event of equilibrium, demand overhangs are avoided on the one hand, and by association monetary stability is guaranteed. But on the other hand, supply overhangs are also avoided and thus the aim of full employment is guaranteed.

But there are very well factually caused conflicts, namely by:

- the existence of bottlenecks,

- Price increases, which already occur even though there still persists underemployment.

- rising macroeconomic unit costs. A reduction in production leads to cost increases and by association to price increases.

One speaks of bottlenecks always when shortages occur, so e.g. due to the scarcity of a raw material or when due to lack of production capacities the production must be throttled. Here, the supply adapts itself only delayed to the increasing demand and just therefore the prices can rise here even if there are still supply overhangs in total.

Furthermore, we had already pointed out that a cyclical upturn is far from being synchronous, namely in the sense that not all sectors of activity are starting up at the same time and expanding at the same rate. Here, too, is the result that the capacity limit has been reached already in certain sectors and therefore prices are raising due to scarcity, even though the overall economy is still very well experiencing unemployment and free capacities.

Actually, we can assume that in times of economic downturn, when demand declines and supply has to adjust to this reduced demand, prices will decline. The entrepreneurs are reducing prices here in order to stop or at least alleviate the decline in demand.

But we have already pointed out that at the presence of high fixed costs, the unit costs increase just as production declines, and that therefore entrepreneurs are trying to raise prices. Fixed costs are characterised by the fact that the sum of the total costs is incurred, regardless of whether and how much goods are produced. As a result, fixed costs per item decrease as production increases. Therefore, if entrepreneurs see themselves forced to reduce production, then the fixed unit costs increase.

Now this increase in costs can generally be compensated by the fact that additionally to fixed costs also variable costs are incurred that decline when production is reduced. But if the share of fixed costs is very high, then the total unit costs will increase at a decline of the production.

As already shown, the uncertainty about the economy cycle prevents or at least aggravates an effective economic policy. Actually, contractionary measures should be introduced before reaching full employment, but the uncertainty about the future prevents a timely shift. Also for politicians it is unreasonable to initiate contractionary measures already in times of unemployment.

This aim conflict depends primarily on the respective economic phase:

In the depression, there occurs a general underemployment in all markets with relatively constant prices.

In the upturn, full employment is almost reached: there are price increases on individual markets and nevertheless there is underemployment in other markets;

Finally, when the booming economy is overheating, over-employment and price increases can be seen in almost all markets. (D2.)

In the literature, the Phillips curve theorem is used generally to explain the aim conflict that is present here.

The empirical evidence for this theorem consisted therein that A. W. Phillips had pointed to a trade-off between unemployment rate and wage increases. The theoretical interpretation, though, was supplied by R. G. Lipsey. On the abscissa of a diagram we draw the unemployment rate and on the ordinate the wage increase rate.

The starting point is the negatively inclined Phillips curve, which shows a negative relationship between the wage increase rate and the unemployment rate: (D3.)

Accordingly, the higher the unemployment rate (u) is, the less wage increases can be enforced.

According to Lipsey, the course of the Phillips curve can be explained in terms of a dynamic price theory (wage theory). According to this, wage increases are always to be expected if demand overhangs are present, respectively wage cuts if supply overhangs are present. The rate of change in wage rates can thus be seen as a function of the disequilibria.

We start from the coordinate origin, which signals equilibrium in the labour markets. The unemployment rate (u) is zero and that is just why there is no reason that wages change in a free labour market: The rate of change of the wage rate dl/dt is also zero on this point. That way emerges a negatively inclined curve passing through the origin.

If we take into account that there is always natural unemployment for structural reasons, we can obtain the Phillips curve from a shift in the Lipsey curve to the extent of the natural rate of unemployment to the right. Thus, the Phillips curve is based on the natural rate of unemployment and provides information on which wage rate increases can be expected at alternative unemployment rates.

P. A. Samuelson had now proposed a modified Phillips curve: due to the connections between wages and prices, it is possible to demonstrate a model of the trade-off between price stability and full employment by use of the Lipsey model.

The modification introduced by Samuelson is now obtained by assuming that wage increases which are above the productivity gains will act price increasing. The difference between wage increases and productivity then gives the change in the inflation rate depending on the unemployment rate.

Political conclusions can be deduced within the Keynesian theory:

Employment programmes represent a movement along the Phillips curve and are therefore suitable to reduce unemployment. But the employment increases lead to price increases.

Milton Friedman has criticised these conclusions:

The Phillips curve would namely become a parallel of the ordinate axis in the long-term. Friedman sees the reason for this in the following: the collective bargaining partners implement wage adjustments, these reduce profits and with them the incentive for increased occupation.

Edmond Malinvaud finally pointed out in this context that Friedman's criticism would apply only under the conditions of classical unemployment. At Keynesian unemployment, it does not primarily depend on the profit, but on the sales opportunities, these, though, would not diminish at a wage increase!

Nevertheless, one will have to assume that enterprises are interested in production and sales only as long as they can firstly cover all costs with the proceeds and secondly achieve a minimum return. Since almost all productions and investments involve a certain risk, there will be few enterprises willing to take on these risks if they can not expect a certain return.

15th Conflicts between full employment and income distribution

Our previous considerations suggest that the aims of full employment and a fair distribution of income assort well with each other. The Phillips curve seems to confirm that as the unemployment rate declines, the rate of change in the wage rate will increase to the same extent.

Nevertheless, this relationship is by no means as clear as the Phillips curve seems to indicate. When reviewing possible aim conflicts, we must not only pay attention to the immediate relationships between the two aims. Aim conflicts can also occur - as we have seen in the introductory lecture - due to the choice of the means employed. In fact, Keynes' propagated means for eliminating unemployment seems to involve coincidently a decline in the income share of the employees.

Keynes was indeed convinced that an expansionary monetary policy alone would not be able to stimulate the economy by lowering interest rates and expanding the money supply. Keynes saw the reason for this deficiency in the fact that in times of economic downturn, the enterprises had free production capacity and therefore were not willing to increase their capacity even with a reduction of interest rates, especially since the gains that may result under certain circumstances in an expansion of production and a reduction in the cost of capital had to be passed on immediately to the consumers again in the form of price reductions because of the excess supply present on the markets.

Only an expansion of government expenditure would be able to sustainably boost the economy. However, these government expenditure increases would have to be financed with loans, since otherwise the additional demand of the government would only replace a further contraction of consumer spending due to the necessary tax increase. And here the role of monetary policy comes into play.

The governmental trade cycle policy could - according to this conception - only be successfully implemented if the additional demand caused by the deficit in the government budget was supported with additional money. If namely, the central bank was unwilling to make additional money available to the extent of the government-induced additional demand, then the interest rates would increase. But these increases in interest rates may now jeopardise the success of the governmental economic cycle policy, as the state would then have to spend an ever-increasing share of its revenues for interest on debt payments.

The Keynesian policy therefore needs the support of the central bank, and in the Keynesian sense an expansionary monetary policy is necessary in times of economic downturns, not because the investment demand could be increased directly by the interest rate cuts, but indeed because it was the only way for the state to successfully implement a budget deficit policy.

Now Keynes has once said that it was completely indifferent to the economic policy success, which demand for goods would be increased due to the state employment policy. All that matters was that the aggregate demand increased, whether this increase occurred in public goods or in business investment or, ultimately, in consumer spending, was completely irrelevant to the economic success. The state could also build pyramids in the desert, which obviously are complete useless in Keynes's point of view (?!), it would simply not matter here that useful goods are offered increasingly, but only that more workers are employed.

Despite this opinion has the Keynesian employment policy initiated by the individual governments confined itself almost exclusively to buying more goods (primarily capital goods), or to incentivise the investment readiness with subsidies for the enterprises.

This policy indeed was definitely successful with regard to the occupation within the first years, in which the politicians worldwide made the attempt to get over the problem of the mass unemployment with the help of this Keynesian strategy.

Due to the increased demand of the state (the increase in expense was financed by deficit) the goods prices raised, the profits increased with the prices and the therewith connected expectation, that these profit increases continue, led thereto that the enterprises expanded their production and thus hired additional workers. Thus, it came in fact to an (initial) reduction in unemployment. It seemed as if this strategy was successful.

The truth of the matter is that this success lasted only as long as the entrepreneurs and trade unions had not adapted their strategies to this changed situation.

Since with price and profit increases ceteris paribus, the real wage income is falling, and as this reduces the share of wage income in the domestic product, have the trade unions tried to force a wage increase in the subsequent collective bargaining. On the one hand they did not want to accept the reduction of real incomes due to the price increases; on the other hand they wanted to participate in the profit increases of the entrepreneurs.

But as far as the unions were successful, the situation of the entrepreneurs changed again, too. If unions succeed in their wage increases to fully compensate for price increases, then this is equivalent to the fact that the additional profits - generated by the increased demand of the government - are disappearing again, and thus enterprises must also correct their profit expectations. Now there is nothing to indicate that profit expectations have improved in comparison to the situation before the start of the increased public demand and that therefore this employment policy can also be successful in the long term.

Now one might think that at least a one-off economic boost is generated and that this positive thrust sufficed perhaps to trigger a cyclical upturn with the help of this initial spark.

This opinion is wrong, though. The entrepreneurs learn from past experiences also. They soon realise that the unions will quickly force a wage increase at price increases and that therefore the initial surplus production can not be sustained. But they also know that newly hired workers can not be dismissed without further ado if it turns out that the initial orders have not triggered a sustained economic upturn already.

A dismissal provision handled rigorously often prevents entrepreneurs from dismissing workers even when labour force is no longer needed for further production. In this case, entrepreneurs will attempt to attend the additional government orders the way that those already employed are rendering overtime. In this case, however, the anticipated additional employment did not occur. These examples show that the Keynesian employment policy was only successful at the beginning, and this is because the market partners (trade unions and entrepreneurs) did not adapt to the changed state strategy until after a certain period of time.

So we have seen that the actual Keynesian monetary and employment policies have been successful only as long as it has been possible to change the distribution of income in favour of profits and, at the same time, at the expense of the real wage incomes. So there is very well also a conflict between the aim of full employment and the aim of a fair distribution of income.

The decline in the wage share was obviously the price that one was willing to pay in order to reduce mass unemployment. Either there was a price increase in the course of reducing unemployment, thus this policy was at the expense of wage earners. Or else, this policy failed because the trade unions did not allow the real wages to decline as part of employment policy. In this case, the success of the employment policy came to nothing.

In the long term, anyhow, in comparison with the situation in the early 1930s, the extent of mass unemployment could not be significantly reduced in a sustained manner. Even today, just as 80 years ago when Keynes proclaimed his message, most Western economies face the problem of persistent and recurring mass unemployment.

Here, it kind of surprises why just the social democrats were 'tough Keynesians' for a long time although hereby the employees were put at a disadvantage in terms of the income distribution. Although it could be argued that at most opinion polls most of the workers took occupational safety as much more important than the desire to increase wages. But this argument would only be effective if this policy was successful. If it is not possible to prevent mass unemployment in this way, it is certainly not in the interest of the workforce to accept a reduction in their real wage incomes anyway.

Here, it takes revenge that Keynes had completely excluded the problem of income distribution in his employment-theoretical analyses. This is, by the way, in contrast to Carl Föhl, who had developed a macroeconomic theory at about the same time, but independently of Keynes, in which ex pressis verbis the role of income distribution as a determining and determinable variable was discussed. The question, of how income distribution influences employment on one side and how on the other side government employment policy on its part influences the income distribution, has been completely ignored by Keynes.

Later, Nicholas Kaldor, also a Keynesian proponent, caught up on this omission and made the distribution of income the actual subject of his analysis. He also came to the conclusion that the wage income can by no means be improved by demand increases. Any attempt, to raise again the share - that was diminished as part of the employment policy - of wage incomes in the domestic product by way of raising the nominal wage incomes, would inevitably lead to higher prices, since the income level at which supply and demand coincide (i.e. the intersection of effective demand with the goods supply curve) would not be influenced by mere wage increases.

The demand overhang would persist and with it would all cost increases be passed on in price increases. Only if the trade unions succeeded in increasing the savings rate of the workers, then could this vicious circle of wage increases and subsequent price increases be overcome in the long-term.