Chapter 5 The theoretical
of employment policy part
The Say's law as a starting point
The neo-classical criticism of Say's law
The meaning of the inflexibility
Policy conclusions from the classical position
The criticism from Keynes’ school
The employment theory of Keynes
Employment policy conclusions
The determinants of effective demand
The criticism of the Keynesian theory of employment
Stagflation and hysteresis phenomena
To low supply of employment?
The determinants of effective demand
We have seen that
effective demand plays a crucial role in the scope of Keynesian employment
theory. Therefore, let us ask ourselves on which determinants the effective
demand depends. Effective demand is made up of consumer spending, investment
sum, government spending and export earnings.
Let us begin with the
consumer demand. Here applies the psychological law of consumer demand.
According to this, consumer demand is determined by the level of income in the
Ct = f(Et-1+)
Et-1: Income of the prior period
The total saving, however,
depends also on the income distribution:
S = f(Y+, γ +)
Since consumption in
Keynesian theory depends only on the level of income and not additionally on
the amount of interest, also the savings will only react to changes in income
but not to interest rate changes. Even if savings were to react to changes in
interest rates, it would have to be expected that various saving motives would
trigger different interest rate reactions. With interest rate increases, for
example, the economic savings increases, but specific-purpose saving decreases.
Consumption can now be
influenced by policy through variations in tax rate and transfer income.
Consumption depends directly on the level of private disposable income, which,
in turn, differs from national income once in that, on the one side, the
transfer income paid by the state is added, and on the other side, the direct
taxes payable to the state are deducted:
C = f(Eprv )
Eprv = E + TR - Tdir
Eprv: private disposable income
TR: transfer payments; Tdir: direct taxation
Now let us consider the
investments. These depend on the long-term profit expectations of the
entrepreneurs. Certainly, Keynes acknowledges that investments also depend on
the level of interest rates, i.e. that interest rate reductions tend to
stimulate investment, but interest rate elasticity was too low to achieve
equilibrium at the capital market.
There is still the risk of
the liquidity trap: above a certain minimum interest rate, every additional
amount of money disappears in the speculative funds.
As already mentioned, when
interest rates are particularly low, private economic entities expect interest
rates to rise again in the near future. But interest rate increases trigger
price declines in fixed-income securities. It is worth now to sell fixed-income
securities. The increased supply of fixed-income securities would then lead to
price losses. There is now the risk that these losses will be higher than the
already low interest income with the result that it is temporarily very well
rational not to invest money interest-bearing in this economic phase, but to
keep it in fund.
From these theoretical
contexts, the following political conclusions can be drawn:
· an investment control by
monetary policy alone (interest rate cuts in the recession) is too unreliable.
· investment control can
thus be achieved rather by fiscal policy than by monetary policy.
· there is a direct
influence by way of the state budget deficit, with each expansion of the
deficit the effective demand increases;
· in monetary policy,
however, only incentives exist. Interest rate cuts are intended to stimulate
· but especially in times
when economic recovery is necessary, the investments do not respond adequately
to interest rate cuts!
Finally, influence on the
current account balance takes place via customs and exchange rate policy
measures. The starting point is the revenue equation, according to which the
domestic product (Y) equals the sum of consumption expenditures (C), the
investment (I), the government expenditure surplus (G) by way of the tax
revenues (T) as well as the surplus of the export revenues (EX) over the import
Here, export earnings are
mainly dependent on the exchange rate, a devaluation of the own currency (w)
increases export earnings, as from the perspective of foreign countries,
imports are getting cheaper. Imports will fall, however, if the own currency is
devalued. In the same way, an export surplus can be generated by import duties,
as import duties increase the price of imported goods and thus the demand for
imported goods declines.
Y = C + I + (G-T) + [EX(w -) - IM(w +, zl-)]
G: public expenditure;
w: exchange rate (rate of
the own currency);
zl: Import duty
An increase in the export
surplus may thus increase employment by increasing the domestic product.
For the same reasons,
however, the resulting import surplus abroad leads necessarily to a decline in
production as well as hereof derived to a decline in foreign employment. We
therefore must expect that foreign countries will try to prevent their import
surplus by devaluations or import duties. Thus, if a tariff war or a
devaluation competition takes place, the effects of this policy cancel each
other out largely.
criticism of the Keynesian theory of employment
It cannot be denied that
the Keynesian employment policy had made some initial successes. Both in the
USA and in the European countries, depression was overcome by a
deficit-financed expansion of government spending. Karl Schiller was also able
to achieve a considerable success when he tried to overcome the recession with
Keynesian recipes in the first grand coalition in the FRG as economics and
But the long-term
successes are less convincing, however. During the more than 80 years since the
Great Depression of the late 1920s, mass unemployment could not be reduced
significantly. And it is not because the politicians would have disregarded the
recommendations of the Keynesian theory. Quite the contrary. Hardly any other
economic recommendation has been implemented as one-to-one as the Keynesian recipes.
Keynesian policy was taken for granted in almost all major industrialised
nations in Europe and America, no effort was spared, and it is precisely due to
this policy that several states were close to a state bankruptcy because of the
immense public debt. Therefore, let us ask for the causes of this failure.
In a Keynesian economic
policy, a treating of the symptoms is present. An economic event (changes in
the domestic product) is namely attributed to another economic event (changes
in the investment behaviour). Depending on the market conditions, the
investment volume is changing and this change triggers a change in income and
But this criticism is not
valid against the business cycle theory formulated by Paul Samuelson. Here, a
combination of multiplier and accelerator takes place, by help of which
economic fluctuations can be explained very well.
Here, it depends on the
ratio of the accelerator to the multiplier, whether normal, damped or explosive
oscillations of the domestic product can be determined:
To explain these
movements, we consider the graphic below.
Firstly, we assume that
government expenditures (G) increase once (black line). This one-time increase
in expenditure leads to increases in incomes according to the income
multiplier, initially to a larger increase, in the following periods due to the
induced increases in consumption to ever smaller increases (red line).
The changes in income lead
to a change in the investment now due to the accelerator, whereby initially an
increase in the investment takes place, but then, due to reduced income
increases, a reduction of the investment (orange line) occurs.
This increase in
investment itself, in turn, leads to increases in income resulting in induced
growth in consumption (purple line). Due to the increase in investment and
consumption, an increase in income is expected eventually, which itself again
represents a multiple of consumer and investment growth.
We will continue in the
criticism of the Keynesian doctrine. The psychological law of consumer demand
could not be confirmed empirically. First, we consider the psychological law in
the form of the Robertson function. According to this, today's consumption
depends on the level of income of the previous period. Consumption thus follows
the changes in income lagged by one period:
Yt-1: Income of
the previous period
The Permanent Income
Hypothesis developed by M. Friedman is closer to reality:
Ct = f( Ypermanent +)
Ypermanent : long-term expected lifetime
Furthermore applies: a low
interest rate elasticity was only confirmed for fixed asset investments in
industry. Construction investments, however, respond interest-elastically. By
means of multiplier effects, interest rate cuts can thus very well trigger
employment-increasing effects. Rationalisation investments are responding to
interest rate variations in any case.
According to Hicks, full
employment can also be achieved in a Keynesian world through monetary policy.
However, there are exceptions when the IS curve intersects the abscissa on this
side of the full employment line or when the intersection of the LM curve with
the IS curve is in the horizontal branch of the LM curve.
In the IS-LM model
developed by Hicks we therefore plot the income (Y) on the abscissa and the
interest rate (i) on the ordinate. As is well known,
the IS curve (saving through investment curve) has a negative course, whereas
this curve shows which combinations of income and interest rate bring the
capital market to equilibrium.
The LM curve (liquidity
preference money supply curve) initially starts as a parallel to the abscissa
and then increases more and more from a certain income level on. The interest
rate cannot fall below a critical limit, namely. (?) If the interest rate is
extremely low, the economic units will keep money in the purse and not invest
At an interest-bearing
investment, economic units do not only generate interest revenue. They must
assume that price losses occur also in future interest rate increases, which
possibly are greater than the expected interest revenues.
The lower the interest
rates are now, the greater is the expectation that interest rates will rise in
the near future, and therewith prices will fall. Rising interest rates
therefore correspond to falling prices, since fixed-income securities are
increasingly offered when interest rates rise, in order to switch over to more
favourable interest rate investments. With an increased supply, however, the
price goes down.
We consider initially the
In principle, it is
possible to reach an equilibrium at full employment by way of an expansion of
the money supply (the LM curve shifts to the bottom right). Due to the
expansion of the money supply, interest rates are falling, and this interest
rate cut leads to an increase in investment and through this influence to a
multiple increase in domestic product and employment.
However, there are
exceptional situations. A first exception is present when the IS curve runs
extremely steep, so that the IS curve intersects the abscissa at an income less
than the income achieved at full employment:
A second exception occurs
when the LM curve intersects the IS curve in the horizontal branch and again
there is no intersection of both curves at full employment:
An overly hectic economic
policy leads furthermore to uncertainty among investors, since changes in
interest rates are to be expected permanently.
Too excessive time lags
impede efficient fiscal policy. A contractionary fiscal policy would have to
start yet in times of recession actually, since employment effects can only be
expected after about one to two years. However, it is unlikely to expect that a
democratic government will initiate contractionary measures already during the
Furthermore, a demand
policy is efficient only if Keynesian unemployment is present. However,
according to a broadly conviction, since the 1990s we have to deal rather with
structural unemployment –based on supply-theoretical reasons.
democratic electoral process intensifies the economic fluctuations. (Theory of
W. D. Nordhaus)
influences reduce the efficiency of economic policy: there occurs an import of
With a decline in foreign
income YA, the domestic export opportunities
decrease EX and with them the domestic income YI and domestic employment. An externally induced
crowding out takes place:
At autarky applies:
in foreign trade, however,
the following applies:
employment theory suffers from the fact that in its conclusions it does not
consider how economic units adapt to Keynesian employment policies. The
Keynesian employment policy consisted primarily therein that the increased
government demand led to price increases and by these price increases to
increased profits. These initial increases in profit expectations were the
cause why entrepreneurs were led to produce and invest more and thus hire more
The increase in prices
meant for workers, however, a decrease in their real wage incomes, and the
increase in profits simultaneously led to a decline in the wage share (in the
share of wage income in domestic product). It was clear that the unions were
unwilling to accept this deterioration in the income situation of the workers
In the subsequent
collective bargaining they forced an adjustment of the wage rates to this
changed situation. However, this led to a decline in profits once again and the
real reason for a sustained expansion of production and hence employment was
All that remained then was
the temporary increases in profits, which continued as long as the unions had
not yet adapted to this changed situation. But even the temporary gains in
profits could not persuade entrepreneurs to hire more workers than before. The
entrepreneurs ran the risk that if they no longer needed the additional hired
workers after the expiry of these orders for production, they could not dismiss
them timely due to a rigorous termination legislation. Therefore, most
enterprises tried to fulfil these initial orders by offering their employees
the opportunity to work overtime. Effectively, nothing was gained with regards
to the employment situation.
Finally, there is a risk
that a Keynesian policy will actually increase the demand for goods, but yet
domestic employment will not increase, since the enterprises will have the
demanded products or parts of these products produced abroad for reasons of
profitability because labour costs are lower there.
On the other hand, the
development in the unemployment rate during the last economic crisis shows that
unemployment can be partly avoided by the government granting wage subsidies
for short-time work. For enterprises, it is beneficial to let workers work
briefly in times of crisis in order to have a skilled workforce in the
Stagflation and hysteresis phenomena
The stagflation that has
occurred in recent decades has also reduced the chances of success for
Keynesian politics. Stagflation is defined as a simultaneous rise in
unemployment and inflation. In the scope of Keynesian theory, an explanation
for stagflation is no longer possible: the decline in demand leads to a decline
in production and thus to an increase in unemployment, prices should indeed
fall or at least remain constant. However, they are still rising because the
fixed cost share in many enterprises is extremely high and determines
significantly the development of the total unit costs.
Although the traditional
cost curves suggest that the unit costs increase with increasing production, at
least from a certain product quantity on, it could be expected actually that
with decreasing production the unit costs decline and with them also prices.
However, the fixed costs
are characterised by the fact that with increasing production the fixed unit
costs decline indefinitely to the capacity limit. Thus, the fixed unit costs
will increase with a reduction in production. Now, if the share of fixed costs in total costs is relatively high, the
total (fixed and variable including) costs will increase as production declines
and entrepreneurs will endeavour to pass on these cost increases to consumers
in the price. These efforts are also successful in an economic downturn, as
even the competitors are affected by this decline, so that they also try to
increase prices and thus there is no danger that the customers will switch to
competition due to the price increase.
Even the policy of
"go and stop" fails with inflation: always only one target variable
(price level or employment) is influenced in the desired direction.
Even phenomena of
hysteresis have complicated the success of Keynesian politics. A hysteresis is
present when goods markets and labour markets are no longer developing
approaches for hysteresis are as follows:
In the downturn, there
occurs a workers hoarding due to the protection against dismissal or due to
training costs for skilled workers. There is namely a high risk at the
beginning of the upturn, as entrepreneurs must fear that new orders will be of
one-off nature and thus will not signal a cyclical upturn.
Therefore, they are
unwilling to recruit new workers and thereby run the risk of being unable to dismiss
these workers - because of the protection against dismissal - when they are no
Also the collective
bargaining policy gets in a dead end and this can also explain hysteresis
phenomena. Since long-term investment decisions decide on expanding or
eliminating jobs, expansionary as well as moderate wage settlements have a
positive effect on the employment situation only with a mayor delay. Therefore,
the reactions of the social partners no longer correspond to the employment
policy requirements. A wage renunciation does not lead to employment growth in
the short term, an expansive wage policy has no negative employment effects in
the short-term. In the long run, these unwanted or desirable effects still
occur, but due to the relatively long delay, they are not counted against the
union leaders. An expansionary wage policy will not be punished despite negative
effects; and also a moderate wage policy will not be rewarded despite the
In addition, there are
further explanatory approaches of the hysteresis:
The current economic
situation depends on the extent of the past unemployment (human capital
approach). The long-term unemployed are barely employable, as they lose their
skills all the more the longer they have been unemployed. In this case, an
increase in demand is not enough anymore to reintegrate the long-term
unemployed in the production process.
A slightly different
explanation of the phenomenon of hysteresis is given by the insider / outsider
theory: despite unemployment, the willingness of the employees to reduce wages
is lacking. Unemployment does not affect those workers who, because of secure
jobs in the collective agreements, enforce wage increases. An expansive wage
policy then causes unemployment not for the groups of workers who have won the
wage increase, but for other workers who are not responsible at all for the
wage increases and which also do neither benefit from these wage increases.
Both the phenomena of
stagnation as well as hysteresis are closely linked to numerous supply shocks.
The supply shocks of recent years were triggered by the following measures or
· release of the exchange
rates in the mid-1970s,
· the two oil crises (1973
· the creation of the
European single market,
· globalisation in the
context of the GATT rounds,
· the reunification,
· the increase in female
· a strong immigration
stream immediately prior reunification and
· the tax burden due to
Possible solutions consist
of the following measures:
Opening of collective
agreements for company regulations. At company level, employees could refrain
from wage increases if at the same time the otherwise feared redundancies are
renounced on the part of the enterprises.
Profit participation. If
part of the workers' income is granted as profit participation, labour costs
will decrease and therewith employment will increase. Since profit-optimal
production does not change, the profit participation has no negative employment
11th To low
supply of employment?
Very early in the course
of the history of economic theory, the thesis of the saturation of the demand
for goods was set up. With increasing welfare more and more saturation would
This thesis was clearly
refuted by reality. Despite an enormous increase in goods production, there was
no long-term saturation. There is no limit to the expansion of human needs!
Another explanation sought
to explain the thesis of a long-term stagnation with a robotisation of production: technical progress
is always expressed in the destruction of jobs.
Even this thesis does not
withstand criticism. Not every technical advance is labour-saving.
The type of technical
progress depends much more on the wage-interest ratio. It was mainly the
increase in the wage-interest ratio that has led to labour-saving technical
progress in the past. The wage-interest ratio rose during the Keynesian era,
since the state tried to lower the interest rate to reduce its own interest
burden, and since on the other hand, the unions sought to enforce an
expansionary wage policy in which wage rates where increased stronger than
labour productivity was raised.