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Chapter 5 The theoretical foundations

of employment policy part II

Outline:

01st The Say's law as a starting point

02nd The neo-classical criticism of Say's law

03rd The meaning of the inflexibility

04th Policy conclusions from the classical position

05th The criticism from Keynes’ school

06th The employment theory of Keynes

07th Employment policy conclusions

08th The determinants of effective demand

09th The criticism of the Keynesian theory of employment

10th Stagflation and hysteresis phenomena

11th To low supply of employment?

08th 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 prior period:

Ct = f(E_t-1⁺)

E_t-1: Income of the prior period

The total saving, however, depends also on the income distribution:

S = f(Y⁺, γ ⁺)

γ : profit margin

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(E_prv )

E_prv = E + TR - T_dir

E_prv: private disposable income

TR: transfer payments; T_dir: 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 investment!

· 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 expenditures (IM).

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;

EX: export;

IM: import

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.

09th The 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 finance minister.

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 employment.

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:

Ct = f( Y^t-1+ )

Y^t-1: Income of the previous period

The Permanent Income Hypothesis developed by M. Friedman is closer to reality:

Ct = f( Y_permanent ⁺)

Y_permanent : long-term expected lifetime income

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 interest-bearingly.

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 general case:

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 recession.

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.

Furthermore, the democratic electoral process intensifies the economic fluctuations. (Theory of W. D. Nordhaus)

Furthermore, external influences reduce the efficiency of economic policy: there occurs an import of unemployment.

With a decline in foreign income Y^A, the domestic export opportunities decrease EX and with them the domestic income Y^I and domestic employment. An externally induced crowding out takes place:

At autarky applies:

in foreign trade, however, the following applies:

Furthermore, Keynesian 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 workers.

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 lastingly.

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 cancelled.

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 subsequent upswing.

10th 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 synchronised.

Possible explanatory 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 longer required.

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 positive effects.

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 events:

· release of the exchange rates in the mid-1970s,

· the two oil crises (1973 and 1978),

· the creation of the European single market,

· globalisation in the context of the GATT rounds,

· the reunification,

· the increase in female employment,

· a strong immigration stream immediately prior reunification and

· the tax burden due to the reunification.

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 effects.