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Why Keynes Was Wrong about Unemployment

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Large-scale unemployment is another name for a surplus in the labor market. Equilibrium is a state which markets will naturally move toward as buyers and sellers look for mutually advantageous exchanges. Firms can always get some value from additional labor, even under pessimistic forecasts of sale prices and quantities. Workers earning zero wages can improve ...

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Large-scale unemployment is another name for a surplus in the labor market. Equilibrium is a state which markets will naturally move toward as buyers and sellers look for mutually advantageous exchanges. Firms can always get some value from additional labor, even under pessimistic forecasts of sale prices and quantities. Workers earning zero wages can improve their situation by accepting a job—even if they do not accept the first offer. Therefore, a labor market in surplus will absorb unemployed labor at a lower wage. When a market is in surplus, the direction the price must go toward equilibrium is down.

Or so it was thought before Keynes. Keynes’s notion of unemployment equilibrium was a break with prior theory, which held that markets clear through price and quantity adjustments. When there is a surplus, a lower price is needed to clear a greater quantity of employment.

Keynes had two contrary arguments. The first, that wages are inherently stuck at a particular monetary value. It is unclear how this value was arrived at in the first place. It may have been a wage that worked during good times. Keynes’s view is that unemployed workers are unwilling to accept a lower nominal wage than they made at their last job. The second was that even if a lower wage would, at first, employ more workers, the lower wage rate would remove so much purchasing power from the labor force that labor would be unable to purchase the increase in output. Business sales would drop off, business firms would have to lay off the workers, and the market would be back in surplus.

The British-Austrian economist William Harold Hutt identified Keynes’s theory of unemployment equilibrium as the most novel and original aspect of his work. Henry Hazlitt’s second law is the observation that everything in Keynes’s General Theory is either unoriginal or untrue.1 From Hazlitt we know that the unemployment equilibrium doctrine is untrue.2

Hutt was a great but underappreciated critic of Keynes. His critique of the New Economics was rooted in two foundations: the first, Say’s law; the second, an appreciation of how a functioning market price system can integrate all useful services into productive use. Hutt took on both of Keynes’s arguments with a powerful rebuttal. Against the claim of wage rigidity, he argued that, to the extent that wages are rigid downward, this was not a natural feature of labor markets. Workers can and do adjust to changes in the demand for their services, not only by accepting lower wages when that is their best option, but also by moving around to better opportunities. This can be a better wage doing the same thing or a change to an industry or line of work where better opportunities lie. The wage rigidity that was a crucial plank of the unemployment doctrine was a particular characteristic of the British economy at the time. The problem had come about due to labor union coercion, which prevented a free labor market from operating. Hutt also drew attention to incentive payments for not working, such as unemployment insurance, which discouraged workers from accepting a wage that businesses were willing to offer. The Babylon Bee explained the same problem in a piece called “Shocking Study Finds Paying People Not to Work Makes People Not Want to Work.”

The words “general theory” appeared in the title of Keynes’s book. Yet his theory was not a generalization of prior economic theory. His ideas applied to the particular institutions that existed in England in the 1930s. His approach to the unemployment problem relied on the fact that while wages could not easily fall, contracts between labor and industry equally prevented them from rising. Consumer price inflation could lower nominal wages in real terms. At a low enough real wage, businesses could hire labor at the contracted nominal wage.

According to Hutt, a better solution would have been to confront the pricing problems directly. The pricing problem was a political problem and the solution lay in that realm. Political leaders, said Hutt, should have explained to the voters the damage to the general good done by the unions, and pushed them to accept realistic wages so that their members could have returned to productive work.

Keynes’s second argument was a backup in case the first one failed. He argued that even if nominal wages could be reduced, that would not alleviate the chronic unemployment. The program of lower wages would fail due to secondary adjustments that would counteract the initial rise in employment. His argument was as follows. Workers spend their wage income in order to demand all goods and services. Lower wage rates would result in lower wages paid in the aggregate. Any initial gains in business profitability from lowering costs would be competed away in the form of lower selling prices for their products. Earning lower wages, workers would have less ability to demand the products that their employers produced and sold. There would be a subsequent fall in business revenues. Businesses would, after a time, have no long-term demand for the new labor. They would have to lay off the newly hired workers. The system would simply chase wages in a downward spiral of reduced purchasing power and reduced employment.

Hutt made several attacks on Keynes’s second argument. The first is that even at a lower wage, aggregate wages paid could well increase. An increased volume of employment, which is a larger number, multiplied by at a lower wage, a smaller number, could be more, and will be if small wage cuts result in a large amount of demand at that price.3 The average wage will rise if the unemployed workers are included with a wage of “zero” when calculating the average before the wages were reduced.4 Hutt also turned the inflationist argument against Keynesians. They suggested that only a bit of inflation would do the job. If only a small amount of inflation was necessary to bring the unemployed back to work, Hutt observed, then only small cuts in nominal wages should do the same.

Hutt quotes from The General Theory, “[T]here is, as a rule, no means of securing a simultaneous and equal reduction of money wages in all industries.” Hutt criticized Keynes’s model for treating the labor market as if it were a single market with a single wage.

Through thus thinking rather uncritically about aggregates, Keynes appears to have assumed that wage-rate reductions imply reduction of aggregate earnings, irrespective of whether the labor price which is cut is of workers in an exclusive well-paid trade, or that of workers in suboptimal pursuits, doing poorly paid work because they were excluded from well-paid opportunities.5

Hutt hammers on the point that there are as many wages as there are types of labor. Workers, and therefore wages, differ by industry, by geography, by skill, and by season. Only those particular niches in which there is a surplus of supply might need reductions in wages in order to clear. Other markets may stay the same or in some cases wages could increase alongside falling wages elsewhere. Hutt observed that “what is usually needed is not a blanket change in relative price-cost relationships such as is achieved through unanticipated inflation, but a mass of individual adjustments.”6

The core fallacy in Keynes’s second argument, according to Hutt, was his failure to take Say’s law into account. This law is the observation that individuals demand one thing through the supply of another. Whenever a producer brings supply to the market, they also demand in a different form, another good. He applied Say’s law to the process of reemployment. As the unemployed workers in certain industries rejoin the workforce, they produce. As their production is supplied to the market, they regain their ability to demand other goods and services produced by other industries. The point that Keynes missed in his vicious downward spiral was that the increase in production following from the lower wage per worker results in more supply of goods. Hutt agreed that there is a feedback cycle, but it works differently than Keynes explained. One of the factors driving wages down was the depressed condition of the economy, which—ironically—was caused in part by politically induced wage rigidity.7 When more goods are produced, the prices of goods fall. Workers can buy more with the same wage or buy the same amount with a lower wage. Overall lower prices for goods mean a higher average real wage for everyone.

Hutt traced the operation of Say’s law across different sectors. He pointed out that an increase in the demand for carpenters will not—in the main—come from a fall in the wages of carpenters. (For this example to work, it is not even necessary that there exist much unemployment in carpentry). The major part of the increase in the demand for carpenters will come from the other industries in which the wage reductions had the greatest impact on increasing employment. The workers in those areas—through their employment—become producers, and therefore suppliers, and by Say’s law demanders of other, noncompeting goods and services, carpentry included.

This illustrates the circularity in Keynes’s reasoning. The General Theory contained a refutation of Say’s law based on the incorrect thesis that it only worked when all resources were fully employed.8 There is nothing in Say’s law that is specific to full employment or lack of employment. Why should it only work in some cases and not others? Keynes advances two main arguments to prove his point, with unemployment equilibrium being one.9 Yet his argument for unemployment equilibrium already depends on ignoring the effects of Say’s law.

The fallacy of price adjustments being self-frustrating was the foundation on which the “new economics” was built.10 Would we have had a Keynesian revolution without it? According to Hutt this was both the most critical novelty of Keynes, and the first part of the Keynesian edifice to fall to hostile attacks. Hutt, who was active in the field during the ’40s and following Keynes’s death, reports that the unemployment equilibrium thesis was quickly discarded.11 And yet “Keynes’ sophisticated theory of unemployment equilibrium set the greater part of the academic world of economists on a false trail.”

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