Month: December 2012

Failure of the neoclassical synthesis-Long term unemployment

Despite enormously high deficits,  apocalyptic C.A.D levels and mountains public debt, western democracies by and large are still finding themselves in the midst of sluggish growth rates, high unemployment and record levels of income inequality. The U.S public debt levels have been steadily growing, with notable periods of exception, since the advent of fiat money allowed politicians to effectively spend indefinitely (or so they thought)­­ creating money out of thin air. With over 9 trillion dollars artificially circulating in the economy the problems still remain. How is it that even the most vigorous stimulus programs have failed to see noticeable gains in economic growth since the early 1970’s? Surely, with Keynesian logic, we should have seen exponential levels of growth accompanying the public debt. Instead we have seen incrementing deficits and lacklustre growth.

I do not claim to have all (or even any) answers to these problems. I am writing out of the desire to expand my thought and network with others who are passionate about these issues. I am hoping that by exploring these ideas online in a blogging format, I can start a dialogue and prematurely avoid the mistakes that come alongside solitary thinking, and if I get good responses, I will also translate the blogs into Spanish. (As was the motivation of John Maynard Keynes when he wrote ‘The General Theory of Employment, Interest and Money’). In my intended exploration of the failure of current employment theory, I am going to briefly go through the orthodox theories that have encapsulated economics over the past century, and analyse them one by one.

In classical economics, or supply side theory (according to Keynes), a recession cannot logically exist. The logic here is that basically in Say’s law, supply creates its own demand (Again, the definition has been changed, but this was Keynes’ interpretation). There is no such thing as diminishing returns, or levels of production efficiency, and an economy should constantly experience full employment levels (the only unemployment being voluntary and frictional). When demand falls, there will be excess supply, and so, prices as a result will fall until supply matches demand (In basic macroeconomics, lower prices increase demand for an individual item, this is one of the fundamental economic propositions). This can be applied to labour markets, so that when there is high unemployment (In Keynesian jargon- high factor cost competition), there is an excess supply of labour; therefore wages will fall, and businesses will be able to cut the wages of their employees, and lower the cost of their product assuming the industry isn’t monopolised. From here, production costs are lower, and demand is restored, so the employment should start to rise again straight away, and no recession should occur because prices and wages are flexible.

(Please note this is the cynical Keynesian version of the theory, if any Neoliberals out there could correct my interpretation of the classical theory, please do!!)

Keynes’ theory on the other hand, accepts many of these assumptions but refutes the idea that wages and prices are flexible. In Keynesian thought, wages and prices are “sticky” due to a host of external political factors, such as the influence of trade unions, wage agreements and reluctance of businesses to lower prices enormously and witness immediate losses. As a result, the only way for businesses to reach efficient levels of production to meet the decreased demand is to cut employment levels until the workers and businesses accept lower wages and prices respectively. Therefore the duration of a recession depends upon the flexibility of the system.

This may all seem quite intuitive but the modern textbooks have acknowledged a problem, that the ‘neoclassical synthesis’ addresses. In demand-side economics, as opposed to supply-side, the problem is low aggregate demand and insufficient sales. The problem stems from the fact that the initial problem is low aggregate demand. If wages fall to increase supply, demand is not likely to increase, and may fall. How are lower wages across all sectors going lead to increased consumption?! The only compensating factor will be increased profits for the firm. Prices also work differently than is thought at first sight. Whilst lower prices lead to increased demand in individual sectors and firms, lower aggregate prices could react differently. There is no alternative for lower/higher consumption patterns when price changes are universal and so demand again will not be restored disproportionately. Where the neoclassical synthesis comes in is next, and it is a little hard to summarize but basically, the higher utility of the currency leads to smaller demand for cash in hand, since the same product can be purchased with less physical money. As a result there is less demand for currency and so the ‘price’ falls. The price of money is the interest rate. This encourages increased borrowing and investment, stimulating growth. Another accompanying factor is a psychological “wealth effect”. Whereby the relative return on assets becomes more valuable and so consumption temporarily increases because people feel they are wealthier, although this is offset by something else which I am about to raise, and has not been addressed by orthodox thinkers. With these theories considered, long term unemployment should not occur, even in highly debt ridden countries such as Japan. How then, have these countries managed to muck up their growth prospects so much?

Well, one of the most important effects of wage adjustment has simply been ignored by politicians internationally; and a number of economists (Both Peter Schiff monetarily and Paul Krugman fiscally) also fail to see these effects that destabilise the economic environment and lead to hampered long term growth. Indeed, it appears the only institutions that have embraced the theory wholeheartedly are the central banks of the world, especially the Federal Reserve. The ignored effects are the ones of deflation, or more accurately in the modern economic environment, disinflation (Lower than expected levels of inflation, not falling into deflation). With disinflation, people are earning less than they normally would, but their debts have remained constant. This leads to an opposite effect to that of a ‘wealth effect’; only the effects are permanent if the economy does not return to pre-recession levels of inflation, or reduce debt levels substantially. The borrowers will often reduce borrowing and spending as a result of disinflation making debts more burdensome, or close down their enterprises, whilst lenders may also be less inclined to loan funds due to the riskier return rates (The ‘too-big-to-fail’ policies will reduce this lending tendency, but cause even worse problems down the line which I will address in another blog article). This factor helps to explain in macroeconomic terms, why countries heavily involved in credit activities have had slowing recovery rates over the past 40 years, and why constrained aggregate demand seems so persistent in many areas of the Western world despite policies designed to remedy it. Employment rates if this theory is correct, will be largely dependent upon the credit composition of an economy.

Evidence can be seen in the lacklustre stimulus performance of Japan in the past 2 decades, despite all efforts to ramp up activity; and also in the sluggish recovery of the USA and Southern Europe right now. If these factors are taken into account, it appears the European fiscal policies are ahead of those in the USA, putting long-term growth ahead of short-term viability, but it is unfortunate that it requires the bust on sovereign debt to have been so severe before proper action to reduce the deficit is taken. Monetary-base expansion (As proposed in Japan by Paul Krugman) could be another way to reduce the burden of disinflation, and explains why the short-term inflationary policies of the Federal Reserve may actually be working in the medium-long term (SHOCK!), that is not to say we should advocate Central Banking monetary policy on the whole, but rather give Bernanke a little credit for understanding the effects of disinflation on a heavily indebted country. The mixture of fiscal austerity, with monetary expansion seems very unpopular and indeed counter intuitive, but if debt has a significant impact upon employment levels, as many well known economists believe, action must be taken in both monetary and fiscal policy to reduce it.

Sovereigns and international leaders alike need to completely reform their frame for economic policies and look even further into monetary economics (and all social science fields) if we want to see real and sustainable global development. The neoclassical synthesis has historically failed its adherents, and economists need to start looking at the economy as an aggregate again, and not focus solely on labour markets. Macroeconomics requires subtle analysis of the economy as a whole and her components, we have lost touch with it, and we need to find it again if we seriously expect and desire sustainable global development.