Out of Work. Richard K Vedder

      In figure 2.2, the individual chooses to take a new job when the best offered position equals (or exceeds) the reservation wage. It is optimal for the individual to remain unemployed for a duration of OX weeks. Government policies might change the reservation wage. For example, if the unemployed receives generous unemployment benefits, he or she may be more choosy about taking a new job. In the context of figure 2.2, unemployment compensation raises the reservation wage to the dotted line, leading to the optimal employment occurring after a longer duration of unemployment. This raises the reported unemployment rate, as well as the natural rate of unemployment.¹²

      There are still other difficulties with the unemployment definition. Some persons become discouraged after long unemployment spells and stop looking for jobs, even though they certainly would like one. They are dropped from the labor force and no longer classified as unemployed, even though in a meaningful sense they are in fact unemployed. Still other problems deal with part-time work, workers in the “underground economy” not included in the government statistics, and with some welfare recipients in workfare programs.¹³

      Some economists believe that the employment-population ratio is a better measure of job opportunities. Over time, that ratio has tended to rise with increased female labor-force participation. For example, in both 1960 and 1988, the civilian unemployment rate was 5.5 percent. Yet 62.6 percent of the noninstutionalized population over sixteen worked in 1988, compared with but 56.8 percent in 1960. By the unemployment measure, job opportunities were similar in both years, but the employment-population ratio tells a different story.

      While the imperfections of the unemployment statistics are numerous, to some extent they cancel each other out. While the fact that some people temporarily choose to be unemployed leads to some inflation in the unemployment numbers, so the discouraged-worker effect causes some understatement of the problem. In any case, changes in the unemployment rate from year to year should be a pretty good indicator of changes in employment opportunity, even if the exact magnitude of the statistics is incorrect.

       Underconsumptionist and Income-Expenditure Approaches

      The demand for labor services is ultimately derived from the demand for goods and services: labor markets are impacted by product markets. At the same time that modern neoclassical and Austrian economics was evolving at the turn of the century and beyond, a different explanation of business fluctuations and unemployment was put forward. The alternative theory placed most of the blame for declines in business activity on inadequate spending, either consumption or investment. Until the 1930s, these theories were generally dismissed by neoclassical economists as being superficial and mistaken. With John Maynard Keynes’s General Theory of Employment, Interest and Money (1936), however, the underconsumptionist approach rose to a position of dominance among economists.

      Among the pre-Keynesian writers, John Hobson and, at a more popular level, William T. Foster and Waddill Catchings emphasized the importance of demand for products in the maintenance of prosperity.¹⁴ This, in turn, implied that adequate purchasing power was necessary to sustain production and full employment. Implicitly, these writers rejected the classical/neoclassical propositions of Jean Baptiste Say that “supply creates its own demand.”¹⁵

      In his General Theory, Keynes did not actually reject the appropriateness of the simple wage theory as outlined in figure 2.1, but he did reject the notion that reductions in money wages were likely to succeed in restoring full employment. He pointed out that money wages were often rigid, set by contracts, making rapid wage adjustments infeasible. However, even if money wages were somehow reduced, the marginal cost of producing goods would decline, increasing product supply and lowering the prices of goods. Thus, as wages fell prices would likewise fall, causing the demand-for-labor curve to shift to the left, and leaving real wages essentially unchanged. Thus a policy of wage reduction was not likely to be effective in restoring a full employment equilibrium.

      Keynes argued that unemployment can be reduced, however, by stimulating the aggregate demand for goods and services. If, at existing income levels, people increase the amount they wish to spend, this will lead to both increased output of goods and an increased demand for labor. In the context of figure 2.1, the demand-for-labor curve can be shifted rightward by increased demand for goods and services.

      How does one stimulate aggregate demand? By engaging in such fiscal policy actions as increasing levels of government spending or by increasing people’s disposable (after-tax) income by simply lowering taxes. Either increased government expenditures or reduced taxation serves to increase the budget deficit of the government. Thus deficit government financing will stimulate aggregate demand (consumption, investment, government, and net export spending), thus increasing the demand for labor, reducing unemployment.

      In classical and neoclassical economics, saving was viewed as a positive economic act, since the act of saving ultimately stimulated investment by lowering interest rates, and thus enhanced capital formation, productivity, and real output. In Keynesian economics, however, saving took on a negative connotation. Higher saving meant a reduced “propensity to consume,” and with that, a reduced aggregate demand for goods and thus a reduced demand for labor. Surges in consumer saving meant sudden reductions in the aggregate demand for goods, with the initial decrease in consumption (arising from more saving out of a given income) getting multiplied several times as the chain reaction impact of reduced spending spread throughout the economy.

      The stimulus to aggregate demand from deficit-financed government fiscal actions would directly raise the demand for labor, the Keynesians believed. In addition, increased demand for goods would lead to increased prices, particularly in sectors where the economy was already operating near capacity. Higher prices, in turn, other things equal, meant lower real wages. Thus inflation, previously viewed as an evil that reduced the efficiency of the price mechanism as an allocative device, was somewhat virtuous. A generation after Keynes, A. W. Phillips developed the famous Phillips curve which, as modified by others, stated that higher rates of inflation are associated with reduced rates of unemployment.¹⁶

      While Keynes very explicitly discussed the neoclassical approach to unemployment, he nonetheless believed that cyclical fluctuations were largely related to financial and capital markets, not the labor market. Neoclassical economists argued that another key price—the interest rate—could adjust to resolve problems arising from sudden reductions in consumer or investment spending. If people tried to save (not spend) more than businesses wanted to invest for new plant and equipment, a reduction in economic activity would be thwarted by falling interest rates. Keynes argued that was not necessarily so, introducing the concept of the “liquidity trap” where interest