Involuntary Unemployment

Michel de Vroey

• Publisher: Routledge
• Year: 2004
• ISBN:
  9781134894000
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The Great Depression of the 1930s with its dramatic unemployment rates was one of the most striking economic events of the past century. It shook economists' beliefs in the existence of self-adjusting forces and prompted Keynes to write his masterwork, The General Theory of Employment, Interest and Money. Involuntary unemployment was the central co

1

INTRODUCTION

The Great Depression of the 1930s was one of the most dramatic economic events of the last century. It shook economists’ belief in the existence of self-adjusting forces and prompted Keynes to write his master-work, The General Theory of Employment, Interest and Money (1936). His aim in this book was to justify the possibility that the economy might be stuck in a state of underemployment, which he qualified as involuntary unemployment and which, he claimed, could be remedied only through state interventions.

A large majority of economists soon rallied to Keynes’ views and praised his enterprise as a success. Nobody objected to the involuntary unemployment concept because, in the wake of the Great Depression, it looked evident that the prevailing mass unemployment was involuntary. It took economists several decades to realise that important stumbling blocks were standing in the way of the integration of this concept into neoclassical theory. At the end of the 1960s and in the 1970s Milton Friedman and, later, Robert Lucas and his new classical colleagues launched a scathing criticism of Keynesian theory bearing on both its conceptual consistency and the efficiency of its policy prescriptions. Involuntary unemployment was not the central target of their attack, yet it became a collateral victim. So-called New Keynesian economists reacted by constructing new involuntary unemployment models built on stronger microfoundations. However, while still claiming that the functioning of the market system could be marred by market failures, they gradually ceased to put the defence of involuntary unemployment on top of the agenda, thereby implicitly giving in to the Lucasian criticism that theoretical conversations would lose nothing by dispensing with it. The aim of my book is to recount and ponder this demise.

Why devote a whole book to a concept that to all appearances has failed? Several justifications can be offered. First of all, the possibility cannot be discounted that, in spite of its present disrepute, involuntary unemployment will return to prominence in the future. Moreover, involuntary unemployment has played a central role in the development of macroeconomics – it was once deemed to be the sine qua non of macroeconomics. Hence its study may constitute a powerful angle of attack for the understanding of the broader evolution of macroeconomics. Finally, this concept has been the object of heated debates, defended and attacked by prominent economists with equal vehemence. Witness the following two quotations from Mancur Olson and Robert Lucas:

There are, of course, large numbers of people who voluntarily choose not to work for pay (such as the voluntarily retired, the idle rich, those who prefer handouts to working at jobs, those who stay at home full time to care for children, and so on) and, given the way unemployment statistics are gathered in the United States and other countries, no doubt some of these show up in the unemployment statistics. Yet common sense and the observations and experiences of literally hundred of millions of people testify that there is also involuntary unemployment and that it is by no means an isolated or rare phenomenon … Only a madman – or an economist with both ‘trained incapacity’ and doctrinal passion – could deny the reality of involuntary unemployment.

(Olson 1982: 195)

Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain … It does not appear possible, even in principle, to classify individual unemployed people as either voluntary or involuntarily unemployed depending on the characteristics of the decision problem they face. One cannot, even conceptually, arrive at a usable definition of full employment as a state in which no involuntary unemployment exists.

(Lucas 1978: 315)

A concept that gives rise to such trenchant views must be of some interest!

To the layperson, the expression ‘involuntary unemployment’ raises no eyebrow. Perhaps the usefulness of the ‘involuntary’ modifier could be questioned because of its redundancy – leaving aside a small proportion of profiteers, unemployment seems involuntary by definition. A philosopher might have a different attitude, realising that a basic philosophical issue, freedom, is hidden behind this modifier – a theme on which Aristotle pondered in his Nichomachean Ethics, on which I will reflect in Chapter 14. Turning to economics, it is clear that theorising involuntary unemployment proved to be more difficult than expected.¹ Is this difficulty due to a defect of economic theory or is it rather that, in spite of its prima facie plausibility, the involuntary unemployment concept is of little use when it comes to economic theory?

Unfortunately, no compelling answer can be given to this question. Let me just point out a few factors that are responsible for the complexity of the problem. First, for better or worse, economic theory is about human choice. It is predicated on the optimising rationality assumption: economic agents are depicted as making constrained optimising choices. The question then arises of how a theory which is premised on such an assumption might be left with non-chosen results. Another factor is that involuntary unemployment was only one element within Keynes’ broader programme. Hence the challenge facing Keynesian authors was not just to demonstrate involuntary unemployment. Such a demonstration had also to prove to be congruent with the other facets of Keynes’ programme. As will be seen, several decades had to pass before involuntary unemployment models saw the light of day, at which juncture it turned out that their success occurred at the expense of other elements of his programme. This in turn raises the question as to whether it is worthwhile to give priority to the involuntary unemployment aim over the others. Finally, involuntary unemployment is a value-laden concept. Most of the authors who have set forth the task of demonstrating it wanted to bring out something deeper, a flaw in the functioning of the capitalist economy. Actually, to them, involuntary unemployment seemed to be the market failure par excellence. Involuntary unemployment thus carries a symbolic charge and constitutes a rallying banner for those who do not believe in laissez-faire. The opposite is true for its opponents, their rejection usually going hand-in-hand with an endorsement of the free market.

In order to disentangle these issues, I will critically examine the different explanations of involuntary unemployment that have been offered, starting with Keynes’ The General Theory and ending with New Keynesian developments up to the end of the 1980s, as well as the criticisms that have been levelled against them. My investigation does not claim to comprehensiveness. Instead of trying to cover the whole range of models that have been proposed, my attention will be limited to seminal contributions.²

Most of my book will follow a historical thread except for the three chapters forming Part I of the book. Written in a retrospective spirit, they pursue the twofold aim of clarifying the concepts that will be used subsequently and of constructing the benchmarks against which my historical analysis will proceed.

In Chapter 2, I compare different definitions of involuntary unemployment and justify my endorsement of the ‘breaching the reservation wage principle’ definition. I also emphasise the need to make a distinction between involuntary unemployment and underemployment. Finally, I bring to the fore the ambiguity of the notion of full employment, of which no less than six different meanings are shown to be possible.

In most of the models that will be surveyed, labour market rationing and involuntary unemployment are considered synonymous. This is also the definitional line that I shall adopt. Chapter 3, ‘From labour rationing to (involuntary) unemployment’, stands as an exception in this respect since it explores the consequences of drawing a distinction between labour rationing and unemployment. That is, labour rationing exists when a given labour market features an excess supply of labour while unemployment refers to the specific activity of job searching. The former can be viewed as a necessary yet insufficient condition for the latter. Hence the need to study agents’ post-rationing trajectories, of which voluntary and involuntary unemployment are two conceivable end-results amongst others. By bringing out the conditions under which labour rationing can result in involuntary unemployment, I show that Lucas’ assertion above as to the impossibility of making sense of the opposition between voluntary and involuntary unemployment can be overturned.

While my work was in progress, I gradually realised that I needed to tackle some broader topics. The first is the working of markets or what, following Clower, I shall call trade technology or trade organisation, i.e. the institutional assumptions that are necessary in order that a logically existing equilibrium may come into effective existence as the result of economic agents’ interactions. The second is the relationship between the Marshallian and the Walrasian approaches, both of them broadly understood as encompassing neo-Marshallian as well as neo-Walrasian models. The standard view is that the Marshallian and the Walrasian approaches are complements, the former being supposedly concerned with partial equilibrium, the latter with general equilibrium. I have been led to question this view and to argue instead that they are alternative research programmes. The models that will be studied can be classified as belonging either to the Walrasian or the Marshallian line. It then occurred to me that the stumbling block impeding the attainment of the involuntary unemployment result were different according to which approach was taken. In short, in the Walrasian framework the obstacle relates to trade organisation, in particular the auctioneer hypothesis, while in the Marshallian approach it lies in the specifically Marshallian perfect information assumption upon which the working of markets rests.

These views are expounded in Chapter 4. I start by drawing the reader’s attention to the difference between centralised and decentralised markets. Although most real-world markets are decentralised, for better or worse, economic theory, be it Marshallian or Walrasian, usually assumes that markets function in a centralised way. An essential feature of the centralised market is that exchanges are confined within well-defined trade rounds. Hicks’ week device, with exchanges taking place exclusively on Mondays, turns out to be the proper time framework both for Marshallian and Walrasian models. Next, I examine the trade organisation assumptions underpinning the Walrasian and Marshallian approaches, a rather easy task for the Walrasian, a more complicated one when it comes to the Marshallian stream. In a further step, I bring out the two stumbling blocks mentioned above. Chapter 4 ends with a critical reflection on the meaning on the notions of rigidity, flexibility and slow adjustment.

Part II investigates Keynes’ attempt to give a foundation to involuntary unemployment in his The General Theory. The purpose of Chapter 5 is to delineate the theoretical project that Keynes set forth in this book. In my reconstruction it comprises four linked objectives: demonstrating the existence of involuntary unemployment; demonstrating that wage rigidity can be exonerated as a cause of the phenomenon; explaining involuntary unemployment in a market interdependency perspective while assuming perfect competition; demonstrating that demand stimulation is its remedy.

Chapter 6 probes into the inaugural chapters of The General Theory. While few works have been as much dissected, I nonetheless believe that I am able to say something original about it. This is due to my following Clower and Leijonhufvud in taking in earnest the premise that The General Theory ought to be read against the background of Marshallian theory. Two main lines of argumentation are developed by Keynes. The first concerns the working of the labour market. Keynes’ claim in this respect is that wage-earners are unable to fix the market-clearing real wage in spite of their ability to fix the nominal wage. Market non-clearing supposedly ensues. Keynes’ second line of argumentation consists of claiming that involuntary unemployment is caused by a deficiency in effective demand. After an in-depth examination of these two claims, I come to the conclusion that neither of them stands up. I also elucidate why the contrary has long been held true. In my view this has to do with the ambiguity of the full employment concept and a confusion between involuntary unemployment and underemployment. Finally, I also consider the claim developed by Keynes in Chapter 19 of The General Theory that the wage-rigidity assumption can be removed without harm for his earlier conclusions, and show that it is flawed. In sum, no valid explanation of involuntary unemployment remains after Keynes’ reasoning errors have been straightened out.

My concern in Part III is the first generation of Keynesian economists. In Chapters 7 and 8, I study the rise of the IS-LM model, Chapter 7 dealing with Hicks, Chapter 8 with Modigliani. My claim in these chapters is that, although Hicks invented the IS-LM model, it is Modigliani who gave it lasting form. In Hicks’ model, involuntary unemployment exists both in the classical and the Keynesian regime, the result of nominal wage rigidity. The contrast between the two regimes is a matter of policy effectiveness. An increase in monetary supply is able to counteract the effects of wage rigidity in the classical regime, yet it fails to do so in the Keynesian regime, due to the preference for liquidity. In contrast, in Modigliani’s model, market clearing prevails in the classical regime while involuntary unemployment, still resulting from wage rigidity, characterises only the Keynesian regime. Money activation is now the proper remedy. Chapter 9 critically examines the contributions of other pioneering Keynesian economists, Lange, Leontief, Tobin, Klein and Hansen. Finally, in Chapter 10, I examine the account of involuntary unemployment to be found in a few macroeconomics textbooks of the 1960s during the heyday of Keynesian economics. I show that these textbooks mark no progress on The General Theory for what concerns the vindication of involuntary unemployment. Their basic flaw is a confusion between underemployment and involuntary unemployment: while macroeconomists were claiming that their models were about involuntary unemployment, their actual object of analysis was underemployment in its most trivial form.

Gradually, the weakness of standard Keynesian theory became better perceived. This led to two distinct developments. First, as I show in Part IV, a few authors, who were initially known under the ‘disequilibrium school’ label, became aware of the need to give Keynesian theory better microfoundations. Chapter 11 examines the pioneering works of Patinkin, Clower and Leijonhufvud, Chapter 12 the models of Barro-Grossman, Drèze, Malinvaud and Benassy. I show that the link between these authors is thinner than usually claimed. Patinkin and Leijonhufvud are criticised on the ground of their willingness to explain involuntary unemployment as the result of slow adjustment, a claim that I have discounted in Chapter 4. The ambiguities of Clower’s celebrated ‘Keynesian Counter-revolution’ article (1965) are brought to the fore, and I show that none of its possible interpretations stand up to scrutiny. As for the authors of the second generation, I endorse Lucas’ criticism that the price rigidity assumption comes on a collision course with the Walrasian trade technology hypothesis. Eventually, the lesson to be drawn from the disequilibrium episode is that Keynes and Walras are indeed incompatible bedfellows.

While the authors studied in Part IV were trying to salvage Keynes, the contrary is true for the other reaction to standard Keynesianism that I study in Part V of the book, entitled ‘The anti-Keynesian offensive’. It arose at the end of the 1960s and the beginning of the 1970s. In a context where the upsurge of stagflation suggested the failure of traditional Keynesian demand-activation policy, economists who did not share the Keynesian viewpoint as to the role of the state in the economy started to become more outspoken and to break away from the earlier existing consensus. Partly responsible for this move was Milton Friedman. His influential 1967 Presidential Address to the American Economic Association, introducing the expectations-augmented Phillips Curve, was a powerful first step in the dismissal of the too-hastily endorsed Phillips Curve apparatus. But the decisive blow was struck by Lucas. In his ground-breaking 1972 ‘Expectations and the Neutrality of Money’ article, he demonstrated the ineffectiveness of monetary policy in a more rigorous way than Friedman. From a broader perspective, Lucas’ blunt view on Keynesian theory was that it was to be disposed of. Macroeconomics, he claimed, needed to abide by the discipline imposed by equilibrium, and to rest on the twin postulates of optimising behaviour and market clearing.

Chapter 11 provides an in-depth – and again, I think, original – analysis of Friedman’s 1967 Presidential Address. I show that it must be read against the background of Marshallian theory to make sense. However, Friedman failed to be a fully consistent Marshallian economist. In particular, his famous notion of the natural rate of unemployment comprises two features which I find contradictory, the ma...