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The Critical Flaw in Keynes's System

Mises Daily: Monday, July 18, 2011 by

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As part of my Mises Academy class Keynes, Krugman, and the Crisis, I have reread large portions of The General Theory. In his masterpiece, Keynes erects an impressive framework on one crucial assumption: left to its own devices, the free market can get stuck in an equilibrium with very high unemployment.

Although Keynes's whole edifice and critique of the "classical economists" rests on this belief, he devotes surprisingly little time to supporting it. In the present article I'll point out the weakness in his view. If it turns out that the free market does naturally move toward full employment in the labor market, then the entire Keynesian "general theory" falls apart.

Keynes's "General" Theory Versus the "Special Case" of the Orthodox Economists

Keynes called his framework a general theory to contrast it with the "special case" handled by the orthodox, free-market economists (whom Keynes somewhat confusingly called the "classical economists"). The analogy here was with the tremendous advancement in physics, where Albert Einstein's relativity theory explained things (such as the behavior of clocks at high velocities) that the classical Newtonian framework couldn't handle. However, Einstein wasn't completely throwing out Isaac Newton, because at low velocities (relative to the speed of light), the equations of relativity "reduced to" the more familiar Newtonian mechanics.

Keynes claimed that there was an analogous situation in economics. While he agreed that the classical economists (as epitomized in the work of David Ricardo and J.B. Say) and their modern disciples had accurately described the principles of income distribution and the tradeoffs between consumption and savings for an economy at full employment, Keynes was offering a more general theory — one that could model the economy even when it was operating well below capacity with "idle resources."

Modern Keynesians believe that one of the crucial contributions of The General Theory was to provide a coherent framework that explained how the economy could be stuck for many years at less than full employment. The "classical" economists believed that a free market would quickly eradicate a glut in the labor market (i.e., a situation of high unemployment), but Keynes apparently showed that their arguments were specious.

If one reads The General Theory cover to cover, this theme is frequently mentioned: The Keynesian system handles the fact that the economy can have varying levels of employment. It won't do to talk of "the" equilibrium rate of investment or saving, because these are endogenous variables that are influenced by the total amount of employment and income. Therefore the classical views on government spending and the function of the interest rate are (allegedly) erroneous. The classical economists falsely focus on the special, limiting case of full employment, while not realizing that their views are wrong, in general.

Therefore, it is absolutely critical to the Keynesian framework that the free market in fact can be stuck at less than full employment for long stretches. For if the classical wisdom of J.B. Say and others is correct — and the economy naturally moves to clear markets and achieve "full output" — then it is the Keynesian policy proposals that will lead to disaster, not the orthodox free-market ones.

Why the Orthodox Economists Thought Unemployment Was Voluntary

In chapter 2, Keynes takes on the twin postulates of the Classical School. The first is that (in a competitive equilibrium) the wage rate equals the marginal product of labor. Keynes has no problem with this.

However, it is the second postulate that causes controversy. It is the claim that (in a competitive equilibrium) the utility of the wage rate will just balance the disutility of labor.

If this second postulate is true, then all unemployment is "voluntary." Workers may be in between jobs, it's true, but they are deliberately withholding their labor, seeking better offers than the ones on the table. They could take a job at the prevailing market wage rate, but they choose not to. Thus, the second postulate is upheld, because the "disutility of labor" (all things considered, including the opportunity cost of ending a job search prematurely) is high enough to offset the advantage of taking a job and earning the market wage rate.

"In the real world, there definitely is 'involuntary unemployment,' but this is due to government, union, and central-bank distortions."

But hold on a second. Surely the orthodox, free-market economists could open their eyes and see that there was widespread unemployment during the early 1930s. Did they really think that this was just a Great Vacation, as some modern critics of Real Business Cycle theory claim of their free-market colleagues?

Keynes thought so, and explained how they could reconcile their "second postulate" with the widespread unemployment staring them in the face:

Is it true that the above categories are comprehensive in view of the fact that the population generally is seldom doing as much work as it would like to do on the basis of the current wage? For, admittedly, more labour would, as a rule, be forthcoming at the existing money-wage if it were demanded. The classical school reconcile this phenomenon with their second postulate by arguing that, while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of 'voluntary' unemployment due to the effects of collective bargaining, etc.

Now we can quibble over how "voluntary" it is if, say, an unemployed person can't get a job because union picketers threaten to beat up any "scabs" who show up at a factory. In any event, the important point is that the orthodox economists thought that widespread unemployment was due to wage rates being held above the market-clearing level. If unions would simply agree to wage reductions, then the quantity demanded for labor would rise, the quantity supplied would fall, and the market would once again be at full employment.

Ah, but Keynes didn't think things were so simple as the naïve classical economists argued.

Why Keynes Thought the Labor Market Could Be Stuck in a Glut

Keynes rejected the notion that, left to its own devices (and without union interference), the labor market would clear, such that anybody who remained unemployed was doing so as a voluntary choice. He had two main arguments, one empirical, and the other theoretical.

First, Keynes thought the workers adhered to "money illusion" (though Keynes thought they had rational justifications for doing so). In other words, workers did not respond merely to the "real" (price-inflation-adjusted) wage rate, but cared about the absolute money (nominal) wages they received in their paychecks:

Now ordinary experience tells us, beyond doubt, that a situation where labour stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods. It is sometimes said that it would be illogical for labour to resist a reduction of money-wages but not to resist a reduction of real wages. For reasons given below … this might not be so illogical as it appears at first; and, as we shall see later, fortunately so. But, whether logical or illogical, experience shows that this is how labour in fact behaves.

This is the standard "sticky wages" argument for monetary inflation: If real wages are too high, so that there is a surplus of labor being offered on the market, then the solution is for real wages to fall. But because workers resist cuts in their nominal money-wages, the only answer is for the central bank to inflate the money supply, driving up prices faster than wages, so that workers end up earning less in real terms.

The problem with such a diagnosis of "the free market" is that money-wages are sticky in large part because of government intervention, including the possibility of central-bank inflation. As I document in my book on the Great Depression, average money wages fell very sharply in the depression of 1920–1921, in contrast to the much more modest decline during the early years of the Great Depression. Perhaps the change was due to enhanced union power, or to Herbert Hoover's pleas with business to maintain wages. Whatever the cause, the "sticky wages" of the first phase of the Great Depression were not inherent to the market economy, because wages were much more flexible a decade earlier.

More generally, government programs such as unemployment benefits obviously give workers an incentive to hold out for better offers before going back to work.

Could Labor Accept Wage Cuts Even If They Wanted to?

Besides his empirical observation that wage earners tend to resist cuts in their money-wages, Keynes provides a more fundamental and theoretical objection to the orthodox view that the labor market can quickly return to full employment with flexible wages:

The classical theory assumes that it is always open to labour to reduce its real wage by accepting a reduction in its money-wage. The postulate that there is a tendency for the real wage to come to equality with the marginal disutility of labour clearly presumes that labour itself is in a position to decide the real wage for which it works, though not the quantity of employment forthcoming at this wage.

The traditional theory maintains, in short, that the wage bargains between the entrepreneurs and the workers determine the real wage; so that, assuming free competition amongst employers and no restrictive combination amongst workers, the latter can, if they wish, bring their real wages into conformity with the marginal disutility of the amount of employment offered by the employers at that wage. If this is not true, then there is no longer any reason to expect a tendency towards equality between the real wage and the marginal disutility of labour.…

Now the assumption that the general level of real wages depends on the money-wage bargains between the employers and the workers is not obviously true. Indeed it is strange that so little attempt should have been made to prove or to refute it. For it is far from being consistent with the general tenor of the classical theory, which has taught us to believe that prices are governed by marginal prime cost in terms of money and that money-wages largely govern marginal prime cost. Thus if money-wages change, one would have expected the classical school to argue that prices would change in almost the same proportion, leaving the real wage and the level of unemployment practically the same as before, any small gain or loss to labour being at the expense or profit of other elements of marginal cost which have been left unaltered.

Before criticizing him, let's be clear what Keynes is saying. Yes, unemployed workers might be willing to take jobs at significant pay cuts (in terms of the absolute dollar amount of the paychecks). Even currently employed workers would have to follow suit, lest they get laid off.

But we can't assume that everything else would remain the same, with the only difference being lower money-wages. Keynes points out that with reduced labor costs, businesses would pass along those savings to their customers in the form of lower prices. Because labor accounts for such a large fraction of total costs, firms might find that just about all of their savings in wages was offset by drops in revenue. Thus, real wages would still be too high, and there would still be too many workers looking for jobs compared to the amount of positions employers wanted to fill.

There are several problems with this analysis. For one thing, labor costs are a large fraction of total expenses, but they are hardly the whole thing. According to this article, labor's share of national income in the United States has varied between 52 and 60 percent in the postwar era.

"Keynes was simply wrong when he argued that the workers didn't have the power to accept lower real wages."

So even if we mechanically assumed that a fall in labor's money-wages would translate into a proportional fall in retail prices, labor would nonetheless have the power to reduce its real wages. For example, if laborers received a cut of 10 percent in their money-wages, then the prices of the goods they produce would only fall between 5 and 6 percent. Labor would be cheaper, even in real terms, and employers would move out along their demand curve and hire more workers.

But there are other problems with Keynes's analysis. Consider: What is the actual mechanism through which falling costs lead to falling retail prices? We start in an initial equilibrium, where workers earn (say) $10 per hour, and the retail good sells for $100. Firms are happy with the number of workers they have employed at $10 per hour, and the amount of goods they can sell at $100 each.

Now, because unemployment is very high, the firms can get away with cutting their workers' pay to $9 per hour. Holding everything else constant, they are making more profit than before. What would induce them to lower their retail price from $100?

The obvious answer is that they want to capture a larger share of the market. That is, they want to sell more units of the retail good to their customers. They can't do this with their original labor force. No, in order to make it profitable to cut their retail price, they need to hire more workers and boost output. Then, in order to move the larger quantity of product, they cut prices from $100 to (say) $98. Even though they make less revenue per unit, they nonetheless make more total profit.

Other firms do the same thing, of course, until the new equilibrium settles down with wage rates at $9 per hour and the retail price at (say) $95 per unit. Thus a large part of the workers' wage cuts have been passed along to the consumers in the form of lower retail prices. Nonetheless, in the new equilibrium, each firm is producing more units, and thus is carrying a larger workforce than before the wage reduction.

One final point: The Keynesian could object to the above analysis by saying, "Murphy, you are overlooking the fact that the customers will reduce their demand for the firm's products, because many of them are workers themselves who are experiencing cuts in their money-wages. If workers go from earning $10 per hour to $9 per hour, then they will have to cut back on their purchases of goods and services. So the firms will need to lower their prices not to expand output, but just to keep sales from dropping."

But this too repeats the mistake of assuming that all customers consist of wage earners. As we've seen, workers (at least in the postwar years in the United States) only earn about 50–60 percent of total income. Capitalists, landowners, and others earn the remaining 40–50 percent. So although it is true that the demand for retail products would fall off from the wage earners, it's also true that (a) the falloff wouldn't be one-for-one with the reduction in wages, and (b) it might even be completely offset because the other groups would see their incomes go up initially.

For example, consider the firms the moment after the workers accept pay cuts from $10 down to $9 per hour. Holding everything else constant, the shareholders of the firms are now reaping extra profit. If they chose to spend their higher incomes on exactly the same items where the wage earners were now cutting back purchases, then the demand for retail goods wouldn't change at all.

More realistically, the shareholders of firms probably would spend their higher incomes on different things. So some industries (yachts, fancy restaurants, capital goods, housing, etc.) would expand, while others (movie theaters, low-scale restaurants, beer industry) would contract.

Someone might object to this change in the distribution of income as immoral or unfair. The point, however, is that Keynes was simply wrong when he argued that the workers didn't have the power to accept lower real wages.

Another consideration is that there are more workers receiving wages once firms expand output. For example, if wages go down from $10 to $9, but total employment rises from 90 million to 100 million wage earners, then labor itself has the same amount of "total income" with which to buy goods and services, so there is no reason to expect a collapse in business revenue.

Conclusion

The entire system of John Maynard Keynes's General Theory rests on the claim that under laissez-faire, the labor market could be stuck in an equilibrium with a large glut, for years on end. But Keynes devoted only a few pages to this proposition. His argument fails on both empirical and theoretical grounds. Absent government intervention, wages and salaries would adjust to clear the labor market. In the real world, there definitely is "involuntary unemployment," but this is due to government, union, and central-bank distortions.