The ECB had another lavish annual talkfest in Portugal over the weekend just gone in the guise of their – Forum on Central Banking. Like all these EU-type gatherings there was plenty of fine food and wines. They even provided footage along those lines. The President of the ECB Mario Draghi gave the opening speech – href=”http://www.ecb.europa.eu/press/key/date/2015/html/sp150522.en.html”>Structural reforms, inflation and monetary policy – on May 22, 2015. There was also talk about how “structural and cyclical policies … are heavily interdependent” but then a denial of the same. The message from the President was like a record stuck on the turntable – “to accelerate structural reforms in Europe … even in a weak demand environment”. Well here is my message – similarly like a stuck record – structural imbalances occur because of weak demand and the best time to assess structural policy is when you have first attained full employment by appropriate setting of fiscal deficits, not before. It is madness to deliberately constrain fiscal balances to levels that ensure high and entrenched unemployment and rising underemployment and then expect citizens to support microeconomic policies that further undermine their welfare and damage what job security they have. But that is the EU way and that is why the Eurozone is a massive basket-case failure.
I recently wrote about issues germane to the President’s speech in this blog – Demand and supply interdependence – stimulus wins, austerity fails.
I talked about the term ‘hysteresis’ in that blog, which was a topic of my PhD and early academic publications in the 1980s (that long ago).
In the spirit of the cracked record, mainstream economics literature (text books, most of the New Keynesian models etc), which dominates the academy and the policy makers, considers the supply-side of the economy to be independent of the demand-side. The main models used in textbooks and policy advice continue to cast the supply-side of the economy as following a long-run trajectory which is independent of where the economy is at any point in time in terms of actual demand and activity.
What does that mean in English? Simply, that the path the economy takes is ultimately dependent on the growth in capital stock (physical and human) and population and the spending side of the economy will typically adjust through price flexibility. In other words, it doesn’t really matter if spending falls below the level required to fully engage the productive capacity of the economy at some point in time.
There will be temporary deviations from the potential growth path but soon enough, market adjustments (price and income shifts) will restore the level of spending (for example, prices fall and consumers spend more, which, in turn, stimulates more private investment spending etc). But the supply-side momemtum continues – and that defines the growth path of the economy.
Mario Draghi stated that:
Structural reforms are … policies that permanently and positively alter the supply-side of the economy … they lift the path of potential output, either by raising the inputs to production – the supply and quality of labour and the amount of capital per worker – or by ensuring that those inputs are used more efficiently …
He believes these reforms “will often increase both short-term flexibility and long-term growth” and reduce “hysteresis effects” because he thinks they allow an economy to rebound “faster after a shock”.
His depiction is classic neo-classical textbook dreamland sort of stuff. He thinks if an economy is rendered “resilient” it will react to a “negative demand shock … by immediately lowering prices” and avoid unemployment.
The standard neoclassical textbook analysis of the labour market, which dominates the public debate when it comes to discussions about unemployment, welfare payments, the impact of taxation etc, makes no distinction between exchanges between labour and capital and the use by firms of other productive inputs.
Many years ago, the then Economics editor of The Financial Times, Samuel Brittain made this statement, which reflects the viewpoint still held by most economists today:
If the price of bananas is kept too high in relation to the price required to balance supply and demand there will be a surplus of bananas. If the price of bananas is below the market clearing price there will be a shortage. The same applies to labour. If the price – i.e. the wage – is too high there will be a surplus of workers, i.e. unemployment. If it is kept too low there will be a shortage of workers … Workers do sell their services just as banana producers sell their bananas.
In other words, they explain mass unemployment by excessive real wages. If the workers are willing to accept lower money wage when their is a decline in total spending in the economy then according to this view, the real wage will fall and firms will not reduce employment.
This debate was settled (against the neo-classical view) in the 1930s during the Great Depression. Is is amazing how false ideas have persisted for so long (or more accurately, returned to dominance) after being so categorically debunked 80 or so years ago.
Please read my series – Keynes and the Classics – to learn more about why this neo-classical view is erroneous.
- Keynes and the Classics – Part 1
- Keynes and the Classics – Part 2
- Keynes and the Classics – Part 3
- Keynes and the Classics – Part 4
- Keynes and the Classics – Part 5
- Keynes and the Classics Part 6
- Keynes and the Classics Part 7
- Keynes and the Classics Part 8
- Keynes and the Classics Part 9
Keynes noted that even if real wage flexibility was possible, the economy could still tend to and persist in a state of mass unemployment. In other words, he sought to demonstrate that the existence of mass unemployment was not related to whether real wages were flexible or not.
Keynes ultimately showed that the real wage and total employment level were not determined in the labour market but by the level of effective demand, which we take to mean (loosely) total spending on goods and services.
All that is agreed on in labour markets, no matter how flexible they are is the money wage. To argue that unemployment is voluntary and can be solved by a reduction in the real wage assumes that workers have volition and can engineer the appropriate real wage cut by accepting lower money wages.
Keynes showed that even if workers agreed to money wage cuts in the face of falling demand, it is likely to lower prices because marginal costs would be lower (ignoring shifts in productivity due to issues relating to workforce morale).
Imagine that money wages fell by 5 per cent and the price level fell by 5 per cent, then the real wage would be unchanged. This was the basis of Keynes’ argument.
He wrote that the idea that money wage cuts would lead to real wage cuts was:
… 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.
Moreover, the Classical theory of employment focused on only one aspect of money wages – that they were a cost of production and influenced the supply-side of th economy. However, Keynes noted that money wages were also a significant component of a worker’s income and by aggregation, national income.
Given that consumption spending was directly tied to national income and investment spending was also likely to fall, if consumption spending fell, Keynes argued that the demand curves (at the firm, industry and aggregate) level would shift inwards (spending at each price level would be lower) after a money wage cut.
While firms might enjoy lower unit costs they also faced a declining demand for their goods, in general, because the lost income resulting from an economy-wide money wage cut would be significant.
This insight means that the output demand and supply curves are interdependent. So while costs might be lower so will be total spending and it is likely that the latter effect overrides the former – meaning that economic activity declines.
What about the impact of the falling prices, which is Draghi’s path to adjustment. When the neo-classical economists realised they had been backed into an illogical corner by Keynes (and Marx before him by the way), they resorted to the so-called Pigou effect, after the British economist Arthur Pigou.
This effect is also referred to more generally as the real balance effect or the wealth effect.
When Keynes attacked the Classical employment theory he noted that cutting money wages would not likely lead to a fall in real wages because competition would also drive prices down, given that firms now enjoyed lower unit costs, assuming productivity did not fall due to low morale brought about by the money wage decline.
Reluctantly, the Classical economists in the 1930s, which had recommended money wage cuts as the way to engineer the real wage cuts they considered necessary to restore labour market equilibrium, as per the Classical model of the labour market, were forced to acknowledge that if money wages were cut and prices followed the cost reductions, then the real wage might not fall at all. It was possible the real wage could even rise if the fall in money wages was less than the fall in prices.
However, Arthur Pigou responded in a famous 1943 article with a proposed solution to the problem of the economy being stuck in an unemployment impasse. He argued that real consumption spending was also a positive function of the stock of real wealth that individuals possessed. This wealth was held (in nominal terms) in the form of money balances and other financial assets such as government bonds.
Thus, even if a fall in money wages leads to a equivalent percentage fall in the price level, leaving the real wage unchanged, the lower prices would increase the real wealth of all those who were holding nominal wealth balances. So all wealth holders would feel richer as a consequence and it was argued would thus increase real consumption at each level of income.
The increase in real balances at lower prices thus gave proponents of the the Classical employment theory another conduit through which money wage falls could stimulate employment, in the event that real wages did not move.
In other words, the inverse relationship between money wages and employment was restored by this real balance effect.
It was pointed out that borrowers would feel poorer when prices fell, because the real value of their debt burdens would rise and, using the same logic, this would lead to a reduction in real consumption at each level of income. To some extent this would offset the stimulus that the debt holders might impart.
If most of the debt was in the form of government bonds, then the net effect would probably be larger than if private lenders had provided the majority of the debt held.
Thus, when money wages are very low, US economist Sydney Weintraub wrote that:
… those owning “pennies” become “millionaires” – a calamitous prospect! – full employment may well be assured.
In the real world, if prices fell so low that a real balance effect of any significant size was generated, then it is likely that the entire banking system would collapse because while the nominal liabilities held by the banks would not be altered, their real values would rise by so much as to bankrupt most of their borrowers. The mass defaults would, in turn, cripple the financial system.
The empirical evidence is that in normal price movement ranges, the measured real balance or wealth effect is very small and clearly insufficient to remedy a major shortfall in aggregate demand. So while the Pigou effect presents a logical possibility it did not provide the Classical employment theory with the response it required to negate the damaging critique made by Keynes.
Draghi’s flexible economy would not save the Eurozone from the massive rise in unemployment it has endured. The reason for the mass unemployment in the monetary union is all down to the failure of demand and that has been exacerbated by the fiscal austerity.
There is no escaping that conclusion. They can skate around it for all they like while sipping the wine and expanding their waistlines at sumptuous talkfest gatherings but until aggregate spending across the monetary union increases, nothing will be gained by hacking into wage and employment conditions other than further worker impoverishment.
Draghi claimed that:
Labour and product market rigidities contributed to a more painful adjustment process in the stressed economies, which was initially driven more by compression of demand than by a reduction of costs relative to other economies, albeit with differences across countries based on their initial degree of flexibility … As a result, we now face a situation of significant divergence in unemployment across the euro area.
No, the reason unemployment rose at differential rates across the Eurozone was because the spending collapse was not symmetric. The maintenance of the unemployment disparities is due to the uneven nature of the fiscal austerity that has been imposed on the nations.
Greece could have been at full employment now if the Government had have been allowed to fund a Job Guarantee program with increased fiscal deficits and the ECB had have ensured the deficits were funded. No question about that.
To say otherwise and try to divert the blame onto “rigidities” is to avoid facing up to being part of the policy failure.
He also specifically addressed the issue of “Structural reform in a fragile demand environment” and concluded that:
… the earlier they take place, the better.
But then he admits that there “is some empirical foundation” to arguments that say that introducing structural reforms (like cutting wages and income support, etc) when the economy is already is a weak state because of deficient total spending will further reduce economic activity and employment and push up unemployment.
The flow-on effects such as “depressed housing market would also exacerbate these effects by hindering geographical mobility and the reallocation of resources.”
But that “empirical foundation” doesn’t deter his ideological zeal. He claims that as long as the structural reforms are “credible” they will boost growth through thereir impact on “confidence”.
Which is a derivative of the fiscal contraction expansion argument that has so categorically failed in the recent crisis.
According to Draghi, even if the economy is depressed, investors will jump to build new factories and buy productive equipment if policy makers signal they will make labour markets more flexible (increase the proportion of non-standard work, make it easier to sack workers, undermine income support systems to make workers more desperate etc).
And pigs might fly!
Firms will not invest unless they have a firm expectation that the extra output that would be produced from the extra capacity they build will sell. Undermining the ability of consumers to spend more freely will not engender positive expectations.
Draghi also thinks that by raising the minimum retirement age, workers will respond by spending more because they no longer have to save as much as they are working longer.
This is as fanciful as saying that workers will reduce saving if fiscal deficits are lower because their fear of higher future taxes will be alleviated.
If there is a recessed economy and unemployment is rising and firms are rationing hours of work and creating underemployment, a further deterioration in working conditions for those who retain incomes will not help them save.
The structural changes that have been encouraged by the likes of Draghi over the last few decades have been disastrous for economic growth.
We dealt with some of that in yesterday’s blog – The rise of non-standard work undermines growth and increases inequality
The other startling thing to emerge from the ECB Forum in Portugal was the latest projections by the ECB models of the ‘full employment unemployment rate’.
The article in the Financial Times (May 24, 2015) – Will eurozone ever regain its spring? – notes that:
According to their latest projections, the ECB’s economists think that even when the region’s cyclical recovery is complete and demand has returned to full strength, unemployment will still be 10 per cent … unemployment will remain well into double digits in economies such as Spain and Italy.
And presumably well into the 20 per cent range in Greece.
Which makes a total mockery of the term “economic modelling”. I could model the Eurozone with realistic policy changes – increased deficits, targetted job creation programs, that would see full employment with unemployment rates everywhere well below 5 per cent.
Which brings me to the latest offering by Greek Syriza central committee member Stathis Kouvelakis (May 22, 2015) – The Impossible “Honorable Compromise”.
He is commenting on the “much in vogue” claim that Syriza is going to come to an “honourable compromise” with the Troika. In relation to that, he writes:
Needless to say that, on the part of Syriza, this discursive slippage amounts to an abandonment of the objective of the break with the memoranda and the troika rule on the basis of which it won the elections.
That much is obvious to date.
But he helps us understand the mindset of Draghi and his co-conspirators in the Troika.
To put it somewhat differently: it is precisely because “compromise” under present conditions is in practical terms impossible, that its compulsive evocation obscures the actual issues, depoliticizing and presenting them as a clash of ethical preferences: “realists” vs. “hardliners,” “pragmatists” vs. “utopians,” and so on.
What is actually reflected in the current discursive struggle is that “honorable compromise” is not possible because the prerequisites for it do exist. The stronger party, the European Union, is not interested in compromise but only in administering humiliation, which by definition entails dishonor.
Because during the full employment era after the Second World War, which was the “only period in history when capitalism, in the countries of the ‘world center,’ functioned on the basis of a class compromise” because social democratic political parties fought hard to establish the role of government as a class mediator – to provide workers with some power against the capital monolith.
Even though the capitalists hated the idea of full employment, it worked to produce a environment where profits could be realised while workers enjoyed secure jobs and real wage gains.
But the profits didn’t satisfy the greed of capital.
And so the “neoliberal counterrevolution” began, first in 1973 in Chile when the US backed junta overthrew Salvadore Allende’s democratically-elected government and hired the University of Chicago Freidmanite economists to design and implement the sort of structural reforms that Draghi advocates.
As Kouvelakis notes this counterrevolution “scattered all the above to the four winds” where all of the above was the social democratic class compromise.
The result is that:
The balance of forces that had sustained the postwar class compromise was crushingly overturned to the advantage of capital … The shock therapy applied to Greece over the past five years is nothing more than a radical (by the standards of a Western European country) version of this same neoliberal counterrevolution. Those who embody it, inside and outside the country, are executors of an operation of plundering and naked subjection. They are at once violent and vulgar, the antithesis of the type that would seek compromise. In those conditions only the action of the oppressed can open up a perspective of political, social, and ethical regeneration.
Which is why Draghi keeps harping on the need for structural reform. It is just code for further entrenching the grip that capital has on economies and furthering the subjugation of the workers to the needs of the financial capital elites.
It has nothing at all to do with the well-being of the population.
A sensible structural reform right now would be a massive investment in public education and health in the Eurozone. Investment in the capacity of people is the most enduring outlay a society can make.
That would require substantial increases in fiscal deficits at the moment given how weak the economies are.
Would Draghi fund that? How does he justify having youth unemployment rates over 50 per cent given the intergenerational consequences of that wastage now will be massive? Much more than whether trains run on time or there are too many workers cleaning the parks!
It is an on-going matter of public education to arm the populace with counter-arguments and knowledge to debunk the likes of Mario Draghi.
I would also propose linking his salary and pension benefits to the unemployment rate in Greece. He would soon be advocating job creation and fiscal expansion in that nation.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.