Economics Analysis

Full employment not necessarily the holy grail in a flexible market economy

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Alternative disciplines of economics have long argued against the mainstream that the pathway to perfectly functioning markets does not necessitate full employment, writes Associate Professor Graham White.

IT IS OFTEN said that with ten different economists you get at least ten different opinions. There’s more than a grain of truth in this. Economics is not an "exact science".

But there exists another kind of difference within the economics profession — mostly at the academic level. And this has to do with "fundamental" building blocks — the basics on which complex models are eventually erected and policy prescriptions derived.

These are differences which many within the academic side are at best vaguely aware of, particularly among younger academics. Not least, perhaps, because the study of the history of economic thought is typically regarded as a quaint, relatively unimportant indulgence for a few, though one tolerated at least for now. Regrettably, it appears that tolerance is waning.

Regrettable, because study of the history of economic thought reveals progress in economics not to be one of continuity, where this generation’s work is steady and gradual enlightenment will influence the views of the next generation. It comes instead with significant twists and turns – for some, wrong turns – and a dominant strain, at times, seemingly capable of reinventing the wheel. Thus, for some, the use of the term "science" as applied to economics is pushing the proverbial uphill.

The most profound differences in views about the building blocks might best be illustrated by sharing some thoughts primarily in the area of macroeconomics and specifically about one of its standard topics: unemployment.

Students typically come to approach that topic by starting with the seemingly obvious question: why does unemployment exist? Seems fair enough. (Here, unemployment refers to an environment where there is insufficient work for those willing to work at the current real wage.) But, an alternative starting point might be to ask: why should one expect full employment (the absence of unemployment in the sense defined above), at least over time?

At one level, this difference in starting points seems neither here nor there. Yet for anyone having the history of macroeconomic thought in the back of their mind, the difference would be striking. It is the belief that left to itself, a flexibly-working competitive market economy would deliver a path to full employment that leads one to start by asking why there should be unemployment. And the answer – given by traditional theory – would be in terms of deviations from that “benchmark” flexibly-working competitive case.

A multitude of factors (imperfections and rigidities) – for example, minimum wages laws, unfair dismissal legislation and minimum unemployment benefits – could be a spanner in the works, short-circuiting the path to this benchmark and thus the path to full employment. And these “spanners” need not be limited to the so-called labour market.

Nor need they be inconsistent with optimising individuals, that is, individuals choosing from among alternative actions those which maximise their satisfaction.

This general approach to unemployment is the story long told by economists, since the late 19th Century in fact. Involuntary unemployment was ultimately seen to reflect one or more of a multitude of possible imperfections. To bring it more up to date, the fashionable topic of the “zero lower bound” on monetary policy may be seen as a more recent version of an imperfect explanation — its pedigree, however, is close to 100 years old.

This particular rigidity – a constraint on the ability of central banks to engineer real interest rates to levels consistent with full employment – has enjoyed a resurgence in explanations of stagnating demand in advanced economies post-Global Financial Crisis (GFC) and prior to the pandemic, even justifying fiscal expansion.

However, the alternative starting point – why would one expect full employment? – might be warranted if one takes a fundamentally different perspective on how, at its most flexible, a competitive market economy might work.

This alternative (call it heterodox, for want of a better term) would say that the benchmark competitive model that economists have in mind – sometimes implicit at best – is not up to the task.

Heterodox critics have argued for many years that mainstream theory is unable to tell us how a real economy functioning at its most flexible might, in real time, trace out a path approaching the ideal benchmark of mainstream theory. Heterodox alternatives, buried in the underworld of economics (to borrow a phrase from English economist Keynes), start from a radically different view of how markets would work at their most efficient individually and in combination.

These alternatives have many inspirations. One is the work of 20th-Century-Italian economist Piero Sraffa and the subsequent 60 years of research inspired by it. There is also the work of Keynes in the 1930s and Polish economist Michał Kalecki between the 1930s and 1960s.

Then there’s the Anglo-Italian stream pioneered by economists Joan Robinson, Nicholas Kaldor, Luigi Pasinetti and Pierangelo Garegnani in the 1950s and '60s. Their work has also spawned an ongoing research agenda to the present day.

Differences certainly exist within this broad research stream. But a common denominator is that the development of fundamental building blocks in economics took a wrong turn a long time ago, circa, the 1870s.

Most importantly, the heterodox alternative does not associate fully flexible markets and properly informed economic actors with any necessary path to full employment. Nor is any such link to be found in the work of the most famous of the classical economists, Adam Smith, David Ricardo and critic of political economy Karl Marx.

Heterodox economists have long argued that the connection between fully functioning markets and full employment is a purely “modern” invention — and one based on shaky foundations. Serious criticism of these foundations came to a head in the 1960s.

From a heterodox standpoint, unemployment is not an example of “market failure”. Rather, it’s a normal (though obviously objectionable) characteristic of a fully functioning competitive capitalist economy.

This was the overarching insight Keynes attempted (unsuccessfully) to convince the profession of in the 1930s. Garegnani had highlighted that the criticism of orthodox foundations in the 1960s allowed Keynes’s insight to stand on firmer ground.

In this view, there is no inherent tendency for the amount of employment to adapt itself to the available supply of workers regardless of how well markets work. Any adaptation is more along reverse lines as the labour supply (that is, people seeking work) adapts to the volume of employment available. This kind of adjustment, we know, can show itself in the behaviour of the participation rate.

What’s also remarkable is how this heterodox view changes so many other things (as Keynes also emphasised long ago). Money matters!

The existence of money will change the very nature of outcomes in the real economy produced by a flexible market economy in both the short and long run. Not an easy result to achieve in conventional economics as its history demonstrates. And, relatedly, monetary and fiscal policy can have permanent effects on the economy’s growth path.

Recognition of this would represent a sea-change in conventional thinking. Moreover, no longer need perfectly functioning markets be associated with maximising “welfare” once one dispenses with any hard and fast association of imperfect functioning and unemployment.

To many academic economists, these claims would seem bizarre. Yet, perhaps this is where a lack of serious appreciation of the history of one’s discipline really comes into play.

And a heterodox alternative is not just about macroeconomics.

It would likely proceed along a radically different path to that of the dominant view in how it explains things like relative prices (the price of one good or service relative to another) and the distribution of income between different groups in society — the more traditional yet less fashionable, nowadays, parts of economics.

In doing so, it may well eschew what’s sometimes referred to as the “methodological individualism” that’s long been the underpinning of the economist’s approach to just about everything, including the view that economics is co-extensive with the theory of human choice.  

Arguably the latter has been a driving force in the profession’s quest over many years to cohabit in (or “colonise”, depending on your view) other social sciences.

For some heterodox critics, to require that every economic proposition should be stated in the language of optimising individual agents is neither necessary nor particularly fruitful in explaining relative prices, the working of markets or the analysis of macro phenomena. To be fair, a few orthodox economists have voiced this concern themselves over the years.

Alternatives exist. But progress in the discipline of economics requires more. At the very least it requires opening some minds in a hitherto intolerant mainstream.

Graham White is an associate professor in the School of Economics at the University of Sydney. He teaches macroeconomics and the history of economic thought. You can follow Graham on Twitter @heterodox_econs.

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