What Causes Unemployment?

April 18, 2010

by Jerry O’Driscoll  

Last week, there was a testy exchange between the Editors of the Editorial Page at the Wall Street Journal and the Director of the National Economic Council, Lawrence H. Summers.  On the April 13th Page, the editors quoted Summers from a 1999 essay on the causes of long-term unemployment.  According to Summers 1999, there are two causes: “welfare payments and unemployment insurance.”  

Summers 2010 has a different view and the Journal printed his letter on April 16th in which he accuses the editors citing him “out of context.”  The true cause of the current unemployment is deficient aggregate demand.  Extending unemployment insurance bolsters consumer spending, “thereby contributing to employment.”  

The editors countered with an even more lengthy quotation from Summers’ 1999 essay on the microeconomic causes of long-term employment. They observe, correctly in my view, that Summers’ new theory amounts to the proposition that “pay people for not working, and more people will work!”  And they address a central issue occupying us at TM: whether macroeconomic effects outweigh microeconomic incentives.

It is instructive reading.

15 Responses to “What Causes Unemployment?”

  1. Daniel Kuehn Says:

    I don’t undertand why you call it “a different view”. It seems to me that Summers probably held the same view of the various causes of unemployment in 1999 and 2010. I haven’t seen any evidence that there are two Summers here – a “Summers 2010” and a “Summers 1999”. I’m guessing you know very well that “Summers 1999” accepted the role played by deficient aggregate demand as readily as “Summers 2010” did. What changed wasn’t Larry Summers – what changed was the circumstances. Deficient aggregate demand was largely irrelevant to unemployment in 1999, while it’s very relevant to unemployment in 2010.

    And yet you treat Summers as the inconsistent one here. Why?

    I suppose a better way to frame it is this way: do you really think that the Larry Summers of today rejects the insights of the Larry Summers 1999? I think that’s highly doubtful. All he’s doing is recognizing the different circumstances. Acknowledging multiple causes for economic phenomena that vary in importance over time is hardly a “different view”. It’s a different economy, not a “different view”.

  2. Richard Ebeling Says:

    There is, of course, another possible reason for prolonged and extensive unemployment in society, besides welfare payments and unemployment insurance.

    This reason is: incorrect relative wages. That is, an unwillingness or a delay in appropriate wage adjustment (downwards) in the face of shifts in demand, misdirections of resources caused in a prior inflationary period, or a decrease in the quantity of money, etc.

    It is interesting that even pro-market advocates have, in general, spoken hardly at all about wage (and price) flexibility as market means for re-coordination in the current downturn.

    Some people need to read a bit of W. H. Hutt, I would suggest.

    Richard Ebeling

  3. Zach Says:

    Perhaps this is inappropriate for this forum, but would Dr. Ebeling mind pointing an interested party towards the W.H. Hutt work mentioned above? I only know of his work discussing apartheid and his economic history essays on the industrial revolution. Thanks!

  4. Mario Rizzo Says:

    W.H. Hutt, The Theory of Idle Resources.


  5. Daniel Kuehn should read the exchanges in their entirety. My summary was intended only as an introduction to a very interesting exchange.

    Everyone should decide the substance for themselves. That’s what posts and comments on a blog are about.

    On substance, I do think prolonged unemployment needs to be explained and more seriously than by invoking “aggregate demand.” If you say aggregate demand is insufficient, what would a “sufficient” level be? Otherwise it’s just question-begging.

    I agree with Richard generally, but wages have been pretty flexible in the private sector. As I have commented before, however, wages are being propped up in the public sector (the real goal of “stimulus”). Labor markets in the private sector are bearing a disproportionate amount of the needed adjustment. This is a micro not macro explanation. In that sense, Richard is on the mark.

  6. Richard Ebeling Says:

    For W. H. Hutt, I would recommend his books:

    “The Keynesian Episode” (or the earlier, and longer edition of this same work, “Keynesianism: Retrospect and Prospect.”

    and

    “The Rehabilitation of Say’s Law,”

    besides “The Theory of Idle Resources,” as Mario points out.

    I should warn that Hutt is not always an easy read. He often chose to make up his own terminology, and explain things in a way that requires you to read it twice to really get the message. But . . . it is almost always worth the effort.

    Hutt had been a been a student of Edwin Cannan at the London School of Economics in the 1920s, from whom he learned a great deal.

    I would also recommend Cannan’s book, “Economic Scares” (1933), especially the chapter, “Enough Work for All.”

    Richard Ebeling

  7. Dave Pullin Says:

    I have contrary view. (There’s a shock🙂

    I suggest unemployment is a consequence of a massive market defect.

    Imagine you are the CEO of one of a handful of companies manufacturing robots. The design of the robots took hundreds of years to development and each individual robot took at least 20 years, and sometimes 40 years, to manufacture and tune to full capability. There isn’t the slight chance that you would sell your robots at the price and terms and conditions that companies purchase “people”.

    The reason that layoffs are the first response to a recession is that its so cheap (to the company) to do it. Our buildings are on a 20 year lease with hefty early termination penalties. We bought the specialized manufacturing equipment and there are no buyers for it. But the people are “at-will” employees. We can get rid of people for little or no cost penalty.

    But this is just externalizing the cost.

    A CEO that has invested in manufacturing equipment, has a duty to find business to utilize that equipment to the fullest possible extent. He sees no duty in utilizing the people, because he can externalize the costs of non-utilizing them.

    If the marketing power of the “People Company” could insist that people were bought on 20 year contracts with hefty early termination penalties – like buildings or equipment – then picture for unemployment (at least recession driven unemployment) would be very different.

  8. Daniel Kuehn Says:

    Jerry –
    I did read the exchanges – thanks.

    As for a “sufficient” level of aggregate demand, I’m not sure what reports have come out of the NEC specifically, but the CEA and CBO have been quite explicit about what “sufficient” would consist of.

    I’m still at a loss for understanding why “Summers 1999” an “Summers 2010” represent “different views”. I guess it’s just hard because I personally hold both the 1999 and the 2010 views, and I don’t feel that I hold conflicting views of unemployment.

  9. Mario Rizzo Says:

    A New Keynesian could believe both that the current recession and unemployment are due (largely) to insufficient aggregate demand and that unemployment insurance slows adjustment. Consider this: Suppose the government pumps up demand, in some other way, by an amount equal to the value of the additional unemployment benefits. It could spend more on bridges or whatever. Then we get would get the aggregate demand benefits for employment without creating incentives for workers to have higher reservation wages.

    Keynes himself would have not favored this policy (I think) but New Keynesians could since they accept that labor search affects unemployment rates.

    I believe Summers is a New Keynesian.

  10. Daniel Says:

    Keynes made a point of ridiculing politicians who supported unemployment benefits in the General Theory:

    http://factsandotherstubbornthings.blogspot.com/2010/04/thoughts-from-keynes-and-kuehn-on.html

    His point is slightly different – he’s more concerned about the inconsistency of politicians here, and he doesn’t really delve into the efficacy of UI. But I’ve always thought that was interesting.

  11. Richard Ebeling Says:

    In reply to Dave Pallin’s comment.

    There has been an attempt in Europe to do what you have suggested through the legal and regulatory barriers to discharging workers once employed.

    What has been the consequence? It has been one of the factors making persistently higher levels of unemployment in the EU compared to the U.S., looking over several decades.

    Why? Well, if you make it that more difficult to fire, you reduce the incentive to hire.

    So, your suggestion, rather than reducing unemployment, would likely make it more prolonged and higher in general.

    Richard Ebeling


  12. For me, the exchange is most interesting because it focuses on the clash between micro and macro reasoning. New Keynesians believe they have produced an Heglian synthesis of the two. Instead they have masked two systems of reasoning about the economy.

  13. Dave Pullin Says:

    Richard Ebeling: So government regulation didn’t work, therefore a market solution would not work? I suspect there are few participants in this forum who consider that to be a sequitor. What’s more, European governments have not wholly prevented firms from externalizing the cost. They tax all firms to pay for unemployment benefits rather than charge the firm that chooses layoffs. Therefore the cost of the unemployment benefit does not enter the firm-s layoff-cost-tradeoff.

    Suppose (for the sake of argument) that the real estate market in the US is a acceptable approximation to the free market. Does that mean there are no unutilized lots? There are people in the market waiting for a buyer to come along with the right deal. People build warehouses and office blocks speculatively and they stand empty for some time under a buyer comes along. Markets (even good ones) do not guarantee 100% utilization.

    Economists generally accept there is a level of base unemployment, just like in real estate. (but they don’t know what it is, and the availability of unemployment insurance definitively distorts the statistics.)

    Interestingly real wages have remained flat in the US in the last twenty years or so, but have risen in Europe. If you are selling a good in a market that enables you to get a better price because you have a more even-handed negotiating position you are more likely to wait longer to get a better deal, than if you have no negotiating power and are forced to take whatever you get offered.

    So you may be describing a situation that is better for people even though the unemployment figures are higher.

    It might sound like I’m arguing for “unions” — I am not. I am arguing that a more efficient market in “people” would be better, and that the major inefficiency in the current “market” is the hugely imbalanced power position between employer and employee.

    (Walmart “negotiating with” a Greeter is a graphic illustration).

    “Unions” are an answer in the same sense that Mutually Assured Destruction is an answer to a nuclear threat, or that Federal Govt bulk purchase of health care is an answer to market failure in health care provisioning.

    If free markets are the answer, why not a free market in “people”?


  14. Follow up:

    (1) The Journal printed readers’ letters on the original editorial today.

    (2) There is a lively debate over at Coordination problem on the concept of aggregate demand. I just posted my comments, which also address some issues raised here.

    (3) AT AEI, Kevin Hassett argues that Obama’s economic team is not providing the president good economic advice. Hassett says they have crossed a line, and are engaged in politics rather than policy. Strong stuff and I am only bringing it to readers’ attention.


  15. The reason for unemployment is work remains same. it doesn’t change. work needs to change – and indeed already is changing. It just so happens that a lot of companies are choosing either to ignore this fact, or to try to block it by not allowing social realities to impinge on them.


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