The classical or neoclassical economic models argue that Keynesian views that government-induced increases in economic activity can stimulate aggregate demand are wrong. Suppose the government increases its spending, financed by borrowing. Increased demand for loanable funds would raise interest rates, lowering investment spending. Higher interest rates would also increase savings, lowering consumption. Increases in government spending would be offset by declines in investment and consumption spending, leaving aggregate demand unchanged. Thus demand-side intervention is inherently ineffective.17
Returning to a comparison of the Keynesian and neoclassical perspectives, Keynes never went so far as to say “wages do not matter,” but he implied there was little one could do about wage levels in a policy sense. Later Keynesians increasingly ignored wages or even implied that unemployment was negatively related to wage levels.18 Generally, in the 1950s and 1960s, the subject of wages was seldom even mentioned in discussing the issue of unemployment. Essentially the view had become, “Wages don’t matter,” almost in direct contrast to the neoclassical position that almost said “Wages alone matter.”
Late Twentieth-Century Perspectives on Unemployment
By the middle part of the twentieth century, Keynesian economics was the new orthodoxy, and the wages approach to unemployment determination was all but completely abandoned. As Richard Nixon, a moderately conservative Republican president, is alleged to have said around 1970, “we are all Keynesians now.” Yet beginning in the 1960s a challenge to the Keynesian approach arose as to the cause of economic fluctuations and, by inference, the causes of unemployment.
MONETARISM
Even before the twentieth century, economists were aware that the amount of circulating medium—money—was a factor in determining the level of prices, interest rates, and possibly other important economic phenomena. Roughly simultaneously with the development of both the neoclassical and pre-Keynesian underconsumptionist (demand-oriented) theories of unemployment, the quantity theory of money was more systematically elucidated.19 A more sophisticated and appealing version of the theory gained increasing acceptance in the 1960s and 1970s, largely because of the work of Milton Friedman.20 Adherents of the modern version of the quantity theory were called “monetarists.”
Monetarists believe that the primary cause of economic fluctuations is variations in the supply of money. Over time, they suggest, there is a strong statistical correlation between changes in the stock of money and changes in prices and, when monetary changes are unanticipated, real output. Out of monetarist thinking came still another school of economics in the 1970s, the New Classical school, discussed below.
In some respects, there are similarities between the neoclassicals, the Austrians, and the monetarists. All of them have considerable faith in the ability of markets to correct imbalances. All three groups tend to be skeptical of governmental intervention to right macroeconomic wrongs.
Monetarists, however, like most Keynesians, tend to speak little about labor markets, and usually give little emphasis to the role of wages in unemployment determination. Most monetarists seem to believe that any unemployment-creating wage imbalance likely has its origin in monetary disturbances. For example, a decrease in the supply of money would lower prices and, money wages unchanged, raise real wages, thus aggravating unemployment. Commodity prices are greatly influenced by the supply of money and, other things the same, changing commodity prices mean changing real wages.
EXPECTATIONS AND THE NEW CLASSICAL ECONOMICS
Around 1970, some respected economists, notably Milton Friedman and Edmund Phelps, started to sharply question the long-run efficacy of the prevailing Keynesian/underconsumptionist theory.21 They questioned whether demand stimulus could maintain sustained high-employment levels. They intimated that the negative inflation-unemployment relationship suggested by the Phillips curve was unstable in the short run and nonexistent in the long run.
The evidence from the 1970s supported these and other critics, and a new group of younger economists—the New Classical school—formulated innovative theories that put greater emphasis than previously on the role of expectations. The thrust of these arguments was that government policies designed to stimulate demand would induce behavioral changes among individuals in the private sector, changes that would render the policies ineffective.22
For example, suppose the government announced big spending increases to stimulate aggregate demand or, alternatively, that the Federal Reserve took steps to increase the money supply by creating new bank reserves. Individuals and businesses, sensing the inflationary potential of such policies, would alter their behavior in several ways. Banks would become more concerned about getting paid back their loans in dollars of depreciated purchasing power, and would demand higher interest rates. Thus deficit-financed new government spending would, indirectly, “crowd out” private spending that is sensitive to interest rates. While some proponents of rational expectations disagree with this conclusion, they nonetheless agree that deficit financing would not stimulate aggregate demand because of increased private savings that would mean a lower propensity to consume goods and services by the private sector.23
Also, expansionary federal fiscal (or monetary) policies would lead labor unions to become more militant, demanding larger wage increases. Higher wages, other things equal, would reduce employment (figure 2.1). The demand and employment stimulus of governmental policy, then, if anticipated, would be offset by behavioral modification among the populace. Only if the population were deceived would the policies work.24
In the most extreme form, the new theoretical perspectives evolving in the 1970s and 1980s implied both that cyclical unemployment would not exist for any length of time, and that governmental policies could almost never be effective, even in the short run. Regarding the first point, at least one advocate of the new theoretical approach, in all seriousness, explained away the unemployment of the 1930s as a spontaneous surge in the demand for leisure—involuntary unemployment simply could not exist.25 As Franco Modigliani characterized this interpretation, “What happened to the United States in the 1930s was a severe attack of contagious laziness.”26
It should be pointed out that some of the New Classical economists have exhibited views on the unemployment-wage relationship that is the opposite of that of the original neoclassical/Austrian perspective. For example, when low wages occur, some New Classical economists have argued that workers find leisure less costly in terms of wages foregone, leading them to withdraw from the labor force until wages improve. If actual real wages are less than expected wages, this can lead to labor-force withdrawal. Thus while the New Classical economists are similar to the earlier neoclassical and the Austrian economists in believing that “wages do matter,” they do not adopt the simple view that unemployment is primarily the result of an increase in the relative price of labor.
Other New Classical economists have used other arguments to try to explain unemployment and business cycles. Some have rediscovered Joseph Schumpeter, who argued that fluctuations in the rate of innovation and technological change largely determined business cycles.27 Others have emphasized the unemployment effects of costs associated with sectoral shifts in employment.28
So-called New Keynesian economists turned to microeconomic analysis to question some of the New Classical postulates. Some emphasized wage rigidity.29 Some studies have rediscovered another old hypothesis, namely that firms can maintain labor productivity at high levels by keeping wages high during periods of unemployment; this is the so-called “efficiency wage” argument.30 Others have discussed the stickiness of prices.31 Still others have argued that even with wage and price flexibility, you do not necessarily get economic stability.32
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