What is Structural Unemployment?

So in my previous post, Classical Vs. Keynesian Assumptions: An Introduction, I talked about how the Classical and Keynesian schools of macroeconomic thought differ in terms of basic assumptions. 

One of these critical assumptions is the assumption of “Full Employment”. But before we dissect full employment, I want to talk about “Structural Unemployment”. Why I’m doing this will become clear as you the read the next couple of posts. 

Structural Unemployment is the type of unemployment that occurs when there is a gap/ mismatch/ incompatibility between the skills required for the available jobs and the skillset of the unemployed. 

Structural Unemployment is not what we call Demand side unemployment or Cyclical unemployment, because it doesn’t occur due to a lack of aggregate demand in the economy. For instance, the high unemployment rates (8-10%) witnessed in the US during the 2007-09 recession were primarily due to a deficiency in demand and not due to structural causes. People cut spending when their home values crashed and/or they were laid off and demand dropped sharply. This led to further lay-offs and so on. 

Structural Unemployment is a type of Supply side unemployment which means that it occurs due to changes on the supply side of the economy. More specifically, due to the fact that the skillset of the unemployed (the supply of labour) doesn’t fulfill the skill requirement for the available jobs (the demand for labour). So even though there are jobs, the unemployed are unable to get them.

Let's use a couple of examples to clarify this concept.

Move towards Online Retailing - an Example from India

A strong move towards Online Retailing is happening in India. Rapid revenue growth for online marketplaces such as Flipkart (grew revenues ~3x between FY13 and FY15) and Amazon India (revs grew 6x y-y to ~Rs 1,000 crore in FY15) is testament to this fact.

This is a structural change in the economy. The supply of goods and even services is increasingly being provided online as this cuts down costs for the providers and also allows them to access a geographically diverse set of customers. Brick and mortar stores/showrooms are being trimmed. As a result, sales and other staff employed by these (offline) outlets is being retrenched. The unemployment faced by these retail workers is “structural”. 

In order to be absorbed into the new online retail format, this workforce will have to acquire different skills/be retrained. For instance, they may need to improve their English communication abilities so that they can work in the call centres run by the new e-commerce firms. Alternatively, they may need to acquire the IT skills needed to manage the online infrastructure of these firms. 

Loss of American Manufacturing Jobs - the Poster Child Example for Structural Unemployment

So this example is hard to escape when one starts talking about Structural Unemployment, thanks to the Trump election propaganda regarding manufacturing, China and NAFTA. 

It is true that manufacturing jobs in America have fallen over the decades. From ~20M jobs in 1980, they’ve fallen to ~12M today. Trump has blamed this on China and Trade agreements such as NAFTA. It’s true that the relocation of manufacturing plants to low-cost locations such as China, Mexico, Indonesia etc. has cost America jobs, but where Trump is wrong is when he forgets to talk about automation/technology which shares significant blame for the loss of jobs in manufacturing. 

Also, Trade agreements such as NAFTA have hurt some workers for sure, but the growth in cheaper imports from Mexico would have happened anyway whether NAFTA was signed or not. Why? Because the movement of factories to low-cost locations such as Mexico is an unstoppable structural change that was bound to happen, irrespective of NAFTA. 

These unemployed manufacturing workers in America were/are a poster child example of the “structurally unemployed”. To be absorbed back into the workforce, many have had to retrain themselves in other disciplines. 

(For those interested in reading more about why Trump is wrong about NAFTA, please read my post by the same name, Why Trump is Wrong About NAFTA ;)

Technology is the main Driver of Structural Unemployment across the Globe - a Look at the Indian IT Industry 

Technology is the largest killer of jobs globally. Machines/computers have reduced/eliminated the need for human intervention in many production and service oriented processes. While the ways in which technology kills jobs in manufacturing, retail and service industries are obvious, I want to talk about the much-discussed, technology-driven job losses happening in the Indian IT industry and how these are leading to structural unemployment.

Majority of the workforce employed in the IT industry in India does jobs that can be automated. Infact, global customers have started using technologies such as artificial intelligence and big data analytics to elimated the need for IT workers.

For illustration, lets take the job of an IT worker in India (working for a foreign client) which mainly involves maintaining software by plugging in simple code. This job can be be easily automated. This is where what we call Artificial Intelligence (AI) technology is being used. AI essentially just means using technology to do jobs that humans usually do. So automating software maintenance using AI would mean creating a software that fixes code for legacy software (i.e. software that the client is using). This software would do what the IT worker was doing before - find problems (bugs) in the legacy software that the client is using and make small changes to the code of the legacy software to fix these problems.

Gartner estimates that ~70% of Indian IT jobs in the outsourced business will be eliminated as automation increases. The layoffs are already happening. These workers are experiencing/will experience Structural Unemployment. They will have to retrain themselves in new technologies such as AI, machine learning and big data analytics if they are to find suitable employment.

Finally, as we discussed earlier in this post, besides technology, free trade and movement to low-cost geographies has also led to Structural Unemployment in many nations.

I think we've talked enough about Structural Unemployment. It's time to move on to “Full Employment”. Read about it in my following post What is Full Employment and why it is tricky to Estimate. 

Classical Vs. Keynesian Assumptions: An Introduction

Today, I’m starting to do a series of posts where I contrast some of the key assumptions of the Classical and Keynesian models of economic theory. I cannot stress enough the importance of such an exercise. For any student of economics, it’s critical to understand how the basic assumptions of these two schools of macroeconomic thought differ, in order for her to appreciate how two economists can offer such conflicting solutions to the same problem. They’re both looking at the same problem, but are using models with diametrically opposite assumptions to reach their respective policy recommendations. 

The following are the assumptions of the two models that I am going to discuss and contrast in detail in the following posts.

Assumption #1: Market Structure

Classical theory
Markets are highly/perfectly competitive, and thus always tend to move towards “full employment” levels.

Keynesian theory

Real-life markets are not highly/ perfectly competitive. There are powerful monopolies and oligopolies out there that do not produce at the levels required for full employment. 

Assumption #2: Price Flexibility  

Classical theory

Wages and prices are completely flexible. They adjust rapidly to ensure that demand = supply in output and labour/factor markets. 

Keynesian theory

Wages and prices are NOT flexible in the short term. Rather, they are “sticky”. They do not adjust to ensure the equality of demand and supply. 

Assumption #3: Full Employment

Classical theory

Output is always = Spending; Saving is always = Investment; and the economy always moves towards/is at the “Full employment” level. 

This assumption has its roots in Say’s law. Those of you who want to take a deep dive into Say’s law, read my posts Say’s Law: Context, Criticism and Keynes’s Refutation - Part 1 and Say’s Law: Context, Criticism and Keynes’s Refutation - Part 2. 

Keynesian theory

Refutes this classical assumption. Believes that there are NO natural forces to make Output = Spending or Saving = Investment at full employment levels. The economy can reach equilibrium much below full employment levels and stay there indefinitely.

Assumption #4: Velocity of Money

Classical theory

MV = PY is the quantity equation, where M = money supply, v = the income velocity of money, P = price level and Y = real GDP. Classicals believe that “v” is constant, which implies that ΔM = ΔPY i.e. money supply determines the level of nominal GDP. This is what is commonly known as the “Quantity theory of money”.

Based on the Quantity theory of money, Classicals assert that fiscal policy is ineffective in changing real GDP. Why? Because fiscal policy cannot change MV (LHS of the quantity equation) and thus per the classical view, cannot end up changing PY (RHS of the quantity equation). 

They go on to assert that monetary policy (changing money supply) is also ineffective in changing real GDP, since prices adjust rapidly (see assumption #2) to keep real GDP at the full employment level. As a result, all an increase in money supply accomplishes is an increase in the price level/ inflation. 

Keynesian theory

Keynesians believe that “v” fluctuates. It moves with real output (Y). When the economy is strong and Y is rising, people circulate money more rapidly i.e. “v” rises. When the economy is weak i.e. Y growth is anemic, people circulate money relatively slowly and “v” falls.

This means that fiscal policy works per Keynesians. An increase in government spending can increase “Y” on the RHS of the quantity equation and “v” on the LHS. 

I am going to discuss in detail the above-mentioned opposing Classical and Keynesian assumptions on each of the four listed subjects in following posts.

Demystifying Delhi’s Water Crisis

A couple of years ago, my mom (she’s awesome) and I wrote a series of articles for the news website Point Blank7. The series was titled Demystifying Delhi’s Water Crisis (no points for guessing what it was about!).

Along with the link above where you can read the entire series, I’ve provided below the links to its 5 parts. This way, you can read only the part that you’re interested in or skip right to the end (I did this with my reading all through high school).

  

Jokes apart, this series is a comprehensive yet engaging read. We lay out the nature and scope of the water crisis, talk about the issues plaguing the Delhi Jal Board and its untenable financial heath, and finally, discuss reform and solutions to the problem. And there’s humour in here (how else would I hold your attention for an entire series?). And this stuff is easy to read and absorb. 

So, go ahead! Give it a go.

Part I: So what is this water crisis everyone keeps talking about anyway?

Part II: Delhi Jal Board – the villain of the piece

Part III: It’s all about the money, honey!

Part IV: Whipping the Delhi Jal Board into shape

Part V: The multi-pronged solution…

Say’s Law: Context, Criticism and Keynes’s Refutation - Part 2

In my preceding post Say’s Law: Context, Criticism and Keynes’s Refutation - Part 1, I provided some context for understanding Say’s law. For those of you who havn’t read this post, it’s a good idea to give it a quick read. It will set you up really nicely for this one. 

*5 mins later*

Okay, so I’m assuming you did as I suggested, you astute and fabulous reader of my blog! Pat yourself on the back and begin to read the text below.

In today's post, I will talk about the criticisms and questions raised regarding Say’s law by economists before Keynes and then by Keynes himself. 

Criticism of Say’s law (before Keynes)

While most people think that Keynes was the first to refute Say’s law, this isn’t accurate. Leading economists challenged Say’s law over 100 years before Keynes. Keynes was the first however to develop a detailed counter-model of economic theory that was able to not only refute Say’s law, but also offer an explanation for the prolonged depression of the 1930s and suggest a way out of it. For now, let’s talk about some of the objections made vis-a-vis Say’s law in the pre-Keynesian era. 

1. General “gluts” (overproduction) were observed

Thomas Malthus (1766 - 1834) observed general gluts. He saw widespread unemployment and goods lying unsold following the Napoleonic wars (1803-1815). There did not appear to be any excess demand in certain pockets of the economy to balance out the extra supply in others. The glut appeared to be widespread and chronic. This was in direct contract to Say’s law. 

Infact, Malthus encouraged the state to spend in order to create jobs (Keynesian remedy) so that demand could be raised to meet the excess supply. This again is diametrically opposite to what Say believed. He thought that prices would automatically adjust to bring demand in balance with supply. 

John Stuart Mill (1806 - 1873) also accepted the occurrence of general gluts. He said that during such gluts there was excess supply of all non-monetary commodities (Say believed that this would not happen), while there was an excess demand for money (this would cause “hoarding”). 

2. Money could be “hoarded”

Say considered money to be just a medium of exchange for goods. He did not believe that it would be demanded as a store of value and thus did not believe that there was any reason to hoard money. John Stuart Mill on the other hand, believed that people would tend to “hoard” money when there was a lack of “commercial confidence”. In such a situation, there would be an excess supply of all goods (a glut) and an excess demand for money. 

Thus, even before John Maynard Keynes (1883 - 1946), Say’s law had its share of detractors. 

The Great Depression and Keynes’s Refutation

But it was the Great Depression of the 1930s that presented the biggest challenge to Say’s law. Production dropped, prices plummeted and unemployment soared (to 25-33% of the labour force) in the US and in Europe. This situation continued for most of the decade. There were no automatic forces (price or others) moving economies towards full employment. There was a general, economy-wide deficiency of demand for goods and services and it was not correcting. Say’s law was not working. 

It was during this time (in 1936) that Keynes’s The General Theory of Employment, Interest and Money was published. It rejected Say’s law. Keynes argued that an economy could go into recession due to a lack of aggregate demand and that there were no natural, automatic forces (even in a competitive market) that would push an economy towards full employment. 

To explain why a situation of deficient demand would arise, he explained why people would “hoard” money. 

In A History of Economic Thought, 1967, William J. Barber explains Keynes’s thinking rather well. 

Barber writes:

“Keynes's assault on the Say's Law tradition centred on this analysis of money. He set about the task by reversing the perspective from which money was viewed. Whereas neoclassical writers looked first at money in motion - i.e. when spent - Keynes chose to analyse money as it was held. The primary question to be answered was: how and for what reasons is the community induced to hold the stock of money that exists at a given moment? Obviously the community required some minimum stock of money to lubricate the wheels of commerce and to provide a reserve against contingencies. These motives for holding money were thoroughly compatible with neo-classical thinking. But Keynes insisted that there was also another reason for holding cash - the speculative motive for liquidity. This concept was essential to the opening of space for the analytical innovations of the General Theory.”

What is the speculative motive for holding money? 

It is based on the inverse relationship between interest rates and interest bearing, capital assets. For e.g. lets assume that the face value of a bond is Rs. 100 and it pays a coupon of 5% (Rs. 5) annually. If the interest rate on comparable bonds rises to 10%, the value of this bond will fall to Rs. 50, exposing the bondholder to huge capital losses. In cases when interest rates are low and there is high probability of them moving up, it would be prudent to hold cash as a hedge against the risk of capital loss. In such circumstances, hoarding becomes sensible. 

Barber goes on:

“When this consideration was taken into account, money could no longer be interpreted exclusively as a medium of exchange. Instead it also performed an important function as a store of value. This insight undercut the line of reasoning upon which Say's Law had rested. Hoarding could no longer be ruled out by assumption, nor treated as an irrational activity. Once this link in the neo-classical analytical chain had been broken, confidence in the self-adjusting properties of the economy to a full-employment level of equilibrium could no longer be sustained. On the contrary, an underemployed economy might tend to get stuck at a level of income well below its potential if part of its income stream leaked into the build-up of idle hoards.”

By giving a plausible explanation of why people would hoard money, Keynes demonstrated how spending (demand) could be less that output (supply) and lead to a general glut/ recession. 

He also argued that this lack of aggregate demand would become a vicious cycle, and that ultimately intervention in the form of government spending would be needed to stimulate the level of aggregate demand and move the economy towards full employment. 

The majority view among economists is that the Great Depression ended with World War II, which led to a spike in government spending and drastically reduced unemployment. 

So, is Say’s Law Valid today?

In a strict sense, it is clear that Say’s law does not hold true in modern economies (we don’t have barter economies where everything is produced for exchange) where money can be held as a store of value and spending can easily be less than production. 

That said, many Classicals contend that Say’s law wasn’t intended to be interpreted in the strict sense that we encounter it today. The truncated, absolutist form in which we study Say’s law in school/college is the doing of the many economists who came after Say and tried to interpret his work. 

The fact that production creates incomes sufficient enough to buy back the products produced is true. These incomes are generally spent on consumption and investment; and a stable equilibrium cannot exist unless output = spending. 

Interpreted in this way, without making any absolute statements, Say’s law’s basic principles make sense. 

Say’s Law: Context, Criticism and Keynes’s Refutation - Part 1

What is Say's Law?

French economist Jean-Baptiste Say (1767–1832) introduced what is now famously known as “Say’s Law” in his work, A Treatise on Political Economy in 1803. Say’s law asserts that the production of goods/services creates an equivalent amount of demand for other products.

Say wrote:

“It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products.”

Note: It was Keynes who summarized Say’s law as “Supply creates its own demand”. Say never said this himself. Supporters of Say’s Law contend that this characterisation by Keynes is an over-simplification and does not capture Say’s full argument. While I believe Keynes’ statement captures the essence of Say’s law, I do agree that it's important to understand the context in which Say developed this belief. We’ll get to this soon.

Getting back to what Say said.... he submitted that his law implied that a general glut (a general, economy-wide excess of supply over demand) was impossible. If one good was in excess supply, another must be in excess demand. "The superabundance of goods of one description arises from the deficiency of goods of another description," he wrote.

Say also believed that money received from the sale of products would not be “hoarded” and would be fully spent on the purchase of other goods/services. He thought of money simply as a medium facilitating the exchange of one good for another. Thus, he rejected the idea that it could be held on to or “hoarded” causing demand to be lower than supply.

Context required for understanding Say’s Law

Ludwig von Mises’ article Lord Keynes and Say's Law, first published in The Freeman in October 1950, does a good job of laying down the context one needs to understand the intent behind Say’s law. Those interested in reading this article first hand should click on the link above and read it on the Mises Institute website.

Ludwig von Mises (1881-1973) was a leading economist of the Austrian school. His writings have greatly influenced the American libertarian movement.

In his article, Mises points out that Say’s law was designed (by Say) as a refutation of the misplaced beliefs held by the merchant class long before economics developed into a recognized discipline. In those times, whenever there was downturn in business, merchants blamed it on: 1) a scarcity of money, and 2) general overproduction.

Say was focused on refuting the claim that recessions were caused by general overproduction.

Mises goes on to explain Say’s thought process. Say believed that some goods would be in excess supply while others would be in short supply. The reason that some goods were in excess supply was because producers had erroneously overestimated the demand for them. Goods in excess demand belonged to producers who had correctly estimated the quantum of demand for their products. Thus, the merchants’ explanation that overproduction caused a downturn in their business was incorrect; it was their inability to correctly estimate demand and meet it at the cheapest price.

Also, according to Say, this situation would automatically start correcting, as prices for goods would adjust to bring about a balance between demand and supply (prices for goods in excess demand would rise, prices for goods in excess supply would fall). Say assumed that markets were perfectly competitive with free, unrestricted flow of labour and capital.

Hence, per Say, there could never be a “general overproduction” of all goods, and it was the specific intent of Say’s law to expose the fallacy of this age-old belief.

Now, lets move to another extremely important contextual point. Say’s belief that the supply of goods created a demand equal to the value of those goods rested on the assumption that that all income received from the sale of goods and services was spend on the purchase of other goods and services, and none of it was “hoarded”. To him “hoarding” did not make any sense since he considered money simply a medium of exchange for goods.

In A History of Economic Thought (1967), William J Barber writes:

“Because a deficiency in aggregate demand allegedly could never exist, Say's Law ruled out the possibility of 'general over-production'. This conclusion rested on an important, though implicit, assumption: that all income was spent and none hoarded. For Say and most writers in the classical tradition, the basic premise was too self-evident to call for detailed argument. As they viewed the world, there was no reason why anyone should ever wish to hoard. After all, no intelligent man (as opposed to the exceptional case of the misguided miser) would accumulate idle balances when he could increase his income by lending the same funds at interest. This attitude was held with the force of dogma by the orthodox classical mind, a phenomenon not unrelated to its antipathy toward the mercantilist attitude that hoarding on a national basis was socially beneficial.”

Note: Mercantilism was a pre-Classical school of economic thought that encouraged government intervention, accumulation of monetary reserves and the restriction of domestic consumption.

Appreciating the “Classical” ideas of J.B. Say, Adam Smith (widely regarded as the father of Classical economics) and other thinkers becomes much easier when seen against the backdrop of the economic thought preceding and/or prevailing at their time.

Now that we have context, I’m going to move on to the criticism of Say’s law by Keynes and others before him in my next post Say’s Law: Context, Criticism and Keynes’s Refutation - Part 2.