Knowledge that Transforms

Fluctuations in the equilibrium rate of unemployment can only be understood within a of the natural or equilibrium rate. It is not enough to say that unemployment is the difference between supply and demand in the labor market, though of course it always will be. In equilibrium, no participants in the market can have an unexploited opportunity to make themselves better off. At the equilibrium unemployment rate, employers cannot obtain labor at lower cost by offering work at below the market wage to the unemployed. Unemployed workers cannot raise their effective real incomes by taking lower wages in exchange for immediate employment. The task of the is to explain why any unemployment remains at all when these conditions are satisfied. Part of this problem has been studied in detail in the search theory of unemployment -- once a worker becomes unemployed, it is reasonably well understood why the worker does not become employed again immediately. The of why people become unemployed in the first place is less well developed and is the main concern of this paper. Most of the unemployed are looking for new work because their previous jobs ran out. Consequently, the main ingredient of a of the flow of workers into unemployment is a of the duration of employment. Such a is developed here, along reasonably standard lines.

This paper is one in a series directed toward the construction, with certain modern building blocks, of a non-monetary theory of employment fluctuation in market economies. The closed-economy model here parallels the open-economy model in Phelps (1988). The objective is a plausible theory that helps to account for some or all of the long swings in economic activity over recent decades. In fact, this non-monetary theory has grown out of one of the models used by Fitoussi and Phelps (1988) to account for the 1980s depression over much of the world, a slump that demand-driven models are hard-pressed to explain.

Monetary theory

An understanding of the correct model of intertemporal consumption choice is crucial to evaluating the effects of fiscal policies. The debates over whether deficit policy matters (Martin Feldstein, 1974; Robert Barro, 1974) and, if so, how to measure such policy (Robert Eisner and Paul Pieper, 1985; Kotlikoff, 1986) are fundamentally debates about the correct model of consumption. Unfortunately, distinguishing empirically between different consumption theories is a subtle business that has produced no strong conclusions. One problem confronting many tests of alternative consumption theories is that they require joint and quite specific assumptions about preferences, economic resources, and the consumer's information set that may not be justified. In such cases, what is described as a rejection of a particular model may simply be a rejection of restrictive assumptions placed on the model. A second problem that is also routinely swept under the rug involves the implicit assumption that consumers optimize perfectly given their preferences and resources, and that they correctly value their resources. In order to explore these more fundamental questions we, have conducted an experiment to determine whether individuals, when placed in a controlled life cycle setting, make consistent and coherent consumption choices, and whether they correctly value their future resources. The experiment provides negative answers to both of these questions; in the experiment subjects made significant and systematic errors in their consumption choice, reflecting, in part, an overdiscounting of future income. This paper reviews several of the findings from our 1987 working paper, and then discusses their implications for fiscal policy. We give a brief description in Section I of the experiment. Section II describes inconsistencies and errors in consumption choice and traces them to the overdiscounting of future labor income. Section III presents some regression results also pointing to an undervaluation of future resources. Section IV discusses the implications of these results for viewing fiscal policy and suggests the need for additional experiments as well as consumption models that acknowledge, rather than avoid computation problems.

In his seminal 1943 paper on the political business cycle, Michal Kalecki (1971) argued that industrial leaders feared employment because the economic insecurity created by unemployment was necessary to keep wages low and maintain work intensity and discipline on the shop floor. On the basis of this reasoning, Kalecki concluded that governments would not use demand management policies to achieve permanent full employment. In terms of current macroeconomic debates, Kalecki had sketched the outlines of a theory of the neutral or natural rate of unemployment based on the importance of disciplinary unemployment as a regulator of unit labor costs. Kalecki's pessimism about the prospects for employment was premised in part on a view of firms in which the threat of dismissal was the central motivational device used by employers, and employees had only a tenuous connection to employers. This assumption may have been appropriate when analyzing labor markets in the United States during the 1930's. Since that time, however, the spread of unions, implicit employment contracts, and large, bureaucratically organized enterprises has resulted in a modern U.S. labor market in which many workers enjoy long job tenure and in which many firms do not appear to rely on dismissal threats as their primary motivational strategy (see David Gordon, Richard Edwards, and Michael Reich, 1982; Sanford Jacoby, 1983; and my forthcoming paper). From this perspective, it is reasonable to ask whether the presence of long-term employment relations alters the regulatory role played by unemployment. This paper examines the effect that unemployment and long-term employment relations exert on the determination of unit labor costs. The central empirical findings can be briefly summarized. First, as suggested by Kalecki, movements towards employment increase the rate of growth of wages and reduce the rate of growth of labor productivity. Second, where long-term employment relations are prevalent, the effect of unemployment on both wage and labor productivity growth is diminished.