Productivity And Unemployment

The previous sections of the blog were about the need to use credit and saving to fund capital investment, so that the economy has the productivity to provide enough for everyone. Last week I introduced the other essential factor in this picture, that we also need to distribute not just what is produced, but also the capacity to produce and thereby to earn an income.

So this week we’re going to consider what happens in the current economic system when there is a significant advance in productivity. Suppose a factory, through technological progress, can now produce more goods without increasing inputs. This always means it can produce more goods with less labour.

Now one thing that could happen is that it could continue to produce the same amount of goods for the same price, paying its workers the same rate, but simply reduce the hours of its workforce. And in simple terms, this is how we could improve the conditions of sweatshop workers all over the world. But this never, ever happens.

A significant increase in productivity almost always results in laying off workers. This is how business owners turn the increase in productivity into profits for themselves.

The most marked exception to this is in markets based on new technologies. The increase in productivity can lead to a reduction in price that enables a product to move from being a luxury for the rich, to being commonly owned, even to becoming an essential item. This large-scale increase in demand will of course lead to an increase in employment in that industry. Smart phones, for example, have taken this journey.

Outside of these specific markets there are endless permutations of how exactly increases in productivity will play out, depending on the different structures of businesses, industries and markets, and it would take far too long to outline a range of these examples. For now, just note that the very nature of increasing productivity means you can produce the same number of goods with less staff. It is intuitive that the savings come from laying off staff.

So what happens next? These people are desperate for a job, and will generally be willing to accept one for a lower salary. The increased competition for employment enables a wider range of employers to pay lower salaries – they can recruit the newly unemployed workers at a lower level than they have been paying others. Orthodox economics theory teaches that the labour market will reach a new equilibrium, at a lower wage rate. And indeed, mainstream economics tends to conclude that the only answer to unemployment is to lower wages. So does this make lots of workers a little bit poorer?

Well the reduced costs from lower wages should lead to an increase in profits (or else what’s the point for the business in investing in productivity in the first place), but it’s likely to also lead to a reduction in price. If prices of some products fall, consumers can afford to buy more of other products, stimulating employment elsewhere in the economy. Meanwhile, increased profits mean that shareholders have more money to spend or businesses have funds to reinvest in productivity (or both). Either way, this increases demand in the economy as a whole. If they choose to save instead of spend, financial markets will intermediate this saving back to investment (so says the theory).

One way or another, the savings made by laying off staff become income for someone else and are spent back into the economy. The increased demand stimulates employment, and once we’re at full employment wages will rise again. The free market will enable everything to balance out over time. And because the economy is more productive, in this balancing out everyone should get a little bit richer.

And hence, mainstream economics argues that increasing productivity will not cause any long-term unemployment and cause us all to be better off. They will point to the general rising of living standards over many decades as proof for this assertion.

This theory has 4 fundamental flaws:

  1. As has been explained to death in earlier parts of the blog, financial markets don’t necessarily intermediate saving to investment. Increasing wealth for businesses and shareholders leads to more saving, which means more demand for financial assets, which simply inflates the price of those assets, causing bubbles. As more income flows to the wealthy, more wealth is soaked up by financial markets. The theoretical case for this is described in the “Productivity” section, and the empirical evidence presented in the “Financial Markets” section (both accessed from the menu bar above). That’s 33 posts of detail, I’m not going to repeat any of that here.
  2. The problems with deflation have been mentioned many times before on the blog. To avoid this, rather than prices falling to compensate falling wages, the money supply needs to increase by just the right amount to inflate both prices and wages. If the increasing productivity is making us all wealthier, profits and wages should inflate slightly more than prices. This requires the monetary system to create just the right amount of new money and inject it into the right parts of the economy. The abject failings of this system are detailed in the section on “Money”. The prolonged low inflation and at times deflation since the financial crisis, despite the exceptional steps of monetary policy such as quantitative easing, are symptoms of a system that is broken beyond repair.
  3. The concept that the system will balance itself out is what economists call “equilibrium”. But the economy never has a chance to come close to equilibrium. There are constant innovations and advances in technology. The economy doesn’t quietly rebalance itself after occasional changes in productivity, it is constantly tossed around from one innovation to another.
  4. The description given above states that lower prices, enabled by laying off workers in one industry, means that consumers have more money left over to buy other products, stimulating demand in other industries. But what it leaves out is that the loss of income for the workers who are laid off reduces demand in that specific region. The extra products consumers are buying might be manufactured in completely different countries! This loss of demand within the affected region will impact local businesses and cause a downward spiral – as their income reduces, regional demand falls yet further. What we see time and again is entrenched patterns of decline in regions that lose a major industry. We will look at this effect in more detail next week.

What we have seen in the economy over recent decades is not a balancing out, but a massive widening in the imbalance between the wealthiest, the middle and the poorest. The opening post in the section on “Financial Markets” showed the marked shift in the share of GDP going to profits rather than wages in the last 50 years. The mainstream economic theory is wrong. In an unrestrained, unregulated free market, increases in productivity do not in the long term lead to higher wages and more goods for all, they lead to a concentration of wealth in an ever smaller number of hands. And regardless of whether you see this as unjust or not, this has profound economic affects.

The “Financial Markets” section draws on the work of Zoltan Pozsar to show how this wealth has concentrated in institutional cash pools, has not been invested in productivity, and has destabilised financial markets. The conclusion Pozsar reaches is that to have a stable financial system we need to tax this wealth and redistribute it.

The rapid rise in standards of living and in “real” wages (i.e. measuring the value of wages by what we can purchase, not by the nominal wage level) since the second world war has been hailed as the success of capitalism and vindication of mainstream economics. But the decade of stagnation in real wage growth and productivity since the financial crisis is just as much a result of that system.

As wealth concentrates into fewer and fewer hands, our economic system is not able to distribute the opportunities for employment or the capacity to produce, and after decades of ignoring this issue, believing the free market would magically organise everything, our chickens are coming home to roost. This is manifest both in the stagnant, debt-ridden global economy, whose inflated asset and housing markets are heading for the next crash, and in the resultant mass discontent leading to a terrifying rise of populist far-right regimes. Growth has slowed to the point that young people in the West today are the first generation likely to be poorer than their parents.

But to understand this we need to analyse the economic dynamics in a dispassionate way. This is not about politics, or about justice. It is about understanding the impact of the distribution of wealth on the future performance of the economy. So for now I want to draw your attention back to the essential point of this post, that the savings to a business of raising productivity will tend to be realised by reducing employment, and if these job losses are significant enough to impact the regional economy this will lead to falling incomes throughout the region.

Next week we will look at these dynamics in a bit more detail, before revisiting more closely the implications of mainstream economics theory.

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