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When Labor Is Capital: The Limits of Keynesian Policy

Friday, August 6, 2010

The economic mystery of 2010 is the persistence of high unemployment, in spite of stimulus that follows the prescription of the prevailing Keynesian orthodoxy. Here’s an alternative to that orthodoxy.

In the United States, the economic mystery of 2010 is the persistence of high unemployment, in spite of the application of the stimulus treatment that follows the prescription of the prevailing Keynesian orthodoxy. I wish to offer an alternative to that orthodoxy.

For the followers of John Maynard Keynes, economic activity consists of spending. When economic activity slows down, their prescription is to increase spending by government, businesses, consumers, or all three. Instead, what I like to say is that “economic activity consists of sustainable patterns of specialization and trade.” This is my mantra of macroeconomics. (I also have a mantra of microeconomics, which is that “price discrimination explains everything.” But that is another topic.)

Here is a simple pattern of specialization and trade: Suppose that all of us eat grain and fruit, which we could grow for ourselves. If some of us have land better for fruit trees, while others have land better for growing grain, then specialization and trading can pay off. It is inefficient to waste good tree land by growing grain on it and to waste good grain land by planting trees on it. Instead, economic activity gives all of us more to eat.

If anything, it seems likely that government support for unsustainable patterns of production would probably make the market's recalculation problem more confusing.

What I mean by a sustainable pattern of specialization and trade is that everyone involved would voluntarily continue to follow the pattern. In accounting terms, profits are a sign of sustainability. If the accounts show a profit, then the value of output exceeds the cost of input. If not, then the pattern is not sustainable.

As conditions change, the patterns of specialization and trade evolve. For example, improvements in transportation make new trade patterns sustainable. Recall the changes brought about by ocean-crossing sailing ships, then steamboats, then railroads, then the automobile and the airplane. As new patterns become sustainable, older patterns become unprofitable and therefore unsustainable. The truck replaced the horse-drawn cart.

The Economy’s Increasing Complexity

Patterns of specialization and trade have become more complex over time. The example of fruit pickers and grain harvesters could have been used hundreds of years ago. But many of the jobs that form today's pattern of specialization and trade are less than 50 years old—or younger.

The market needs to undertake a recalculation in order to deploy workers in a new, sustainable pattern of specialization and trade. The process involves gradual, decentralized trial and error.

Lately, I find myself jealous of Alan Marcus, a good friend from my graduate school days of the late 1970s. I have three daughters, and I tell people that I wish just one of them would work for a profit. Instead, the two that have graduated college only want to work for nonprofits. Meanwhile, Alan also has two daughters who have graduated college, and both of them took jobs with profit-seeking firms.

One of Alan's daughters works in software development for the website of one of the leading mutual fund firms. The other daughter just took a job with a company that, according to Alan, “helps organizations do social-media marketing.” Do not ask me (or him) to explain what that means.

Software development and social-media marketing are jobs that supposedly fit in with a sustainable pattern of specialization and trade. However, they produce no tangible output. In that sense, they are very far removed from fruit picking and grain harvesting.

The contemporary pattern of specialization and trade can be described as roundabout production. I first heard the term in a course on capital theory that Alan and I took from Paul Samuelson. Samuelson was explaining the Austrian theory of capital, as articulated by Eugen von Böhm-Bawerk,1 who developed his analysis more than a century ago.

If labor is capital, then we have lost the automatic tight connection between spending and employment.

The idea of roundabout production is to use intermediate activities to increase final output. For example, a plow cannot be eaten, but it can be used by a farmer to produce more food. Using a plow is an example of roundabout production, in that first you produce the plow and then you use the plow to grow more crops.

Whatever it means to do social-media marketing, if it is part of a sustainable pattern of specialization and trade, then somehow it must help the economy increase output, just as a plow helps a farmer increase crops. Jobs like website development and social-media marketing are very far removed from the final stage of production. They illustrate the emergence of increasingly indirect and roundabout patterns of specialization and trade.

The trend is for the proportion of people employed in final-stage production to get smaller and smaller. Two or three generations ago in the United States, agricultural workers and manufacturing production workers made up half of the labor force. Today, that figure is less than 10 percent. However, thanks to roundabout production, we can produce more manufactured goods and more food than ever.

Labor Is Capital

Much of today's American workforce is engaged in roundabout production, which Böhm-Bawerk equated with capital. There is no longer a meaningful distinction between labor and capital. Labor is capital.

The result of the boom-bust cycle superimposed on the ongoing obsolescence is to overload the market's ability to reconfigure production patterns so that workers are fully employed.

If labor is capital, then we have lost the automatic tight connection between spending and employment. Firms can vary their output with little or no variation in employment. This explains how we can have a “jobless recovery,” meaning a large percentage increase in output without a comparable percentage increase in employment. For firms in today's economy, labor represents an investment. Firms hire workers in order to develop capabilities that will eventually produce output more efficiently. The return on an investment in workers may take as long or longer to realize as the return on investment in a machine. The return on investing in workers may be at least as uncertain as the return on investing in equipment.

Investments are risky. Many investments, perhaps a majority, will fail to earn a fair return. Thus, old jobs are constantly being lost and new ones are created. The Labor Department's statistics on job turnover suggest that each month there are several million work separations and a comparable number of new hires. The net difference, which is typically under 300,000, is what the department reports as the gain or loss in employment.

The “jobs lost” (the cumulative net difference) during this recession are only a fraction of the typical job losses in a two-year period. What is atypical is that jobs gained have fallen short of jobs lost. That is, the number of new investments in workers has fallen short of the number of previous investments deemed to have been unprofitable.

Recalculation: A Story for the Current Recession

The phenomenon of roundabout production suggests a story for the current recession. The economy was suddenly caught in an unsustainable pattern of production, which involved too much housing construction in the “sand states” of Florida, Nevada, and California as well as too much financial activity related to mortgages and mortgage securities.

Economic activity consists of sustainable patterns of specialization and trade. This is my mantra of macroeconomics.

The suddenly unsustainable housing and mortgage boom comes atop the ongoing obsolescence of various patterns of specialization, as the Internet and globalization continue to foster new forms of organization and competition. The result of the boom-bust cycle superimposed on the ongoing obsolescence is to overload the market's ability to reconfigure production patterns so that workers are fully employed.

The market needs to undertake a recalculation in order to deploy workers in a new, sustainable pattern of specialization and trade. The process involves gradual, decentralized trial and error. Firms need to be launched by entrepreneurs, who will make risky investments in employees. The failure rate will be high, but eventually the successes will have a cumulative effect that brings about more economic activity.

The challenge is made difficult by the increasing specialization of labor-capital. The problem of matching skills with needs in roundabout production is much more complex than the problem of adding or subtracting workers in final-stage production.

The Limits of the Keynesian Vision—Policy Implications

The Keynesian prescription for a recession is to increase government spending. Even if the resulting output is not valuable (the proverbial digging ditches and filling them in again), the thinking is that this will stimulate productive output. Again, this is based on the theory that economic activity is spending. Supposedly, spending will encourage more spending, through the “multiplier” effect.

The trend is for the proportion of people employed in final-stage production to get smaller and smaller.

From our more Austrian perspective, the Keynesian prescription will fail. Government spending tends to create or reinforce unsustainable patterns of production—temporary housing booms, transitory increases in auto sales, and the like. However, there is no reason to expect unsustainable patterns of production to stimulate the creation of sustainable patterns of specialization and trade. If anything, it would seem likely that government support for unsustainable patterns of production could make the market's recalculation problem more confusing. It will delay long-term recovery, rather than hasten it.

Some Keynesian economists have proposed an even more unlikely solution, which is to revive the New Deal program of government-created jobs, as in the Works Progress Administration. This idea represents a complete denial of the contemporary reality that labor is capital. Real employment in today's economy represents a long-term investment, not short-term make-work.

What needs to emerge are new, sustainable patterns of specialization and trade. Government does not have much incentive to create sustainable patterns of specialization and trade. In fact, the political system tends to favor subsidies to outmoded and unsustainable businesses.

Government could reduce the cost of investing in labor-capital. If it can be done in a fiscally responsible way, it would help to reduce the marginal tax rates on investment (the corporate profits tax) and employment (the payroll tax). This may require offsetting tax changes, such as eliminating the mortgage interest deduction or the deductibility of employer-provided health insurance.

On the whole, the best way to help the process of market recalculation and the creation of sustainable patterns of specialization and trade may be for government to get out of the way.

Arnold Kling is a member of the Financial Markets Working Group of the Mercatus Center at George Mason University. He blogs at http://econlog.econlib.org.

FURTHER READING: Kling is the author, with Nick Schulz, of From Poverty to Prosperity. He has also written “Why Our Current Budget Situation Is a Crisis,” “Not Your Grandfather’s (or Keynes’s) Economy,” and “Regulation and the Financial Crisis: Myths and Realities.”

Image by Darren Wamboldt/Bergman Group.

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