A Summary of the History of Thought on the Theory of Employment.

by Gurmukh Singh.

To quote the oldest book in the world “You shall eat the fruit of the labour of your hands; you shall be blessed, and it shall be well with you.” For countless people work is not just a dull facet of life; for it provides a sense of identity, independence and self-worth. Equally, employment is of the utmost importance for a nation as a nation at work is ever so often a prerequisite for a nation at peace. The alternative, that is, mass unemployment, results in people losing their sense of purpose and a mob without any vision rapidly descends into chaos. Therefore, we often use unemployment numbers to check on a nation’s health. Because unemployment is a societal phenomenon, its study falls into the realm of social science, specifically economics. In order to understand societal phenomena, economists build models. These models are based on theories and assumptions that they make to simplify the workings of the complex economy. Let us take a succinct look at some of these theories that underpin our understanding of the coin whose two faces are employment and unemployment.

At this point, it is convenient to reveal to the occasional readers of economics that the study of the history of economics can be plainly divided into three phases. These are the classical school of economics, the Keynesian economics and the post Keynesian era of which the dominant player is the new classical economics. Furthermore, for those not familiar with the terminology of real wage (used frequently below), it is the wage that one earns when money is taken out of the equations i.e. a person’s purchasing power when the economy is viewed in a barter system.

Firstly, let us look at the classical school which began with Adam Smith, the father of economics. Its main thinkers include Say, Ricardo and Malthus. It builds its theory of employment upon two postulates. The theory firstly postulates that real wage equals the marginal product of labour. In plain English it means that businesses hire to the point where the real wage allocated per hired worker equals the revenue that last worker’s employment brings to the business. This postulate is logically irrefutable thus, it has remained unchallenged throughout history. It also gives us the demand schedule of employment i.e. as wages decrease, labour demanded by businesses increase.

The second postulate of the classical school says that under a given volume of employment, the utility of wage equals to the marginal disutility of that amount of unemployment. Again, in plain English, it means that at the existing level of real wages in the market are ‘always’ sufficient to induce full employment i.e. there is always a job for anyone who wants to work at the prevailing real wage rate. The second postulate allows for the existence of frictional unemployment i.e. people moving from one job to another and voluntary unemployment i.e. where unemployed choose not to accept a job. However, it does not allow the existence of ‘involuntary unemployment’, where people who are looking for a job cannot get a job at the existing wage rate. Nowadays, even a common eye can pick up on the fact that this does not seem like how our world works nevertheless, classical economists persisted in holding this postulate as one of the pillars to their theory of employment. They attributed the existence of underemployment and involuntary unemployment to a conspiracy amongst workers where workers would not work for anything less than the bargained money-wage, which they argued was essentially more than what the rate should be.

Next, came the era of Keynesian economics which started with the publication of the book named ‘The General Theory of Employment, Interest and Money’ by John Maynard Keynes. To put matters into context, Keynes is to economics what Beatles are to the pop music. He attacked the second postulate of classical school in several ways but at the heart of his argument, the preposition was that there are two ways to reduce workers’ real-wages. It can be accomplished by either decreasing workers’ money-wages and leaving the prices of daily goods intact or vice-versa. Keynes then argued that if there is conspiracy amongst workers to go on a mass strike when their real-wages decrease, how come these strikes are not observed every-time there is an increase in the prices of daily goods.

Keynes’s book established the principles of effective demand which Keynes argued, determine the level of employment in the market. In Keynes theory, the volume of employment in an economy depends on three factors namely, aggregate supply function, propensity to consume and the volume of investment. The logic is as follows: Income, paid by businesses and earned by households in an economy is divided into two parts, some of it is consumed and some of it is saved. Consumption part of the income goes towards purchasing products that businesses produce. At close inspection, one might notice that businesses have paid out more in incomes than they have collected from aggregate household consumption spending. Therefore, the gap between collection and spending must be filled by the volume of investment. The volume of investment is determined by something called the ‘inducement to invest’ which, in turn is determined by the relationship between marginal efficiency of capital and prevailing interest rates. Thus, giving the book its names ‘The General Theory of Employment, Interest and Money’ (money is in the title because Keynes regarded money — correctly, if I may add — as something that plays a central role in our economy as opposed to the classical view that economy could be better understood as a barter system where money is neutral, makes no real difference and thus, introduced afterwards — a view that many economists practice to date.)

Next in line is the post Keynesian era dominated by the school of new classical economics, popularized by monetary economists such as Milton Freedman, Robert Lucas and Thomas Sargent (they made the reserve banks famous; in case of Friedman, by insisting that we don’t need so many people working at the reserve bank). As the name suggests, they drew inspiration from mostly classical and some Keynesian works, heavily mathematized the field and gave us the concept of rational expectations i.e. people always act rationally.

The framework created by these homo-economicuses, namely ‘Real Business Cycle Theory’ contends that actual output differs from potential output because of exogenous changes in the real-economic environment such as a sudden and large change in technology employed in the production sector or pandemics such as COVID-19. Importantly, in line with the classical assertion, the school refuses to acknowledge the existence of ‘involuntary unemployment’ and claims that unemployment rate imitates changes in labour preference of work over leisure. To refute this argument, Paul Krugman points out that this “would mean that 25% unemployment at the height of the Great Depression would be the result of a mass decision (of population) to take a long vacation.”

After the 2008 financial crisis, considerable rifts emerged in the modern approach to macroeconomics. Amongst those critiquing the aforementioned approach, the Modern Monetary Theory has emerged as a popular (mostly amongst non-economists and at the fringe of the economics profession) possible alternative. It acknowledges the existence of ‘involuntary unemployment’ and calls on the governments to implement a universal employment scheme. In essence, it argues that the government should be the employer of last resort and it should provide employment to all citizens, who are looking for work but are unable to find it, at a wage rate below the private sector threshold. This scheme will absorb people who are ‘involuntarily unemployed’. When vacancies open up in the private sector, those people employed in the universal employment scheme can be lured to the private sector by the wage rate differences. Empirical evidence from nations where this scheme was implemented has shown some promising results. To make up one’s mind, one only needs to look at empirical data produced by Argentina’s ‘Heads of Households’ scheme and India’s NREGA scheme — that is food for your thought.