The Interdependence of Markets s2

Classical Remedies for Unemployment Or how to make the problem worse!

Keynes rejected the classical remedies for unemployment. According to Keynes, they were more than just useless: they actually made the problem worse. So what were the classical remedies? And why would they make unemployment worse?

‘People should be encouraged to save. This would reduce interest rates and encourage more investment, more growth and more jobs’. But if people save more, they spend less. Firms will therefore sell less. They will thus have idle capacity and will lay off workers. Unemployment will rise. What is more, firms will be discouraged from investing. After all, what is the point in installing extra machines when you are not using all of the existing ones? Keynes called this the paradox of thrift. If the nation becomes more thrifty, it will thereby become poorer. ‘People should be prepared to take wage cuts. This would reduce firms’ costs and allow them to take on more labour.’ But workers are also consumers. If people are paid less, they will spend less and firms will sell less. Firms will thus want to employ less workers, not more. ‘ The government should attempt to balance its budget. If the government were currently running a budget deficit, then it should attempt to eliminate it. This would release resources for private-sector investment. More investment would lead to more employment.’ But if the economy is in recession and unemployment is already high, the budget deficit may be quite large. There are two reasons: a) the government will be spending a lot of money on unemployment benefit; b) if incomes and consumption are low, tax receipts will be low. To eliminate the deficit then, the government would either have to raise taxes or have to reduce its expenditure, for example by reducing the level of benefits. Either way, aggregate demand would fall and firms would sell less. This would merely encourage them to lay off more workers. Unemployment would rise, not fall. ‘Reduce the supply of money. This would reduce prices. This in turn would make goods more competitive overseas and would lead to a recovery in the export industry. Employment would rise.’ But reducing the money supply would raise interest rates and reduce investment. The economy would slide further into recession and unemployment would rise.

So if all these classical remedies were wrong, what was Keynes’ answer? That was simple. There must be more spending, not less. Aggregate demand must be boosted, either directly through a programme of public works, or indirectly by giving tax cuts and thus encouraging more consumer expenditure. Either way it would mean a policy of a deliberately unbalanced budget. According to Keynes, therefore, budget deficits were highly desirable in recessions.

Questions 1. How would a classical economist reply to each of Keynes’ criticisms? 2. Would each of the above classical policies be suitable if there were a problem of excess demand and inflation?