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Australia’s Plummeting Unemployment: Miracle or Good Economics?

Economics / Austrailia Nov 19, 2007 - 11:14 PM GMT

By: Gerard_Jackson

Economics Australia’s seems to be facing the happy prospect of unemployment falling to 4 per cent or less. What was once thought to be impossible has become the mundane. How can this be? We have been told year after year that the jobless were doomed to be always with us because it would require a savage cut in real wage rates to restore full employment (Gittins Gregory). Therefore it would not only be heartless to cut real wages but also suicidal. I said at the time that this view was absolute rubbish. Time has once again proved me correct.

What must be constantly borne in mind is the basic economic fact that labour is only hired for the value of its services. It therefore follows that if labour services (productivity) are priced above their market value unemployment must emerge. In economic jargon: men will be taken on up to the point where the marginal cost of hiring them equals the marginal value of their product. As Henry Wicksteed said more than 100 years ago:

In like manner the individual entrepreneur, if he contemplates taking on or discharging a workman, will ask himself whether that workman will be worth his wage or not, i.e., whether he will increase the product, other factors remaining constant, at least to the extent of his wage; and he will take on more men as long as the last one earns at least as much as his wage, but no longer. The man, on his side, can insist on having as much as the marginal significance of his work, i.e., as much as the difference to the product which the withdrawal of his work would make. ( Essay on the Co-ordination of the Laws of Distribution , Macmillan & Co., 1894, p. 9).

There is the real wage and the nominal wage or money wage. The classical economists fully understood these term and how monetary expansion can cut real wages as nominal wages rise. This is a vitally import fact that has apparently escaped the notice of our economic commentariat. Keynes argue that the way to reduce unemployment is to increase ‘demand’. Keynes, on the other hand, knew that the real cause of persistent unemployment was labour costs exceeding the market clearing value of labour services. In short, excessive wage rates. Keynes understood this and that is why he wrote that workers will

resist reductions of money-wages . . . whereas they do not resist reductions of real wages, which are associated with increases in aggregate employment and leave relative money-wages unchanged . . . Every trade union will put up some resistance to a cut in money-wages, however small. But since no trade union would dream of striking on every occasion of a rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment . . . ( The General Theory of Employment, Interest and Money , Macmillan, St Martin’s Press for the Royal Economic Society, 1973, p. 14).

In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices. (Ibid. p. 264)

Therefore, according to Keynes, inflation was the cure for unemployment. Contrary to what Keynes’ disciples claim, there is absolutely nothing new here. In his discussion of the classical school’s approach to the nature and consequences of forced savings Jacob Viner observed that one version of the doctrine clearly recognised

that an increase in money meant an increase in production, it was argued that an increase in the quantity of money would increase the monetary volume of purchases more rapidly than it would increase prices, with the result that there would be a substantial interval during which the increase of spendable funds would be absorbed by increased employment in the production of consumers’ goods rather than by increased prices. In this form of the doctrine, the increase in money results in increased real consumption, whereas in the forced-saving form it results in increased investment, but in both forms it makes possible increased employment. (Jacob Viner, Studies in the Theory of International Trade , Harper & brothers, 1937, p. 189).

It should be clear by now that the Keynesian approach employs inflation to implement blanket wages cuts. (I am ignoring the discoordinating effects of inflation). The Austrians make the important point that in certain circumstances money wages can be cut without a rise in general prices. What matters is the value of the product relative to the cost of labour. Inflation works its magic by raising the former against the latter. This can result in “withheld capacity” being released which in turn can, for a time, prevent a rise in the price level.

From March 1996 to July 2007 currency grew by 101.6 per cent, bank deposits by 177.7 per cent and M1 by 169 per cent. One of the consequences of the inflationary policy has been to make labour more affordable by allowing real wages to lag behind the increase in the value of its marginal product. Now this does not mean labour has suffered a real cut wages, only that the ratio of the value of product relative to the wage rate — which includes all oncosts — has been allowed to develop.

From March 1996 to last September the CPI rose by 30 per cent. Given this increase and the failure of unions to abort the boom with excessive labour costs it is no wonder that capacity has reached 83.2 per cent (National Australia Bank Business Survey). Unfortunately for Australia none of our media commentators appear to understand any of this. Nicholas Gruen, Chief executive of Lateral Economics, stated that

When an economy approaches full employment, additional spending simply feeds into inflation unless it expands production. With a central bank unwilling to tolerate inflation, tax cuts raise interest rates. That’s Economics 101. ( The Age , Plan needed for decade , 23 October 2007

Economics 101 or not, it is still rubbish. As I have tried to make clear, it’s the inflation that created “full employment” and record “capacity utilisation”. He talks of “additional spending” without telling us where this spending comes from. If we adopt Gruen’s “additional spending” approach we then only have to look at the country’s current account deficit to see that inflation has been around for sometime.

Terry McCrann remarks that the money pouring into real estate is being used to buy old properties rather than build new ones with the result that a rental crisis has emerged. ( The Herald Sun , Barrow project a win-win-win-win situation 11 October 2007). But where did the money come from? It never seems to occur to the likes of McCrann to link the housing boom with our booming money supply. Taking a truly Panglossian view of the economy he brags that the resources boom

is driving [our] dollar further. At a 25-year high against the US dollar and stronger against the Chinese yuan and the euro and yen, [our] income dollars are buying more of what others produce.

It now appears that McCrann really does believe that the Australian economy is a “magic pudding”. I hate to be a party pooper but the effect of running an overvalued currency is to bring about a detrimental change in the structure of domestic prices. Foreign goods become cheaper while the export of domestic manufactures are eventually priced out of foreign markets. Moreover, an overvalued currency combined with a recklessly loose monetary policy will further aggravate the situation and make the inevitable adjustments all the more painful.


By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

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