Structural Slumps

The Economist
March 5, 1994

The economists' Grail
Getting back to full employment

SECOND only to understanding what drives growth and development, uncovering the causes of unemployment is the most pressing task in economics. In this century, broadly speaking, thought on the subject has been dominated by three schools. First came the classical economists; next, Keynes and his followers; then, the so-called neoclassicals, who sought to reconcile Keynes and l the classics (and whose views command a broad consensus among today's mainstream economists). Yet none of these approaches has convincingly explained why unemployment fluctuates in the way it does--not merely during the course of the business cycle, but in longer phases as well. It remains unclear, for instance, why the trend of unemployment in industrial countries has drifted persistently higher since the 1960s.

In recent years a fourth approach--"modem equilibrium theory"--has been taking shape. It offered many striking new insights, but these did not hang together as a coherent system. The significance of this new book by Edmund Phelps--a professor at Columbia University, and a pioneer of modem macroeconomics--is that, in gathering, developing and combining these new ideas, it has substantially remedied that weakness. As a result, academic thinking on unemployment (which will be followed in due course by popular thinking on unemployment) may be about to undergo its third decisive shift this century.

Keynesian, classical and neoclassical economics, despite their differences, have one thing in common: they all regard high unemployment as something that happens when economies are out of equilibrium. In a Keynesian slump, firms are willing to em. ploy more workers at prevailing prices and wagesÄbut don't, because there is too little demand for their output. In a classical slump, firms are unwilling to hire more workersÄnot because demand is too weak but because wages are too high in relation to prices. The neoclassical synthesis of these theories allows for both possibilities.

In either case, high unemployment persists mainly because prices or wages are "sticky". That is, prices or wages fail to move so as to restore equilibrium. According to neoclassical economics, a main reason for this stickiness is that firms ant workers make mistakes in predicting the future.

Modem equilibrium theory, as the name implies, approaches the problem in an entirely different way. High-unemployment, it asserts, can happen when the economy is in equilibrium--that is, when firms and workers are accurately predicting the future, and prices and wages have adjusted accordingly. Instead of seeing high unemployment as the consequence of certain kinds of mistake, and of the circumstances that might give rise to such mistakes, equilibrium theory sees it as something that can emerge from the underlying structure of the economy.

"Structural Slumps" develops an interconnecting set of theories to describe this underlying structure. It draws on earlier work but extends it in substantial ways. Its main achievement, though, is to make these blocks fit together into a larger whole than has been seen hitherto.

Time and again, the resulting body of thought disagrees with earlier accounts. It really is a new departure. One example is the role of interest rates. In neoclassical economics, a rise in interest rates is often one aspect of a "shock"--eg, an increase in public borrowing--that causes unemployment to fall. But the link between interest rates and unemployment is indirect. In contrast, equilibrium theory embodies many direct links between interest rates and the employment decisions of workers and firms.

For instance, training a new worker is costly. Hiring is therefore, in effect, an investment decision. Whether it makes sense to incur the initial cost will depend, in principle, on the discounted flow of future in-come due to the extra worker. Higher interest rates reduce the value of this future income. The investment becomes less attractive and, says the theory, unemployment rises as a direct consequence. In a concluding chapter, Mr Phelps tests this and other predictions against post-war economic history. The fit is impressive.

"Structural Slumps" is addressed to professional economists. They will regard it as one of the most important books of this decade. But brave non-specialists, provided they have a grounding in the subject and are not deterred by the necessary mathematics, can learn a great deal. with luck they will include some of Keynes's practical men "who are usually the slaves of some defunct economist".

Few economists write as lucidly as Mr Phelps; among those toiling at the theoretical frontier of the subject, he is peerless in this respect. And he is unusual in another way, though it is an indictment of his colleagues to say so: he writes with a sense of purpose. Mr Phelps's theory, he lets you know, matters not for its elegance or technical ingenuity--though it has both--but for the new light it sheds on a problem that urgently demands a solution.