There are two schools of thought on the primary cause of our current unemployment problem: Some claim that the unemployment is cyclical (low aggregate demand) whereas others think it’s structural (mismatch in the labour market). The “Structuralists” point to the apparent shift in the Beveridge curve and the increased demand in healthcare and technology whereas the “Cyclicalists” point to the fall in employment across all other sectors. So who’s right? In my opinion, neither explanation is entirely satisfactory. This post is an expansion of some thoughts I touched upon in my last post that describe the “persistent unemployment” problem as a logical consequence of a dynamically uncompetitive “Post Minsky Moment” economy.
Narayana Kocherlakota explains the mismatch thesis as follows: “Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work….the Fed does not have a means to transform construction workers into manufacturing workers.” Undoubtedly this argument has some merit – the real question is how much of our current unemployment can be attributed to the mismatch problem? Kocherlakota draws on work done by Robert Shimer and extrapolates from the Beveridge curve relationship since 2000 to arrive at a implied unemployment rate of 6.3% if mismatch were not a bigger problem and the Beveridge curve relationship had not broken down. Jan Hatzius of Goldman Sachs on the other hand attributes as little as 0.75% of the current unemployment problem to structural reasons. Murat Tasci and Dave Lindner however conclude that the recent behaviour of the Beveridge curve is not anomalous when viewed in the context of previous post-war recessions. Shimer himself was wary of extrapolating too much from the limited data set from 2000 (see pg 12-13 here) This would imply that Kocherlakota’s estimate is an overestimate even if Jan Hatzius’ may be an underestimate.
Incorporating Uncertainty into the Mismatch Argument
It is likely therefore that there is a significant pool of unemployment that cannot be justified by the simple mismatch argument. But this does not mean that the “recalculation” thesis is not valid. The simple mismatch argument ignores the uncertainty involved in the “Post-Minsky Moment economy” – it assumes that firms have known jobs that remain unfilled whereas in reality, firms need to engage in a process of exploration that will determine the nature of jobs consistent with the new economic reality before they search for suitable workers. The problem we face right now is of firms unwilling to take on the risk inherent in such an exploration. The central message in my previous posts on evolvability and organisational rigidity is that this process of exploration is dependent upon the maintenance of a dynamically competitive economy rather than a statically competitive economy. Continuous entry of new firms is of critical importance in maintaining a dynamically competitive economy that retains the ability to evolve and reconfigure itself when faced with a dramatic change in circumstances.
The “Post Minsky Moment” Economy
In Minsky’s Financial Instability Hypothesis, the long period of stability before the crash creates a homogeneous and fragile ecosystem – the fragility arises due to the fragility of the individual firms as well the absence of diversity. Post the inevitable crash, the system inevitably regains some of its robustness via the slack built up by the incumbent firms, usually in the form of financial liquidity. However, so long as this slack at firm level is maintained, the macro-system cannot possibly revert to a state where it attains conventional welfare optima such as full employment. The conventional Keynesian solution suggests that the state pick up the slack in economic activity whereas some assume that sooner or later, market forces will reorganise to utilise this firm-level slack. This post is an attempt to partially refute both explanations – As Burton Klein often noted, there is no hidden hand that can miraculously restore the “animal spirits” of an economy or an industry once it has lost its evolvability. Similarly, Keynesian policies that shore up the position of the incumbent firms can cause fatal damage to the evolvability of the macro-economy.
Corporate Profits and Unemployment
This thesis does not imply that incumbent firms leave money on the table. In fact, incumbents typically redouble their efforts at static optimisation – hence the rise in corporate profits. Some may argue that this rise in profitability is illusory and represents capital consumption i.e. short-term gain at the expense of long-term loss of competence and capabilities at firm level. But in the absence of new firm entry, it is unlikely that there is even a long-term threat to incumbents’ survival i.e. firms are making a calculated bet that loss of evolvability represents a minor risk. It is only the invisible foot of the threat of new firms that prevents incumbents from going down this route.
Small Business Financing Constraints as a Driver of Unemployment
The role of new firms in generating employment is well-established and my argument implies that incumbent firms will effectively contribute to solving the unemployment problem only when prodded to do so by the hidden foot of new firm entry. The credit conditions faced by small businesses remain extremely tight despite funding costs for big incumbent firms having eased considerably since the peak of the crisis. Of course this may be due to insufficient investment opportunities – some of which may be due to dominant large incumbents in specific sectors. But a more plausible explanation lies in the unevolvable and incumbent-dominated state of our banking sector. Expanding lending to new firms is an act of exploration and incumbent banks are almost certainly content with exploiting their known and low-risk sources of income instead. One of Burton Klein’s key insights was how only a few key dynamically uncompetitive sectors can act as a deadweight drag on the entire economy and banking certainly fits the bill.