Annual hours worked per working age American, German and French, 1950–2013

Figure 1 shows that Americans work the same hours per year pretty much the entire post-war period. By contrast, there is been a long decline in hours worked in Germany and France. The large drop in 1992 was German unification.

Figure 1: annual hours worked per working age American, German and French, 1950 – 2013

image

Source: OECD StatExtract and The Conference Board Total Economy Database™,January 2014, http://www.conference-board.org/data/economydatabase/

The long decline seemed to tally with the disproportionately sharp rise in the average tax rate on labour income, including social security contributions in France and Germany. When tax rates on labour income, including social security contributions stabilised in about 1980, hours worked stabilised in all countries.

Figure 2: average tax rate on labour income,USA, Germany and France, 1950 – 2013

image

Source: Source: Cara McDaniel.

Some pander to the great vacation theory of European labour supply. This is the hypothesis of a large increase in the preference for leisure in the European Union member states. That is, mass voluntary unemployment and mass voluntary reductions and labour supply by choice by Europeans. They just decided to work less.

This is not the first outing for the great vacation theory of labour supply. In the late 1970s, Modigliani dismissed the new classical explanation of Lucas and Rapping  (1969) of the U.S. great depression in which the 1930s unemployment was voluntary unemployment  – the great depression was just a great vacation –  with the following remarks:

Sargent (1976) has attempted to remedy this fatal flaw by hypothesizing that the persistent and large fluctuations in unemployment reflect merely corresponding swings in the natural rate itself.

In other words, what happened to the U.S. in the 1930’s was a severe attack of contagious laziness!

I can only say that, despite Sargent’s ingenuity, neither I nor, I expect most others at least of the non-Monetarist persuasion, are quite ready yet. to turn over the field of economic fluctuations to the social psychologist!

As Prescott has pointed out, the USA in the Great Depression and France since the 1970s both had 30% drops in hours worked per adult. That is why Prescott refers to France’s economy as depressed. The reason for the depressed state of the French (and German) economies is taxes, according to Prescott:

Virtually all of the large differences between U.S. labour supply and those of Germany and France are due to differences in tax systems.

Europeans face higher tax rates than Americans, and European tax rates have risen significantly over the past several decades.

Countries with high tax rates devote less time to market work, but more time to home activities, such as cooking and cleaning. The European services sector is much smaller than in the USA.

Time use studies find that lower hours of market work in Europe is entirely offset by higher hours of home production, implying that Europeans do not enjoy more leisure than Americans despite the widespread impression that they do. Europeans did not work less. They worked more on activities that were not taxed.

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Recessions as reorganisations

Most models of the shape of recoveries draw on a learning process. A long tradition in business cycle theory holds that limited knowledge of relative price changes can temporarily disrupt labour demand and supply because of errors in wage and price perceptions (Alchian 1969; Sargent 2007; Hellwig 2008).

Pricing, investment and production plans are made on the basis of incomplete and conflicting knowledge of constantly changing aggregate, industry and local conditions. Firms and workers will over- or under-supply when they misperceive wages and prices.

With imprecise information, it takes time for employers and workers to sort out temporary from permanent shifts in demand and supply, inflation-driven changes from real changes in prices and input costs, and general changes from the local changes that may be more important to particular firms. As Hayek explained in his Nobel prize lecture:

The true, though untestable, explanation of extensive unemployment ascribes it to a discrepancy between the distribution of labour (and the other factors of production) between industries (and localities) and the distribution of demand among their products.

This discrepancy is caused by a distortion of the system of relative prices and wages. And it can be corrected only by a change in these relations, that is, by the establishment in each sector of the economy of those prices and wages at which supply will equal demand.

Recoveries are shaped by the speed of entrepreneurial learning about the new labour and product market conditions, the relative cost of adjusting capital and labour rapidly or slowly and the costs and benefits of labour market search. This new learning is necessary because the old constellation of prices and wages is no longer valid.

It was a misdirection of resources brought about by the initial inflationary firm, as Hayek explained in a visit to Australia in 1950:

During a process of expansion the direction of demand is to some extent necessarily different from what it will be after expansion has stopped.

Labour will be attracted to the particular occupations on which the extra expenditure is made in the first instance.

So long as expansion lasts, demand there will always run a step ahead of the consequential rises in demand elsewhere.

And in so far as this temporary stimulus  to demand in particular sectors leads to a movement of labour, it may well become the cause of unemployment as soon as the expansion comes to an end…

If the real cause of unemployment is that the distribution of labour does not correspond with the distribution of demand, the only way to create stable conditions of high employment which is not dependent on continued inflation (or physical controls), is to bring about a distribution of labour which matches the manner in which a stable money income will be spent.

This depends of course not only on whether during the process of adaptation the distribution of demand is approximately what it will remain, but ‘also on whether conditions in general are conducive to easy and rapid movements of labour.

In a recession, employers and workers do not immediately know that demand has fallen elsewhere as well as in their own local markets and recognise the need to adjust to their poorer prospects everywhere, and it is not known how long the drop in demand will last (Alchian and Allen 1973).

The cost of learning about available opportunities restricts the speed of a recovery. Workers and entrepreneurs must gather information on the new state of demand and the location and nature of new opportunities. This information is costly and is quickly made obsolete by further changes, and the cost of acquiring information is more costly the faster the information is sought to be acquired (Alchian 1969; Alchian and Allen 1967).

The process of recovering from a recession would be a faster process if the new constellation of wages and prices that are the best alternative uses of resources was known immediately and was credible to firms and workers (Alchian and Allen 1973).

Workers and employers must first have sufficient time to discover what new knowledge they now need to know to serve their interests well, leave enough room for the unforeseeable and keep their knowledge fresh in ever-changing markets.

New wage levels must be created by workers and employers testing and retesting in the labour market the new relative scarcities of labour. Imbalances between the allocation of labour supply and demand to different firms and sectors and the new level and pattern of consumer demand are gradually remedied by changes in relative prices and wages, layoffs, business closures and job search.

Prices are a signal wrapped in an incentive. Growing demand induces higher employment and rising wages. Wages stagnate, and there are layoffs where there is an excess supply.

These changes give the unemployed an incentive to move to new uses and entrepreneurs to profitably hire the unemployed. The ensuing reorganisations are time-consuming and information-intensive because a job seeker and an employer with an apt vacancy take time to find each other.

Prices and wages must change sufficiently for firms to profitably create new jobs. New jobs require time to plan and build new job capital. This is the human, physical and organisational capital underlying a new job. There are also job creation costs when reopening existing positions that were mothballed during the downturn.

How is this to be done? Hayek explained again in 1950 in his speech in Australia:

Full employment policies as at present practised attempt the quick and easy way of giving men employment where they happen to be, while the real problem is to bring about a distribution of labour which makes continuous high employment without artificial stimulus possible.

What this distribution is we can never know beforehand. The only way to find out is to let the unhampered market act under conditions which will bring about a stable equilibrium between demand and supply.

Spans of control and the cost of entrepreneurial time

One constraint on the growth of any firm is entrepreneurs have a limited span of control (Coase 1937; Williamson 1967, Lucas 1978; Oi 1983a, 1983b). A span of control is the number of subordinates that an individual supervisor has to control and lead either directly or through a hierarchical managerial chain (Fox 2009).

There are only so many tasks that even the most able entrepreneurs can carry out in one day. Over-stretched spans of control motivate entrepreneurs to hire professional managers and delegate to them a wide range of decision-making rights over the firms they own (Williamson 1975; Foss, Foss and Klein 2008).

Entrepreneurs and the professional managers they hired to assist them must divide their respective time between monitoring employees, identifying new business opportunities, forecasting buyer demand and running the other aspects of their business (Lucas, 1978; Oi 1983, 1983b, 1988; Foss, Foss, and Klein 2008). The larger is the firm, the more employees there are for the entrepreneur to direct, monitor and reward. These costs of directing and monitoring employees will increase with the size of the firm and larger firms will encounter information problems not present in smaller firms (Alchian and Demsetz 1972; Stigler 1962).

The cost of entrepreneurial time spent monitoring employees will increase with the size of the firm (Lucas 1978; Oi 1983b). The time of the more talented entrepreneurs is more valuable because they had the superior managerial skills and entrepreneurial alertness to make their firms large in the first place and remain deft enough to survive in competition. Time spent on the supervision of employees is time that is spent away from other uses of the talents that got these more able entrepreneurs to the top and keeps them there (Williamson 1967; Lucas 1978; Oi 1983b, 1988, 1990; Idson and Oi 1999; Black et al 1999).

Firms in the same industry tend to exhibit systematic differences in their organization of production and the structure of their workforces because entrepreneurial ability is the specific and scarce production input that limits the size of a firm (Lucas, 1978; Oi 1983b). The less able entrepreneurs tend to run the smaller firms while the more able entrepreneurs tend to lead both the currently large firms and the smaller firms that are growing at the expense of market rivals (Lucas 1978, Oi 1983b; Stigler 1958; Alchian 1950).

Robert Lucas explained his support for U.S. monetary policy in 2008 as follows

  • There are many ways to stimulate spending, but monetary policy was the most helpful counter-recession action because it was fast and flexible.
  • There is no other way that so much cash could have been put into the system as fast, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.
  • There is no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These were important virtues.

Is unemployment voluntary or involuntary?

Robert Lucas in a famous 1978 paper argued that all unemployment was voluntary because involuntary unemployment was a meaningless concept. He said as follows:

The worker who loses a good job in prosperous time does not volunteer to be in this situation: he has suffered a capital loss. Similarly, the firm which loses an experienced employee in depressed times suffers an undesirable capital loss.

Nevertheless the unemployed worker at any time can always find some job at once, and a firm can always fill a vacancy instantaneously. That neither typically does so by choice is not difficult to understand given the quality of the jobs and the employees which are easiest to find.

Thus there is an involuntary element in all unemployment, in the sense that no one chooses bad luck over good; there is also a voluntary element in all unemployment, in the sense that however miserable one’s current work options, one can always choose to accept them.

I agree that we all make choices subject to constraints. To say that a choice is involuntary because it is constrained by a scarcity of job-opportunities information is to say that choices are involuntary because there is scarcity.

Alchian said there are always plenty of jobs because to suppose the contrary suggests that scarcity has been abolished. Lucas elaborated further in 1987 in Models of Business Cycles:

A theory that does deal successfully with unemployment needs to address two quite distinct problems.

One is the fact that job separations tend to take the form of unilateral decisions – a worker quits, or is laid off or fired – in which negotiations over wage rates play no explicit role.

The second is that workers who lose jobs, for whatever reason, typically pass through a period of unemployment instead of taking temporary work on the ‘spot’ labour market jobs that are readily available in any economy.

Of these, the second seems to me much the more important: it does not ‘explain’ why someone is unemployed to explain why he does not have a job with company X. After all, most employed people do not have jobs with company X either.

To explain why people allocate time to a particular activity – like unemployment – we need to know why they prefer it to all other available activities: to say that I am allergic to strawberries does not ‘explain’ why I drink coffee. Neither of these puzzles is easy to understand within a Walrasian framework, and it would be good to understand both of them better, but I suggest we begin by focusing on the second of the two.

Another way to understand unemployment is to use a device at the start of Alan Manning’s book on labour market monopsony:

What happens if an employer cuts the wage it pays its workers by one cent? Much of labour economics is built on the assumption that all existing workers immediately leave the firm as that is the implication of the assumption of perfect competition in the labour market.

In such a situation an employer faces a market wage for each type of labour determined by forces beyond its control at which any number of these workers can be hired but any attempt to pay a lower wage will result in the complete inability to hire any of them at all

Suppose workers offered to work for 1 cent. Would employers accept? Many do because they have intern and work experience programmes for students, but is this result of general application?

Understanding the reallocation of labour at the end of the recession requires careful attention to the 1980s writing of Alchian on the theory of the firm. Alchian and Woodward’s 1987 ‘Reflections on a theory of the firm’ says:

… the notion of a quickly equilibrating market price is baffling save in a very few markets. Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances?

If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears?

… But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.

Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

Alchian and Woodward explain unemployment as a side-effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets. They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm make with one another.

My interpretation is the majority of employment relationships are capital intensive long-term contracts. Employers spend a lot of time searching and screening applicants to find those that will stay longer. In less skilled jobs, and in spot market jobs, employers will hire the best applicant quickly because job turnover costs are low. Back to Manning again:

That important frictions exist in the labour market seems undeniable: people go to the pub to celebrate when they get a job rather than greeting the news with the shrug of the shoulders that we might expect if labour markets were frictionless. And people go to the pub to drown their sorrows when they lose their job rather than picking up another one straight away. The importance of frictions has been recognized since at least the work of Stigler (1961, 1962).

Whatever may be among these frictions, wage rigidity is not one of them. Wages are flexible for job stayers and certainly new starters.

See What can wages and employment tell us about the UK’s productivity puzzle? by Richard Blundell, Claire Crawford and Wenchao Jin showing that in the recent UK recession 12% of employees in the same job as 12 months ago experienced wage freezes and 21% of workers in the same job as 12 months ago experienced wage cuts. Their data covered 80% of workers in the New Earnings Survey Panel Dataset.

Larger firms lay off workers; smaller firms tended to reduce wages. This British data showing widespread wage cuts dates back to the 1980s. Recent Irish data also shows extensive wage cuts among job stayers.

See too Chris Pissarides (2009), The Unemployment Volatility Puzzle: Is Wage Stickiness the Answer? arguing the wage stickiness is not the answer since wages in new job matches are highly flexible:

  1. wages of job changers are always substantially more procyclical than the wages of job stayers.
  2. the wages of job stayers, and even of those who remain in the same job with the same employer are still mildly procyclical.
  3. there is more procyclicality in the wages of stayers in Europe than in the United States.
  4. The procyclicality of job stayers’ wages is sometimes due to bonuses, and overtime pay but it still reflects a rise in the hourly cost of labour to the firm in cyclical peaks

How do existing firms who will not cut wages survive in competition with new firms who can start workers on lower wages? Industries with many short term jobs and seasonal jobs would suffer less from wage inflexibility.

Robert Barro (1977) pointed out that wage rigidity matters little because workers can, for example, agree in advance that they will work harder when there is more work to do—that is, when the demand for a firm’s product is high—and work less hard when there is little work. Stickiness of nominal wage rates does not necessarily cause errors in the determination of labour and production.

The ability to make long-term wage contracts and include clauses that guard against opportunistic wage cuts should make the parties better off. Workers will not sign these contracts if they are against their interests. Employers do not offer these contracts, and offer more flexible wage packages, will undercut employers who are more rigid. Furthermore many workers are on performance pay that link there must wages to the profitability of the company.

How can downward wage rigidity be a scientific hypothesis if extensive international evidence of widespread wage cuts since the 1980s and 30%+ of the workforce on performance bonuses is not enough to refute it?

Alchian and Kessel in “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” Amer. Econ. Rev. 50 [March 1960]:43-66) tested the hypothesis that workers suffered from money illusion by comparing the rates of return to firms in capital intensive industries with those of labour intensive industries. Labour intensive industries were not more profitable than capital intensive industries. Employers in labour intensive industries should profit from the misperceptions of workers about wages and future prices, but they did not.  Alchian and Kessel found little evidence of a lag between wage and price changes.

In Canadian industries in the 1960s and 1970s, wage indexation ranged from zero to nearly 100%. Industries with little indexation should show substantial responses of real wage rates, employment and output to nominal shocks. Industries with lots of indexation would be affected little by nominal disturbances. Monetary shocks had positive effects but an industry’s response to these shocks bore no relation to the amount of indexation in the industry. Shaghil Ahmed (1987) found that those industries with lots of indexation were as likely as those with little indexation to respond to shocks.

If the signing of new wage contracts was important to wage rigidity, there should be unusual behaviour of employment and real wage rates just after these signings, but the results are mixed. Olivei and Tenreyro (2010) used the tendency of contracts to be signed at the start of years to show that monetary policy had significant effects in January but little effect in December because the effects were quickly undone.

Alchian (1969) lists three ways to adjust to unanticipated demand fluctuations:
• output adjustments;
• wage and price adjustments; and
• Inventories and queues (including reservations).

Alchian (1969) suggests that there is no reason for wage and price changes to be used regardless of the relative cost of these other options:
• The cost of output adjustment stems from the fact that marginal costs rise with output;
• The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer; and
• The third method of adjustment has holding and queuing costs.

There is a tendency for unpredicted price and wage changes to induce costly additional search. Long-term contracts including implicit contracts arise to share risks and curb opportunism over relationship-specific capital. These factors lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability.

A Great Recession or dropping to a lower long-term growth path

Ed Prescott and Robert Lucas are several of many who use variations of the chart below to show that the USA has moved to a lower long-term growth path.

Source: House of Debt

The chart below for output per working age American (ages 15 to 64) is just as depressing.

Source: Edward Prescott

At least Spain with its 25% unemployment rate is doing a little worse.

Source: Edward Prescott

Why I am not reviewing Thomas Piketty’s Capital in the Twenty-First Century – updated again

It’s 700 pages long and goes on about Marx. Some people were watching the other channel when the Berlin Wall fell.

thomas-piketty-economist-will-hutton

My 1 o’clock lecture at ANU in 1990 was next to a room rented out ironically from 12 to 1 to the Campus Trots and then to the Campus Christians for an hour of prayer to another saviour.

The Twitter summary of Piketty is this:

Karl Marx wasn’t wrong, just early. Pretty much. Sorry, capitalism. #inequalityforevah

The only Marxist I bother with is Jon Elster. He is a leading proponent of Analytical Marxism and one of the last polymaths. Brian Barry once wrote that to review one of Elster’s books one:

would either have to have taken off several years to master the many fields which fall within Elster’s purview or would be a consortium of at least twenty carefully-chosen experts.

All of Elster’s books and writings are worth reading, including

  • Ulysses and the Sirens (1979);
  • Sour Grapes: Studies in the Subversion of Rationality (1983);
  • Making Sense of Marx (1985); and
  • An Introduction to Karl Marx (1986).

As Jon Elster noted:

Marxian economics is, with a few exceptions, intellectually dead

and Marx’s labour theory of value is:

useless at best, harmful and misleading at its not infrequent worst.

To go on with my non-review, I will quote Tyler Cowen:

The crude seven-word version of Piketty’s argument is “rates of return on capital won’t diminish.”

Piketty’s reasons why rates of return on capital won’t diminish are fairly specific and restricted to only a small share of capital.

.. In any case this is pure speculation and Piketty’s entire argument depends upon it.

… Piketty converts the entrepreneur into the rentier.

To the extent capital reaps high returns, it is by assuming risk…

Yet the concept of risk hardly plays a role in the major arguments of this book.

Once you introduce risk, the long-run fate of capital returns again becomes far from certain.

In fact the entire book ought to be about risk but instead we get the rentier…

Overall, the main argument is based on two (false) claims.

First, that capital returns will be high and non-diminishing, relative to other factors.

Second, that this can happen without significant increases in real wages.

Piketty’s advocacy of a top marginal income tax rate of 80% and a an international treaty for a wealth tax are wildly impractical and destructive of economic growth and entrepreneurship. His advocacy of 60% marginal tax rates on incomes above $200,000 strike at the heart of the professional and managerial occupations that are the backbone of day-to-day capitalism. Piketty’s wealth tax would tax the homes and the retirement savings of the ordinary middle class:

  • wealth below 200,000 euros be taxed at a rate of 0.1 percent,
  • wealth between 200,000 and one million euros at 0.5 percent,
  • wealth between one million and five million euros at 1.0 percent, and
  • wealth above five million euros at 2.0 percent.

Piketty’s reason for these high top tax rates is not to bring in more revenue or to redistribute wealth to poor and the downtrodden but simply “to put an end to such incomes.” Harsanyi argues that:

Like many progressives, Piketty doesn’t really believe that most people deserve their wealth anyway, so confiscating it presents no real moral dilemma.

He also argues that we can measure a person’s productivity and the value of a worker (namely, low-skilled labourers) while arguing that other groups of workers (namely, the kind of people he doesn’t admire) are bequeathed undeserved, “arbitrary” salaries. What tangible benefit does a stockbroker or a kulak or an explanatory journalist offer society, after all?

This takes me back to Jon Elster who had this to say on socialism:

Optimism and wishful thinking have been features of socialist thought from its inception.

In Marx, for instance, two main premises appear to be that whatever is desirable is possible, and that whatever is desirable and possible is inevitable.

…It has become clear that classical socialism massively underestimated the importance of economic incentives.

Greg Mankiw is less harsh, but still to the point:

Like President Obama and others on the left, Piketty wants to spread the wealth around.

Another philosophical viewpoint is that it is the government’s job to enforce rules such as contracts and property rights and promote opportunity rather than to achieve a particular distribution of economic outcomes.

No amount of economic history will tell you that John Rawls (and Thomas Piketty) offers a better political philosophy than Robert Nozick (and Milton Friedman).

John Rawls was actually very much alive to the importance of incentives in a just and prosperous society.

Unequal incomes might turn out to be to the advantage of everyone. Work effort and entrepreneurial alertness respond to incentives; incentives channel people into the occupations and jobs where they produce more.

Rawls lent qualified support to the idea of a flat-rate consumption tax because these taxes:

impose a levy according to how much a person takes out of the common store of goods and not according to how much he contributes.

A simple way to have a progressive consumption tax is to exempt all savings from taxation.

With his emphasis on fair distributions of income, Rawls’ initial appeal was to the Left. Left-wing thinkers then started to dislike his acceptance of capitalism and his tolerance of large discrepancies in income and wealth.

It’s impossible to make the workers better off by taxing capital. The optimal rate of tax on income from capital is zero. This is why the Mirrlees Review of the UK taxation system argued for zero taxation of the returns to capital.

Robert Lucas estimated in 1990 that eliminating all taxes on income from capital would increase the U.S. capital stock by about 35% and consumption by 7%.

Hans Fehr, Sabine Jokisch, Ashwin Kambhampati, and Laurence J. Kotlikoff (2014) found that eliminating the corporate income tax completely would raise the U.S. capital stock (machines and buildings) by 23%, output by 8% and the real wages of unskilled and skilled workers each by 12%.

Book reviews serve the same purpose as film reviews. They are filters for our time. Do you agree?

I made a time management decision to not read a long book plenty of others reviewed and some even understood.

As for the growing income inequality, there is a long literature dating back 25-years arguing that skill-biased technological change is increasing the returns to investing in education as Gary Becker blogged in 2011:

Earnings inequality in the United States and many other countries has increased greatly since the late 1970s, due in large measure to globalization and technological progress that raised the productivity of more educated and more skilled individuals.

While the average American college graduate earned about a 40% premium over the average high school graduate in 1980, this premium increased to over 70% in 2000.

The good side of this higher education-based earnings inequality is that it induced more young men, and especially more young women, to go to and finish college.

The bad side is that many sufficiently able children could not take advantage of the greater returns from a college education because their parents did not prepare them to perform well in school, or they went to bad schools, or they lacked the financing to attend college.

As a result, the incomes of high school dropouts and of many high school graduates stagnated while incomes boomed for many persons who graduated college, and even more so for those with post graduate education.

There is nothing new under the sun.