6. Monetary Illusions and Unemployment

In this chapter we will explore the idea that pessimism about future wealth combined with the use of money is a recipe for unemployment. We shall demonstrate, with a thought experiment, that if money is removed from the equation then the pessimism on its own does not lead to unemployment. The resulting insights may help us escape the “paradox of thrift”, an idea popularised in modern times by John Maynard Keynes, though its roots date back very much earlier.

Unemployment types

The study of unemployment is a little messy because it is a problem that exists even in the best of times. In a perfectly thriving economy there will always be new technologies evolving, markets becoming saturated and tastes changing, all of which mean that people must occasionally change jobs from one sector to another, perhaps with some retraining involved. It is impractical to expect people to move from one job to another without spending at least some period being unemployed. Then there is the problem of certain people choosing to be unemployed because government-backed unemployment benefits have been set at a level which is perceived by some as comfortable enough to live on.

In this section we are not going to cover either of those types of unemployment. What we will discuss here is unemployment over and above that level: the kind of unemployment where normally hard-working people, perhaps people who have already worked for many years, suddenly cannot find any work. Or even the kind of underemployment where skilled people find themselves having to wait at tables or take part-time work because that is all they can find. We shall, for want of a better phrase, label this as excess unemployment.

Following the standard procedure of this book, let’s first consider unemployment without money. At first glance it may seem that the use of money could have no possible impact on unemployment. But, perhaps surprisingly, there are major, purely monetary components to it. Before we can explore those, we have to consider the reasons for excess unemployment in the first place.

When do we have high unemployment?

The most obvious periods in which we have excess unemployment is after the bursting of some kind of asset bubble. Large sectors of the economy (house building, for example) have been exposed as being overmanned. Companies in these sectors will start to fail. A wave of new unemployment will occur for this reason alone.

Additionally the value of people’s savings, whether that be tied up in the value of their houses or the value of their pension funds, has now been exposed as being far lower than had previously been assumed. The population at large is being given a message: “Your savings are inadequate.” Quite naturally and rationally there is a rapid aggregate shift from unsustainable profligacy to a new desire to save. Everyone, not just individuals but also government departments and businesses, will now feel the need to cut back on their spending. The consequences of this shift in behavior will be considered next with the aid of some thought experiments.

Pessimism in a world without money

Let’s now consider what would happen in an economy hit by a sudden desire to save that did not have money. For the purposes of this thought experiment, the model society must very strictly be without money. An ordinary vanilla barter economy will not suffice because there will be goods that can act as a kind of money, perhaps gold or jewels. So just for the sake of argument, let us say that we have a “super-barter” world where there is no gold, no jewels and no high-value non-perishable commodities that are stores of value that can act as a money substitute or savings conduit.

It must be noted that the business cycle mechanism, described in Chapter 4, cannot occur in a super-barter economy, so we will have to invent some other reason for pessimism in our experiment. Let’s say that a newspaper article had just been published stating that a famous soothsayer has just predicted hard times in the coming years due to floods, pestilence or the like. This soothsayer had always been right in the past and there is now widespread concern. People may think to themselves, “I’d better save up for the hard times ahead! I’ll carry on working hard, perhaps working even harder than before, and at the same time I’ll consume as little as possible so that I will have an excess of produce that I can use for savings.”

Consider what options will be open to people in this state. We have already eliminated the possibility of the concentrated value storage savings mechanism (there is no gold or jewels by definition in this thought experiment), so the remaining options are “simple warehouse” and “contract” (as defined in chapter 3). Simple warehouse saving are of course extremely inefficient, so there will not be much enthusiasm for that. This leaves one last option, namely contract savings. Unfortunately this needs a willing partner to take the opposite side of that deal. Given all the pessimism about the future, there are going to be very few people willing to take the other side of that deal without driving hard bargains. The borrowers will be able to say, “You give me a large amount of your produce now in return for a small amount of my produce in the future.” As the few remaining people willing to borrow do their deals, there will be fewer and fewer left, driving harder and harder bargains. This avenue of savings will soon become ostensibly blocked. All the savings mechanisms have evaporated, leaving no reasonable savings mechanisms available to anyone.

Now let’s consider what will happen with production and trade in this pessimistic environment with no possibility of saving. Obviously people are still going to be working to manufacture as much as they can, but what will they do with their produce? It is impractical to store it for the long term; they have no option but to either consume it directly themselves, at that time, or use it to exchange for other people’s produce, at that time. When they find people to exchange their goods with, both sides will have the usual incentives to receive as much as possible in return for their produce. So as you should now be able to see there is no reason, no incentive, no possibility to consume less than you produce despite the fact that there is a desire to. The people may wish they could save more, they may well be cursing the fact that they can’t, but it will be clear to everyone that all the savings avenues have been used up. They may as well carry on consuming. We can sum this situation up as follows:

Pessimism about the future cannot lead to a significant reduction in consumption in a super-barter economy.

Pessimism in a world with money

Now we shall consider what happens when money is introduced. Again, a wave of pessimism about the future strikes the population. Everybody wants to save. But now, with money available, people think they can save simply by storing their money. They think to themselves, “If I cut back on buying things with my money then I can store it in the bank and use that for when the hard times come.” Unfortunately, and quite unlike the situation in the barter economy, this now does mean that consumption can decrease.

Pessimism about the future can lead to a significant reduction in consumption in a money-based economy.

This will soon start a feedback loop. As people generally consume less, they will find it harder to sell the goods that they have made. Some people may find certain goods so hard to sell that their businesses go bust. They will lose their jobs. Other people, upon seeing their neighbours losing their jobs, will become even more concerned about the future and will try even harder to cut back on their consumption, causing even more people to lose their jobs. This feedback loop can be quite devastating for an economy.

The end of the spiral

Just in case you were wondering, the downward spiral of job losses does not go on forever. It may go down a long way and be pretty painful, but there is a bottom. The bottom is determined largely by what people decide they will cut back on. Obviously great swathes of the population will cut back on things that they consider luxuries, but the demand for things considered necessities will always remain. So when people have cut back on everything they think they can cut back on, a bottom will have been reached. No further people will be losing their jobs. Once people can see that the contraction in the economy has ceased, or is slowing down, then people will no longer think that they have to cut back any further. The feedback loop can now go into reverse and a recovery can begin.

The job losses after a bubble-bursting can thus be considered as having two components:

• the reverse-migration component.

• the monetary (paradox of thrift) component.

The reverse-migration component are the job losses in the sectors that had became oversubscribed during the upswing of the bubble. Exactly which sectors these are will depend on exactly which asset class was involved in the bubble.

The monetary component are the unfortunate additional jobs lost due to everyone’s desire to cut back on consumption. There will be a tendency for the job losses to be concentrated in sectors providing goods and services that people choose to cut back on when they are pessimistic about their future.

The jobs lost in the process of reverse migration should be seen as a positive thing for the economy, a correction of errors, whereas the jobs lost due to the monetary component simply constitute a loss of wealth, a missed opportunity to produce or supply goods and services.

In conclusion, the key to full employment is to maintain people’s expectations of their future wealth at a constant and realistic level. Remember that any period in which expectations of future wealth are raised above what is realistic will generally be followed by a job-losing correction.

Another way of expressing this is to say that it is essential to maintain a balance between those in the economy that are keen to consume more than they produce and those that wish to produce more than they consume. At the time of writing there is an almost overwhelming desire to consume less than we produce in a great many countries and very few people wish to do the reverse. This is a perfect recipe for a downward spiral of the paradox of thrift type unemployment.

Why major wars end depressive spirals

It has been noticed by many economists that wars appear to end depressions. The reason for this is that at the end of a war, when your cities are in ruins and the economy is on its knees, the balance between savers and borrowers shifts dramatically. In good times, lots of savings take place precisely for use on “a rainy day”. When the city around you is in ruins, what could be more of a rainy day? Very few people are going to be saying to themselves, “I’d better start saving now in case there are some hard times ahead.” These are the hard times. Naturally the general assumption will be that the future will be more prosperous than the present.

A mountain of debt is a constant source of pessimism

If there are high levels of debt after a bubble bursts this can leave an economy in a state from which it is very difficult to recover. Before the bursting of the bubble both individuals and governments may have chosen to run up debts which were towards the limits of repayability, i.e. they may have calculated that the interest on those debts was just about repayable given their predictions of future income and future growth of their investments. The bursting bubble now reveals their predictions were overoptimistic and their debts can become unrepayable. This may not be realised immediately. People may say to themselves, “These debts look pretty bad right now, but maybe things will get better and I could pay them back later. In the meantime I’ll just cut back on my spending to try to keep up the interest payments.” This plan serves only to suppress demand further.

Some economists have tried to suggest that an aggregate drop in demand is nonsensical because for every person in debt there must be a person to whom the debt is owed, so even though the debtor may be pessimistic and cutting back there must be a creditor gleefully collecting all this money and spending it, thereby keeping demand constant. This, however, is not the case. It will be clear to the creditors that the debtors are struggling. Many debtors will be late with their payments, and a few will start to default. The creditors will become concerned that the default problem will get worse in the future. The creditors are liable to become every bit as pessimistic as the debtors. The economy can be in a cul-de-sac from which there seems no escape.

The problem of too much unrepayable debt in an economy has been observed a great many times all over the world since antiquity. Indeed in biblical times there were regular 'debt jubilees' where every few decades all debts would be officially cancelled. Professor Michael Hudson has written of this in his work The Lost Tradition of Biblical Debt Cancellations. Implementing ideas taken from biblical times may seem strange, but if the debts built up in an economy have grown too high, a jubilee or something like it may be the only way to avoid a Great Depression.

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