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Created 12/28/1996
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It Doesn't Work:

A Review of

Out of Work: Unemployment and Government in Twentieth-Century America

by Richard K. Vedder and Lowell E. Gallaway

 

Vedder, Richard K.; and Gallaway, Lowell E. Out of Work: Unemployment and Government in Twentieth-Century America. New York: Holmes and Meier, 1993.


This review is forthcoming in Critical Review (1998). A reponse to their reply to my review.


I think that there are two things wrong with this book.

The first is that it confuses correlation with causation. It jumps from its observed association of high real wages--high wages divided by the average price of commodities; the "real" purchasing power of what workers earn--and high unemployment to conclude that any (government) action that increases real wages increases unemployment. As the back jacket reports: "Out of Work shows... that such policies as minimum wages, legal privileges for unions, civil rights legislation, unemployment compensation, and welfare have all played significant roles in generating joblessness." The conclusion of the book, backed by "relentless and devastating evidence" is "that the major cause of high unemployment in the United States... is government itself."

But when we find high real wages and high unemployment occurring together, which is cause and which is effect? Is unemployment high because workers have relatively high purchasing power? Or are real wages high because unemployment is high? Economists have argued this back and forth for nearly the entire century, and the only sane answer is that sometimes it is one, sometimes it is the other, sometimes some third factor is causing both. In the U.S. in the 1930s, for example, the balance of the evidence is that real wages were high because unemployment was high--and that steps to reduce wage levels would have deepened, not alleviated, the Great Depression. In Europe in the late 1970s, on the other hand, the balance of the evidence is that unemployment was high because real wages were higher than "warranted" as a result of the impact on relative prices of the 1973 tripling of world oil prices (see Bruno and Sachs, 1983)--and steps to reduce wage levels would probably have reduced European unemployment in the late 1970s. Had the authors taken a more careful look at the direction of causation in their presumed correlation between high real wages and high unemployment, they would have been led to a much more measured conclusion than that any (government) action that increases real wages increases unemployment.

The first flaw in the book is bad enough. The second is worse. There is no doubt that there are times, places, and historical episodes--the Great Depression in the U.S., or Europe in the late 1970s--in which high unemployment and high real wages do go together. But there is strong reason to doubt that this is a general pattern. When the business cycle turns downward, the jobs that disappear are disproportionately low-wage jobs held by the lesser-skilled. The jobs that remain pay, on average, more. So the shifting cyclical composition of employment generates the appearance of a countercyclical pattern in real wages: the average real wage rises in recessions because more of the low-paid have lost their jobs.

Correcting for this "composition of employment" effect, the balance of the evidence is that in the average business cycle real wages are slightly procyclical: a particular job with particular skill requirements tends to carry higher real wages in a boom than in a recession (see Barsky and Solon, 1993). Real wages are high in booms because demand for investment goods is high in booms--and thus the derived demand for labor is high in booms as well.

Moreover, Vedder and Gallaway's analysis incorrectly handles long-run productivity growth. Their theory of unemployment is not that unemployment is high when real wages are high in absolute value, but when real wages are high relative to trend productivity growth. But the productivity series that they use to scale their real wage measure is wrong: it contains cyclical movements in productivity that are the result, not the cause of low production and high unemployment.

So not only do Vedder and Gallaway confuse correlation with causation in those historical episodes in which high unemployment and high real wages go together, but their presumed general correlation of high wages and high unemployment is--most likely--an artifact of the way that their data were constructed. High real wages (relative to productivity) cannot possibly be part of a general explanation for high unemployment because real wages are more often than not low when unemployment is high.

Thus I think that there is literally nothing left of Vedder and Gallaway's grand argument that was to "redefine the way we think about one of the most explosive issues of the twentieth century." A lot of work--and a lot of hard work--has led them to false conclusions because it was based on flawed foundations. I do not pretend that I have the key to the riddle of the business cycle. But I do not think that Vedder and Gallaway have it either.

Let me expand on why I have reached my--negative--judgment about this book. Let me first discuss the pattern of real wages over the business cycle, and explain why I believe that the central correlation on which Vedder and Gallaway have based their structure is merely an artifact of how our data are constructed rather than of how the world really works. Let me then go on to, in more detail, explain how it is that when high real wages and high unemployment go together sometimes one is the cause and sometimes the other--certainly the chain of causation is not clear and direct enough to justify their laying of responsibility for unemployment at the door of government policies to raise wages.


What's Wrong with This Book I: Real Wages Are Not Countercyclical

In 1936 John Maynard Keynes published his General Theory of Employment, Interest and Money and started the intellectual tradition of modern macroeconomics. One feature of the business cycle that he included in his book--a feature that he went to significant pains and trouble to include and analyze--was the countercyclical nature of real wage movements: when production was high relative to trend, Keynes argued, unemployment and real wages were low; when production was low relative to trend--when the economy was in recession and depression--both unemployment and real wages were high.

This part of Keynes's book drew sharp and immediate dissent from economists specializing in the study of the labor market and labor institutions. Forty pages of the March, 1939 Economic Journal were devoted to the question of cyclical movements in real wages. John Dunlop--then a young economist, later in his career chairman of the War Labor Board during World War II and Secretary of Labor under President Ford--contributed a substantial article arguing that real wages were not countercyclical: that high unemployment and high real wages relative to trend did not go together. Lori Tarshis contributed a short comment.

John Maynard Keynes wrote a substantial essay essentially conceding the point: Keynes said that he had tried to minimize points of difference between his approach and the previous "Classical" approach; that countercyclical real wages had been an important part of the "Classical" approach; that nothing key in his argument hinged the countercyclical nature of real wages; and that he deferred to the superior statistical, institutional, and historical expertise of the labor economists.

Since then economists have revisited the question of the cyclical behavior of wages and prices. Recent valuable contributions include Mark Bils (1985), Michael Keane, Robert Moffitt, and David Runkle (1988), and Paul Beaudry and John DiNardo (1991) in the Journal of Political Economy; Gary Solon, Robert Barsky, and Jonathan Parker (1994) in the Quarterly Journal of Economics; and Michael Bruno and Jeffrey Sachs (1982) in their book on The Economics of Stagflation. For the most part subsequent revisitations of this question have backed Dunlop: the real wage is moderately procyclical, with higher wages associated with low unemployment, or at most acyclical.

Now comes Out of Work: Unemployment and Government in Twentieth-Century America, by Richard Vedder and Lowell Gallaway, to claim not only that sixty years of economic research has been wrong--that real wages are countercyclical, and that high unemployment is associated with high real wages--but that the association between high unemployment and high real wages is so strong as to account for practically all fluctuations in American unemployment over the past century.

Why this massive cognitive dissonance between what you read in the University of Chicago's Journal of Political Economy and what is reported by Vedder and Gallaway? This is the question that first interested me in the book. And I quickly found that Vedder and Gallaway would be of no help in trying to reconcile these two lines of thought: neither the Journal of Political Economy articles that I see as the latest word on real wages, nor the Bruno and Sachs book make it into Vedder and Gallaway's bibliography.

One reason for this cognitive dissonance is what has been termed "composition bias" in measurements of economy-wide real wages. The jobs that vanish in depressions are disproportionately the low-wage jobs, held by the relatively lesser-skilled. The average wage is calculated by taking total payroll and dividing it by total workhours. Thus anything that shifts the relative proportions of high-wage and low-wage jobs will change the calculated average wage--and a recession or a depression shifts the relative proportions of high-wage and low-wage jobs.

Note that this "composition bias" is all effect and no cause: in its pure form the wages paid to any one individual doing any one job have not changed: yet the economy-wide average real wage does change because the average contains fewer low-wage workers as a result of recession and depression unemployment.

A second reason for this cognitive dissonance is that Vedder and Gallaway have committed an error in how they scale their real wage variable. Real wages are high or low relative to the productive potential of the average worker, so Vedder and Gallaway divide real wages by a measure of productivity. Unfortunately, they divide real wages not by potential productivity--not by what output per hour would have been if factories had been running at normal levels of operation--but by actual productivity. And actual productivity varies greatly over the business cycle: whenever production is depressed, productivity is relatively low because the American economy possesses substantial increasing returns to scale: the "overhead" workers in a factory are necessary to keep it from rusting into oblivion whether the factory is running three, two, one, or zero shifts.

The "composition bias" and the "productivity bias" effects make Vedder and Gallaway's measure of real wages significantly more correlated with and more strongly associated with high real wages than a properly constructed measure would be.

A third--and perhaps the most important--reason for this cognitive dissonance is that the American economy may well not have the same structure today that it had back before World War II. During the Great Depression real wages rose, as prices of commodities in the consumer price index fell faster than did the wages paid to workers. During the Great Depression there was a positive correlation between high real wages and high unemployment.

Since World War II there has been no such correlation. The figure below plots my calculations, based on Vedder and Gallaway's description of how they calculated their data, of their adjusted real wage measure on the x-axis and the unemployment rate on the y-axis. The post-WWII years when unemployment was the highest were not the years in which adjusted real wages were the highest. The post-WWII years when unemployment was the lowest were not the years in which adjusted real wages were the lowest.

 

Thus I conclude that Vedder and Gallaway's book is fatally flawed. The presumed correlation between high adjusted real wages and high unemployment is the foundation on which they build their argument. And this foundation is made out of mud. Since World War II there is no sign that high adjusted real wages go with high unemployment: real wages appear procyclical and not countercyclical. Before the Great Depression real wages may have been countercyclical, but because no one has unscrambled the effect of "composition bias" and "productivity bias" on Vedder and Gallaway's adjusted real wage measure, we really do not know.

During the Great Depression real wages were certainly countercyclical: prices of commodities in the consumer price index fell faster than did the wages paid to workers. During the Great Depression there was a positive correlation between high real wages and high unemployment. But there is no good reason to think that high Depression real wages were a cause rather than an effect of high unemployment.


What's Wrong with This Book II: High Real Wages the Result Not the Cause of Unemployment

When John Maynard Keynes wrote his General Theory (1936), he was convinced (i) that real wages were higher in recessions than in booms, and (ii) that the cause of the business cycle lay in fluctuations in aggregate demand: fluctuations in the marginal propensity to consume of households and in the "animal spirits" of investors that governed purchases of capital goods. In Keynes's vision, there was correlation between high real wages and high unemployment, but no causation: if the government, workers, firms, or unions took steps to reduce nominal wages that had no impact on real aggregate demand, the likely consequence would not be a fall but a rise in unemployment.

How could this be? Keynes's vision of the economy was one in which the nominal wages paid to workers are relatively slow to respond to changing demand and supply conditions. So Keynes conducted his analysis by using the level of nominal wages as his unit of account (note that this is not the same thing as assuming that nominal wages are fixed). In times of recession firms found themselves able to hire additional workers from the unemployed at the prevailing wage. They had every incentive to do so, and to cut their prices a little bit below their competitors' prices in order to expand their market share so that they could sell the production of the newly-hired workers.

But every firm has an incentive to cut its price relative to the prevailing nominal wage. As more and more firms do so, the level of prices falls relative to the prevailing nominal wage. This process of mutual price-cutting continues until the price level has fallen so far that the extra product of an additional worker to a representative firm can no longer be selled at a profit. At that price level (relative to the nominal wage) business demand for labor is at an equilibrium: it doesn't pay firms to hire more workers. And at that price level in a recession real wages are relatively high, because the price level is relatively low.

What did Keynes think would happen if nominal wages were not relatively inflexible in a recession? What if nominal wages fell sharply as unemployment rose? The first-order effect in Keynes's model is that a fall in nominal wages would have no effect on employment: with a lower wage level, firms would find it worthwhile to continue the downward spiral of price cutting further. The end result? An econom with the same real wage, the same level of unemployment, and lower levels of wages and prices. The second-order effect in Keynes's model is that a fall in nominal wages (and the induced further fall in product prices) raises unemployment: falling prices discourage investment because they generate extremely high real interest rates, and because they lead to large-scale bankruptcies and financial collapses that destroy the web of financial intermediation on which so much. The third-order effect in Keynes's model is that a fall in nominal wages (and the induced further fall in product prices) increases the purchasing power of households' real money balances, stimulates consumption, raises aggregate demand, and boosts employment.

Which effect is dominant? DeLong and Summers (1988) presented an analysis (extending Tobin, 1975) that showed that in economies with a Keynesian structure and with parameter values like those of the U.S. today, the second effect dominates: increasing nominal wage flexibility would increase the volatility of the business cycle.

Thus Keynes (1936) presents a vision of the economy in which there would be a stong correlation between high real wages and high unemployment, but in which the chain of causation runs from the second to the first. What do Vedder and Gallaway have to say in response to Keynes's--extended--argument that causation runs from unemployment to high real wages, and that policies to lower nominal wages in a depression would be unhelpful?

They have nothing coherent to say.

On page 47 they assert that any belief that "higher unemployment causes higher adjusted real wages" is "implausible.... It makes sense that higher wages would price workers out of the market causing increased unemployment, but it makes no sense that higher unemployment would cause wages to rise (if anything, higher unemployment might induce wage-cutting)." My immediate reaction was that Vedder and Gallaway need to go back and reread the Keynesian literature, because they have not understood it, and they have no business critiquing what they have not understood. The Keynesian argument was not that higher unemployment would cause nominal wages to rise, but that excess inventories and deficient demand for goods would cause the prices of goods to fall, and that in modern economies the prices of goods would fall further and faster than nominal wages: all nominal wages and prices are falling in a depression at different speeds--and the net result is higher real wages because nominal wage levels are relatively slow to fall.

Thus I finished the book thinking that Vedder and Gallaway had never come to grips with their principal intellectual opponent. They had given me no reasons to accept their interpretation that a high unemployment-high real wage correlation--when it exists--is the result of high real wages causing high unemployment. They had given me no reasons to reject Keynes's theory that when such a correlation exists it is the result of deficient aggregate demand causing high unemployment and also pushing down product prices with the result of a relatively high real wage. And this annoyed me. When the third sentence that authors write is that the "Keynesian Revolution led the economics profession down an unproductive, destructive path for decades," they take on a moral obligation to give reasons why the Keynesian approach is incorrect and unproductive. Yet Vedder and Gallaway do not: they make a contract with their readers, and then casually break it by delivering nothing more than an off-hand remark that "it makes no sense that higher unemployment would cause wages to rise."

This is not to say that I believe that high real wages are always the consequence and never the cause of high unemployment. I think that Edmond Malinvaud (1977) advanced a more complex--and much more reasonable--position in his attempt to extend the scope of Keynesian analysis. Malinvaud argues that the market economy is subject to many possible macroeconomic maladies, and that not all business cycles--not all booms, not all depressions--are alike. Malinvaud distinguishes between "classical" and "Keynesian" unemployment. In both the real wage paid to employed workers is higher than in full-employment equilibrium. But in the second high real wages are the result of a recession, and in the first they are the cause.

Bruno and Sachs (1982) provide a powerful and detailed analysis that attributed high European unemployment in the wake of the 1973 oil shock and productivity slowdown to real wages in excess of "warranted" levels. The French economist Daniel Cohen (1996) believes that high European unemployment today exists because "the war on unemployment is in the hands of governments which represent first and foremost the point of view of the people who have jobs and fear losing them." Thus unemployment has been "feared less than the remedies that would have been necessary to contain it." In Cohen's view, European unemployment could have been reduced by freeing up the labor market, but then the wages of the currently employed would have fallen as "those who have jobs are forced to compete with those who do not.". In Cohen's view, European unemployment could have been reduced if the government had been willing to boost public employment and spend large sums on reentry programs for the jobless, thus boosting the value of the work that the currently-unemployed could do. But these costly reentry programs must be paid for by higher taxation, and the fear is either that higher taxation will slow economic growth or that programs for the unemployed will crowd out other social benefits. The European Union has been stuck in the middle.

So I do not think that the ascription of high unemployment to higher-than-equilibrium real wages is always wrong. I think that there are times and places when it is right.

But I do think that Vedder and Gallaway are wrong when they attempt to demonstrate that government policies to raise real wages have been the source of unemployment in the twentieth century. They are wrong because the foundations of their argument are mud--rests on a presumed correlation between high unemployment and high real wages that does not exist today, and rests on confusion about how to sort out cause from effect in macroeconomic analysis.


References

Paul Beaudry and John DiNardo (1991), "The Effect of Implicit Contracts on the Movement of Wages Over the Business Cycle: Evidence from Micro Data," Journal of Political Economy 99 (August), pp. 665-688.

Mark Bils (1985), "Real Wages Over the Business Cycle: Estimates from Panel Data," Journal of Political Economy 93 (August), pp. 666-689.

Michael Bruno and Jeffrey Sachs (1982), The Economics of Stagflation

Daniel Cohen (1996), The Misfortunes of Prosperity (Cambridge: MIT Press, 1996).

J. Bradford DeLong and Lawrence H. Summers (1986), "Is Increasing Price Flexibility Stabilizing?" American Economic Review

John Dunlop (1938), "The Movement in Real and Money Wage Rates," Economic Journal 48 (September), pp. 349-366.

Michael Keane, Robert Moffitt, and David Runkle (1988), "Real Wages Over the Business Cycle: Estimating the Effect of Heterogeneity with Micro Data," Journal of Political Economy 96 (December), pp. 1232-1266.

John Maynard Keynes (1936), The General Theory of Employment, Interest and Money (London: Macmillan).

John Maynard Keynes (1939), "Relative Movements of Real Wages and Output," Economic Journal 49 (March), pp. 34-51.

Edmond Malinvaud (1977), The Theory of Unemployment Reconsidered, Oxford: Basil Blackwell.

Gary Solon, Robert Barsky, and Jonathan Parker (1994), "Measuring the Cyclicality of Real Wages: How Important Is Composition Bias?" Quarterly Journal of Economics 109 (February), pp. 1-25.

Lori Tarshis (1939), "Changes in Real and Money Wage Rates," Economic Journal 49 (March), pp. 150-154.

Richard K. Vedder, and Lowell E. Gallaway, Out of Work: Unemployment and Government in Twentieth-Century America (New York: Holmes and Meier, 1993).


Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
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