The Role of Governments in Aligning Functional Income Distribution with Full Employment

Abstract:

Demand is an incentive for investment. The latter is necessary to create employment. If demand lags behind supply, then unemployment and underemployment rise. Persistent unemployment and underemployment indicate a dysfunctional price mechanism. Then, only governments can stimulate demand. They may equalize ex ante saving and investment by public investment, income redistribution, or market regulation.

Keywords::

• economic policies
• Keynesian economics
• United States

JEL Classification Codes::

• E6
• E12
• N12

According to John Maynard Keynes (1936, 161), human actions are led by “animal spirits” — that is, by spontaneous choices rather than by calculation. This concerns both consumers and investors whose mood and behavior influence each other. If consumers are pessimistic about their income, generally they restrict consumption and increase their saving account for precautionary reasons or hoard money because of speculative motives. Consequently, entrepreneurs abstain from investment due to an expected lack of demand and a corresponding fear of loss. Instead, they park profits in banks, repay debt, buy back their own stocks, acquire competitors or merge with them. This behavior contributes to an increase in unemployment and underemployment, and demotivates consumers even further.¹ Governments may combat persistent unemployment and underemployment by equalizing ex ante saving and investment through public investment, market regulation, and redistribution of income.

Keynes’s animal spirits and his approach to uncertainty were ignored by the Keynesian economists. This might have contributed to the financial crisis of 2007–2008 and the subsequent great recession (the period of economic decline during the late 2000s and the early 2010s), which are the subject of my analysis in this article. In section one, I briefly elaborate on the economics of Keynes and Keynesian economics. In section two, I summarize the economic policies in the period from 1970 to 2008. In section three, I describe how the financial crisis and the subsequent great recession were addressed. In the final section, I wrap up with some conclusions and discussion notes. In the process, I stress on the need of government policies to improve the functional distribution of income today, thus updating Keynes.

The Economics of Keynes and Keynesian Economics

The Economics of Keynes

Keynes’s general theory of employment proclaims a central role for governments in combatting poverty, unemployment, and underemployment. It is founded upon five postulates:

1. He claims that “the utility of the wage when a given volume of labor is employed is [not] equal to the marginal disutility of that amount of employment,” postulating that, in the short run, money wages and real wages develop in opposite direction. Marginal productivity determines real wages which diminish with expanding employment, whereas money wages may fall because workers are likely to accept wage cuts when employment falls. Therefore, the traditional postulate that wage bargains determine the real wage is not true (Keynes 1936, 10-11).

2. Monetary authorities may influence investment through the interest rate. Interest rates are the opportunity costs of holding cash. However, because of liquidity preference, lower interest rates do not boost investment if demand is slack. They do not equalize ex ante saving and investment. Eventually, it is not the interest rate, but the level of income as a whole that determines investment and employment. Investment and income as a whole are related through the investment multiplier, whereas investment and employment are related through the employment multiplier. The size of these multipliers is context-dependent (Keynes 1936, 113–116, 166–172, 202–208, 247; Skidelsky 2015, 365).

3. What matters is how market participants view the future. The key cause to hoard money is the divergence of the interest rate from what is considered to be a fairly safe level. The decision factor to invest is the foresight of reaping profits in the future. The latter requires the expectation of being able to sell production at a profit (Keynes 1936, 46-47, 201).

4. Investment occurs under fundamental uncertainty about its yields in the future. To be precise, economic relations are heterogeneous because of “motives, expectations and psychological uncertainties.” Due to a lack of “scientific basis on which to form any calculable probability whatever,” investors may tend to conform to “the behavior of the majority or the average.” This herding behavior, which Keynes illustrates with the metaphor of forecasting the winner in a “beauty contest,” may create bubbles that could suddenly bust (Skidelsky 2015, 211, 214, 221, 265, 276, 281).

5. Equilibrium between ex post saving and investment does not necessarily occur at full employment. Equilibrium with full employment only exists “by accident or design.” Namely, if income recipients plan to consume a smaller share — that is, to save a bigger share of their income — then entrepreneurs adjust their investment plans if they fear failure. Consequently, fewer people get employed, income drops, poverty rises, and saving falls. This transforms an ex ante disequilibrium between saving and investment into an ex post equilibrium, but under circumstances of unemployment. Therefore, only a third actor, whose decisions are independent of short-term expectations, may turn the tide. This actor is the government. Governments may stimulate the economy by fiscal expansion, redistribution of income (lower incomes have a higher propensity to consume), or regulating markets, among other things, through import tariffs (Skidelsky 2015 115, 189–193, 250, 344, 352, 386, 528). In this process, governments are not bound by any sort of natural distribution of income. According to Keynes (1981, 7), the relative rates of remuneration of the factors of production are the product of historical and social forces and, therefore, they have a large arbitrary element.

Keynesian Economics

Keynes’s economic theory became the fundament of the welfare state. What remained was to develop a method to determine the timing and size of government intervention in order to foster economic growth, stability, and full employment. This was fostered by “revolutions” in national accounting and econometrics (Patinkin 1976, 1092, 1094, 1104). Examples of these “revolutions” are Wassily Leontief’s input-output model (Spithoven and Brenner 1996, 189–194), the use of regression analysis, and the probability foundation of econometrics. These methods have enabled economists to provide quantitative answers to policy questions that are based upon theoretical models, describing “the causal structure of an economy … [and consisting] of behavioral and definitional equations with endogenous and exogenous variables” (Maas 2014, 81).

The economics of Keynes became transformed into Keynesian quantity-adjustment models. Paul Samuelson’s multiplier model (the Keynesian cross) showed that equilibrium does not necessarily occur at full employment, while John Hicks and Alvin Hansen integrated the financial and the real sectors in the investment-savings, liquidity-money (IS-LM) model (Spithoven and Brenner 1996, 166–188). Joan Robinson qualified the Keynesian quantity-adjustment models as “bastard” Keynesianism (Skidelsky 1974, 181), whereas Alan Coddington (1976, 1264) coined the term “hydraulic Keynesianism” to describe the macroeconomic approach that conceives “the economy at the aggregate level in terms of disembodied and [stable relations between] homogeneous flows [of expenditure, income or output].” The Keynesian quantity-adjustment models brought forth a mechanistic view of the economy as a whole. All that was needed was the right fiscal and monetary policies to achieve full employment.

The Keynesian quantity-adjustment models do not address international trade. International trade limits the possibilities of governments to interfere in the economy. First, austerity measures to foster international competition may negatively impact employment in wage-led countries like the United States, whereas expansionary fiscal policies to stimulate employment may harm exports (Spithoven 2013). Second, international trade negatively affects the multiplier. This might be partly compensated by a redistribution of the gains of trade toward the losers.

Another ignored problem in the Keynesian quantity-adjustment models concerns animal spirits and fundamental uncertainty, as John Hicks acknowledged (1980, 140, 145–146, 152). Although uncertainty might become manageable through empirical examinations by economists and econometricians, it may not be possible to eliminate it entirely (Keynes 1936, 148, 247, 249). Additionally, governments may provide relief by creating an environment for businesses where they experience less uncertainty. However, regulatory uncertainty continues to exist because democratic elections may enforce institutional adaptations and because of “inconsistencies in government decisions,” such as bailing out Bear Stearns in March 2008 and letting Lehman Brothers file bankruptcy in August 2008.

Finally, the monetarists under the leadership of Milton Friedman criticized the Keynesian approach for, among other things, ignoring wealth effects. They argued that people want to hold a stable ratio between the real cash stock and other assets/wealth. Under this condition, unemployment might be addressed by an increase in the supply of money. In order to keep the ratio of the cash stock to the other assets stable, people have to spend more, and the higher effective demand implies more employment. Alternatively, employment might also be stimulated by lower wages. The latter are assumed to result in lower prices. Lower prices also result in higher demand. This approach became much more sophisticated in the course of time. The monetarists added the hypothesis that a larger money supply results in falling interest rates and higher investment and consumption. A smaller money supply results in rising interest rates and lower investment and consumption. Generally speaking, they effectively argued that only money matters (Spithoven and Brenner 1996, 198–204).

Economic Policies in the Period from 1970 to 2008

Until the early 1970s, the Keynesian quantity-adjustment models enabled governments to avoid “socialized investment,” and convinced economists that the Keynesian approach provided a solid base to control the market economy by monetary and fiscal instruments. This conviction was seriously challenged by the oil crises in 1973 and 1979. In the early 1980s, the coincidence of abiding mass unemployment and inflation became “construed as a refutation of the Keynesian ideas. Once again the focus of attention shifted to the supply side of the economic system” (Spithoven 1996, 39).

In the 1980s, President Ronald Reagan blamed the government for the high inflation rates and practically resurrected Say’s Law (i.e., that supply creates its own demand) to justify his policies, among which tax cuts and financial market deregulation (Spithoven 1996, 47). An example of the latter concerns the Garn-St. Germain Depository Institutions Act which allowed riskier investment in the housing market and constituted the run up to the saving-and-loan crisis in the late 1980s and early1990s. Unemployment fell, but not below 5.0 percent. The latter was achieved no sooner than Bill Clinton became President. The relatively low unemployment rate from 1998 to 2002 (Table 1), with its lowest level at 4.0 percent in 2000, may be ascribed to the “third-way” policies of President Clinton.²

On one hand, President Clinton’s third-way policies comprised stringent fiscal policies, privatization, deregulation, and globalization policies. They were embedded in tight monetary policies that aimed at 2.0-to-3.0 percent inflation and maintaining low interest rates:³

	Clinton’s fiscal policies aimed at eliminating the budget deficit. They eventually resulted in a government budget surplus in the period from 1998 to 2001.
	His privatization policies affected prisons and resulted in the Federal Activities Inventory Reform Act.
	His deregulation policies are exemplified by, among other things, the Gramm-Leach-Bliley Act that repealed the Glass-Steagall Act, the Commodity Futures Modernization Act that exempted credit-default swaps from regulation, and the Community Reinvestment Act that reduced red lining (i.e., banks were encouraged to lend more to citizens in low-income neighborhoods).
	Finally, Clinton’s globalization policies concerned several free trade agreements. He signed the North American Free Trade Agreement (with Mexico and Canada) in 1993. The trade agreements with Canada and Mexico contributed to the deterioration of the trade balance. In addition, it must be acknowledged that the trade balance with China and Germany also worsened. The deficits speeded up since China and Germany joined the World Trade Organization in December 2001 and January 2005, respectively. These developments brought forth the transformation of the U.S. economy into a more open economy, with GDP, export, and import rising by 7.1, 9.4, and 10.6 percent per year, respectively, (compound growth rates) in the period from 1970 to 2008.

Table 1. U.S. Economic Policy Indicators

	1971–1975	1976–1983	1984–1992	1993–2000	2001–2008	2009–2010	2011–2015
Gross Domestic Product (GDP), (constant prices)^Footnote(1)	2.7	2.9	3.5	3.9	2.1	0.2	2.0
Investment (constant prices)^Footnote(1)	0.6	4.3	3.8	7.1	0.6	–4.6	4.3
Consumption (constant prices)^Footnote(1)	2.7	2.8	3.3	7.0	2.5	0.5	1.6
Consumer confidence composite indicator (month average)	11.5	3.4	3.3	5.3	5.0^Footnote(2)	–7.2^Footnote(3)	7.0
Consumer prices^Footnote(1)	6.7	8	3.9	2.6	2.8	0.6	1.7
Household savings rate (year average)	12.9	10.5	9.2	5.8	3.9^Footnote(4)	5.8	5.7
Federal funds rate (quarter average)	6.6	9.6	7.0	4.9	2.8	0	0
Monetary base (month average)^Footnote(3)	7.0	6.8	7.2	7.0	4.8^Footnote(2)	45.7^Footnote(3)	14.6
Dow Jones Index^Footnote(1)	0.3	5.0	11.3	16.0	3.0^Footnote(4)	–33.8^Footnote(5)	8.5
Government debt (fiscal year average)	–1.8	–3.2	–4.0	–0.8	–1.9	–8.5^Footnote(6)	–3.2^Footnote(7)
Multifactor productivity^Footnote(1)	1.1	0.4	1.0	0.9	1.0	1.3	0.4
Civilian employment growth^Footnote(1)	1.8	2	1.8	1.8	0.8	–2.2	1.4
Participation rate men (average)	86.4	85.6	85.4	84.3	82.2	80.0	78.7
Participation rate women (average)	51.3	59.0	66.3	70.1	69.5	68.7	67.3
Participation rate total (average)	68.2	71.9	75.6	77.1	75.8	74.3	72.9
Poverty rate (year average)	11.8	13.0	13.7	13.3	12.5	14.7	14.6
Unemployment rate (average)	6.1	7.6	6.5	5.2	5.3	9.5	7.6
	1975	1983	1992	2000	2009	2010	2015
Gini coefficient (disposable income)	0.316^Footnote(8)	0.336	0.352	0.357	0.379	0.38	0.401^Footnote(9)

Sources: See Footnote 2.

Notes:

⁽¹⁾ =compound growth rates;

⁽²⁾ =2001–Aug. 2008;

⁽³⁾ =Sept. 2008–2010;

⁽⁴⁾ =2001–2007;

⁽⁵⁾ =2008;

⁽⁶⁾ =2009–2011;

⁽⁷⁾ =2013–2015;

⁽⁸⁾ =1974;

⁽⁹⁾ =2013.

On the other hand, President Clinton’s third-way policies comprised social policies through ushering in higher minimum wage, tax cuts for workers and the Temporary Assistance for Needy Families program (White House 2001; Wray and Pigeon 2000, 835). The latter policy imposed mandatory work requirements for welfare recipients. It provided that specific work participation rates should be achieved for states to claim federal funding. In line with these policies, Clinton corrected the widening income differentials by fiscal measures like expansion of the earned income tax credit and the provision of a middle-class tax relief. Lastly, he stimulated the housing market through the pressure on Fannie Mae to expand “mortgage loans among low and moderate income people,” and through public securitization of loans to low income borrowers since 1997 (Holmes 1999). In combination with Clinton’s deregulation policies, this boosted the housing market and employment in the housing industry.

Innovations also influenced the economy. Examples of these innovations are the opening of the World Wide Web for everyone in 1993 by the European Organization for Nuclear Research, and the credit default swaps in 1994. Together with the (financial) deregulation of markets, these innovations contributed to boosting the stock exchange. The rising prices of houses and stocks constituted a “wealth effect” that triggered consumption and entrepreneurial animal spirits. The latter is indicated by the remarkable rise in investment and may explain the significant fall in unemployment from 1993 to 2000. The “wealth effects” compensated the negatively influenced private demand through the stringent fiscal policies.

In line with the fall in unemployment rates, poverty rates fell from 15.1 percent in 1993 to 11.3 percent in 2000 — the lowest level since the mid-1970s. However, it was not all roses. International trade, computerization, and the internet contributed to a polarization of the U.S. labor market (Autor, Katz and Kearney 2006). Globalization resulted in the loss of medium paid jobs in industrial manufacturing, whereas the internet resulted in the growth of high paid internet jobs. After Clinton’s Presidency, the U.S. economy and society had to cope with three crises: the dot.com crisis of 2000–2001, the attack on the World Trade Center in 2001, and the financial crisis of 2007–2008. The dot.com crisis and the 2001 terrorist attack negatively influenced the animal spirits of consumers and investors, but the continued speculation on the housing market provided some solace. On balance, the period from 2001 to 2008 was characterized by a fall in the growth rates of GDP, consumption, and investment. The unemployment rate marginally increased.

The financial crisis of 2007–2008 is associated with highly leveraged bets on assets tied to subprime mortgages by hedge funds and banks like Bear Stearns and Lehman Brothers. In hindsight, this speculation is mainly rooted in Reagan and Clinton’s deregulation policies, and the ability of the financial sector to innovate and to circumvent regulations. This ability was manifest in the issuance of subprime mortgages, the hedging of subprime mortgages, and the shift to speculative and Ponzi lending (Minsky 1994, 157).

Addressing the Financial Crisis and the Subsequent Great Recession

Rising default rates resulted in the BNP Paribas decision (in August 2007) to cease activity in three mortgage hedge funds. This marked the beginning of the housing crisis. Eventually, the bankruptcy of Lehman Brothers in August 2008 revealed that the mortgage assets were worthless. Banks did not trust each other anymore and a systemic risk was lurking.

The financial crisis and the subsequent great recession were limited in their effects due to deposit insurance, guaranteed bank debt issuance, and aggressive monetary and fiscal instruments. Examples of the monetary instruments include: setting the federal funds rate at zero percent; financial stress tests; and quantitative easing through purchasing huge amounts of treasury securities, agency mortgage-backed securities, and agency debt (i.e., Fannie Mae and Freddie Mac). Examples of the fiscal instruments are (i) the Troubled Asset Relief Program (TARP) through which capital was injected into banks and General Motors and Chrysler were saved, (ii) the Economic Stimulus Act of 2008, and (iii) the American Recovery and Reinvestment Act of 2009 (Blinder and Zandi 2010).

The unprecedented, aggressive monetary policies — together with the TARP — resulted in saving the banking system from a meltdown. Simultaneously, interest rates fell significantly, the growth of household savings marginally fell, and the Dow Jones Index eventually revived again. The latter was more than 30 percent higher in 2015 than in 2007. The fiscal stimuli in 2009–2011 resulted in a huge rise in the government debt. However, this debt was soon almost completely counterbalanced by successive fiscal austerity measures (Krugman 2015). Government debt was 9.8 percent of GDP in 2009 and 2.5 percent in 2015.

In 2008 and 2009, macroeconomic indicators significantly worsened, but they recovered in the period from 2010 to 2015, when GDP rose, investment recovered, more jobs were created, and unemployment rates improved. Nevertheless, quite a few socio-economic indicators lagged behind. Falling unemployment rates notwithstanding (especially through a significant fall of the labor participation rate, which was partly due to the aging of population, and because of the creation of jobs), these rates were still higher in 32 U.S. states in September 2016 than they had been in September 2007. The unemployment in the Rustbelt and among African Americans seems to be structural. The purchasing power of those who lost their jobs decreased dramatically and the low interest rates affected pensions very badly. In line with this, the poverty rate in 2015 was higher than in 2007, and the middle-class has declined dramatically in the twenty-first century (Pressman 2017, 28). Additionally, many workers still struggle to keep their head up (because of low-paid jobs, underinsurance for healthcare, high-deductible health plans and high out-of-pocket health payments), or are working below their capacities. These issues demand not lower taxes for big companies, but fiscal expansion and measures like higher minimum wages, adequate health insurance, and social security. Economic researchers have shown that the multiplier effect for the US is substantial during recessions (Batini et al. 2014, 4, 8; Krugman 2015).

An alternative to fiscal policies is privatization of semi-public goods, for example, by offering the private sector the possibility to invest in the infrastructure in exchange for allowing them to reap profits in the form of tollage. Privatization of semi-public goods not only changes the character of the good or service involved, but might also make it more expensive than when it is provided by the government. Due to the historic low interest rates, fiscal expansion is not likely to result in a real threat to regular government spending, whereas the costs of the provision of the privatized goods and services are likely to be higher due to the high costs of collecting tollage — the relatively high interest rates that the private sector has to pay in comparison to governments, and profits on the exploitation of the investment.

In order to combat persistent unemployment, protectionist measures are likely to be limited in size. For example, the World Trade Organization’s safeguard, subsidy, and anti-dumping rules limit protectionist measures. An alternative policy might be to accept international trade and to redistribute income from beneficiaries to losers through expanding tax credits for lower income individuals, as well as providing social security and reemployment assistance. For the US, this implies a redistribution of income from capital — especially the big firms — to labor. Those who benefit continue to benefit, but less so than before.

Conclusion and Discussion Notes

The root of the great recession can be found in the deregulation of financial markets, beginning with President Reagan. President Clinton also contributed through further deregulation of financial markets, in combination with stimulating home-ownership in low-income neighborhoods. The possible positive psychological impact of Clinton’s policies on investors, the booming internet and housing industry, as well as the growing number of jobs might be some of the reasons why the budding of the great recession escaped the economists’ notice.

The financial crisis of 2007–2008 and the subsequent great recession were addressed with aggressive monetary and fiscal policies. They saved the banks from a complete meltdown, boosted the value of stocks, and contributed to a recovery of the main macro-economic data. However (regional) unemployment, underemployment, and poverty seem to persist. Governments can address these problems by fiscal expansion, redistribution of income, and/or regulating markets. This might require increasing tax credits for lower income households, expanding the social security system, and offering reemployment assistance. Policies like providing more social security and reemployment assistance, such as the voted down HR 3920 Trade and Globalization Assistance Act (110th Congress), implies abandoning the principle of limited government, and requires the revival of a meaningful democracy. A meaningful democracy depends on citizens and governments who have the awareness that they are not helpless victims of mysterious economic laws or of the vested interests’ influence over the social and economic conditions.

A grassroots movement might produce policies that provide upward social mobility for American families and children. Governments may subsidize social provisions and improve the functional distribution of income by progressive (corporate) taxation. Additionally, governments may negotiate provisions in free trade agreements that help globalization to the benefit of American consumers and companies. They can foster fair international competition by using trade agreements as levers to promote respect for labor rights, human rights, and environmental protection. Fundamentally, governments should cooperate internationally to end tax heavens and profitable tax rulings in favor of multinational organizations (Gravelle 2015, 6).

Keynes (1981, 12) struggled with the functional distribution of income. He thought that higher wages are detrimental to companies in open economies. He believed that higher wages would squeeze profits. Therefore, he preferred progressive corporate taxation because this would not affect the drive to earn profits and to raise output. However, wage increases may rise on the policy preference scheme if one takes into account that the U.S. economy is wage-led. Then one might conclude that higher wages in domestic services industries may positively affect the economy — at least, this seems to be true for the U.S. fast-food industry. According to Robert Pollin and Jeannette Wicks-Lim (2016), a policy of raising the minimum wage is feasible in the U.S. fast-food industry without reducing the workforce and without having to lower the average profit. This suggests that the regulation of markets might be well overcome so long as there is enough purchasing power.

Additional information

Notes on contributors

Antoon Spithoven

Antoon Spithoven is a research fellow in the Tjalling C. Koopmans Institute at the Utrecht University School of Economics. An earlier version of this article was presented at AFEE’s Annual Meeting at the ASSA conference in Chicago in January 2017. The author wishes to thank John F. Henry, Steven Pressman, Marcel Boumans, and Fatme Myuhtar-May for their constructive comments. The usual disclaimer applies.

Notes

¹ Unemployment is a statistical artifact and underemployment concerns employment below one’s capacities (Skidelsky 1974, 184).

² My empirical statements are based on statistical data that I derived from the following web sites: https://bea.gov/ (consumption, inflation, investment, saving); www.bls.gov/ (productivity, unemployment (for states) and prices); www.census.gov/ (completed new houses; discouraged workers; U.S. foreign trade per country; poverty); www.huduser.gov/ (housing); www.quandl.com/ (Dow Jones Index); https://stats.oecd.org (consumer confidence, consumption, employment, Gini, investment, saving, trade, unemployment); and www.whitehouse.gov/ (debt).

According to Larry Summers, the optimal inflation rate would be between 2.0 and 3.0 percent (Mankiw 2001, 10, 14, 34, 51). Actually, this level was realized during the Clinton Presidency. That the Fed targeted this inflation of 2.0-to-3.0 percent may be deduced from the fact that Alan Greenspan (2008, 160, 162) and Summers met with each other on a weekly basis.