The Iatrogenic and Incoherent “Theory” of Flexibility

In its report on “The long-term decline in prime-age male labor force participation,” President Obama’s Council of Economic Advisers writes:

Conventional economic theory posits that more ‘flexible’ labor markets—where it is easier to hire and fire workers—facilitate matches between employers and individuals who want to work. Yet despite having among the most flexible labor markets in the OECD—with low levels of labor market regulation and employment protections, a low minimum cost of labor, and low rates of collective bargaining coverage—the United States has one of the lowest prime-age male labor force participation rates of OECD member countries.

Although it has indeed become conventional, the ‘flexible’ labor markets mantra is not a theory. It is dogma. An article of faith. The theory behind the nostrum of flexible labor markets is Milton Friedman’s natural rate theory of unemployment, which, as Jamie Galbraith pointed out twenty years ago, was constructed by adding expectations to the empirical Philips Curve observation of a relationship between unemployment and inflation:

The Phillips curve had always been a purely empirical relation, patched into IS-LM Keynesianism to relieve that model’s lack of a theory of inflation. Friedman supplied no theory for a short-run Phillips curve, yet he affirmed that such a relation would “always” exist. And Friedman’s argument depends on it. If the Phillips relation fails empirically— that is, if levels of unemployment do not in fact predict the rate of inflation in the short run—then the construct of the natural rate of unemployment also loses meaning.

Galbraith’s evisceration of the natural rate theory and NAIRU is incisive, persuasive and accessible. Read it.

At the other end of the flexibility spectrum, intellectually, is Layard, Nickell and Jackman’s Unemployment: Macroeconomic Performance and the Labour Market. In their influential textbook, Layard et al. grafted the dubious NAIRU concept onto the archaic lump-of-labor fallacy claim to create their own chimera hybrid, the LUMP-OF-OUTPUT FALLACY.

Galbraith’s “Time to Ditch NAIRU” has 293 citations on Google Scholar. Layard et al’s “Unemployment” has 5824.

To appreciate the pretzel logic of Layard et al., one has to first understand that the old fallacy claim is essentially an inversion of the “supply creates its own demand” nutshell known as Say’s Law. Jamie’s dad, John Kenneth Galbraith, had argued back in 1975 that Say’s Law had “sank without trace” after Keynes had shown that interest “was not the price people were paid to save… [but] what was paid to overcome their liquidity preference” and thus a fall in interest rates might encourage cash hoarding rather than investment, resulting in a shortfall of purchasing power.

So, at one end of their graft Layard et al. were resuscitating the old dogma that Keynes had supposedly “brought to an end.” At the other end of the graft was Friedman’s tweaking of an atheoretical empirical observation — the Philips Curve — that was  “patched into IS-LM Keynesianism to relieve that model’s lack of a theory of inflation. (James Tobin once elegantly described the Phillips curve as a set of empirical observations in search of theory, like Pirandello characters in search of a plot.)” And let’s not even get started with IS-LMist fundamentalism.

Churchill’s “riddle wrapped in a mystery inside an enigma” quip about the Soviet Union has nothing on Layard et al.’s antithetical and anachronistic graft on a tweak of an atheoretical patch on an unsatisfactory “attempt to reduce the General Theory to a system of equilibrium,” as Joan Robinson described IS-LM “Keynesianism”:

Whenever equilibrium theory is breached, economists rush like bees whose comb has been broken to patch up the damage. J. R. Hicks was one of the first, with his IS-LM, to try to reduce the General Theory to a system of equilibrium. This had a wide success and has distorted teaching for many generations of students. Hicks used to be fond of quoting a letter from Keynes which, because of its friendly tone, seemed to approve of IS-LM, but it contained a clear objection to a system that leaves out expectations of the future from the inducement to invest.

And by “expectations,” Keynes clearly had in mind uncertainty, not honeycomb equilibrium.

So that’s the tangled ‘theory’ behind ‘flexible’ labor market policy prescriptions. A regurgitated dog’s breakfast of contradiction and amnesia.

Layard et al.’s lump-of-output fallacy flexibility chimera thus resembles a sort of a theoretical ouroboros chicken-snake swallowing its own entrails:

To many people, shorter working hours and early retirement appear to be common-sense solutions for unemployment. But they are not, because they are not based on any coherent theory of what determines unemployment. The only theory behind them is the lump-of-output theory: output is a given. In this section we have shown that output is unlikely to remain constant.

This is simply FALSE. Shorter working hours is based on the same theory as full employment fiscal policy: Keynes’s theory. But don’t take my word for it. In an April 1945 letter to T.S. Eliot, Keynes wrote:

The full employment policy by means of investment is only one particular application of an intellectual theorem. You can produce the result just as well by consuming more or working less. Personally I regard the investment policy as first aid. In U.S. it almost certainly will not do the trick. Less work is the ultimate solution.


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