Dick Sargent
To Full Employment: The Keynesian Experience and After
SUMMARY OF THE ARGUMENT
Was the low unemployment of the 1950s and 1960s due to 'Keynesian' policies, such as
government deficit spending or expansion of the money supply? The answer must be 'no',
for the following reasons :
- when the output of firms is limited by rising marginal costs, a boost to aggregate demand
cannot produce a sustained rise in output and employment, such as one lasting for two
decades. Its end result is only higher prices ;
- a boost to aggregate demand would certainly produce rising output if this led to lower
marginal costs. But prices would then be falling, whereas for the 1950s and 1960s
prices were rising at a low but persistent rate ;
- there is little evidence of sustained government action to boost demand until the 'Barber
boom' of the early 1970s.
It was not the demand-side but the supply-side of the economy which provided the
mainspring for full employment in the 1950s and 1960s, through the unusually high level of
investment during the period. This was stimulated by :
- a decline in the post-tax rate of return sought by investors, and
- various government measures to reduce the pre-tax rate of return needed to produce a
given post-tax rate of return.
As the cheaper access to capital funds caused the capital-labour ratio to rise at an
abnormally rapid rate, the marginal productivity of labour rose with it, encouraging firms to
raise employment at going levels of money wages and prices. It was the pressure of
demand thus generated in the labour market that kept unemployment low.
That applied upward pressure also, of course, to real wages. But thanks to the accelerated
growth of labour productivity, employers found that they could afford increases in money
wages which were larger than usual compared with increases in their product prices. At the
same time, because of the cheaper cost of capital funds, they could accept a lower realised
rate of return on the funds invested. So although there was a decline in profitability during
the period, it reflected a process of adjustment to an improved economic climate, and was
not a threat to full employment.
But why was there still some price inflation, despite the stimulus to the supply-side of the
economy? Since the cause of the stimulus was the boost to investment, the latter raised the
demand for capital goods. So through this channel there was an impact on the demand-side
of the economy as well. But the developing stimulus to the supply-side enabled this impact
to be substantially absorbed, and so the balance of excess demand at the aggregate level was
kept small enough to limit inflation to the low and stable rate which prevailed.
Low inflation, low unemployment, high investment, and an unusually rapid rise in
productivity and real wages - these features of the 1950s and 1960s have caused the period
to be acclaimed as a 'Golden Age'. Then why did it begin to crumble in the 1970s? There
were, of course, external influences due to the oil-price 'shocks' which the U.K had to cope
with in that decade, in common with other economies. But if these external 'shocks' had
not occurred, were there nevertheless internal problems undermining the 'Golden Age' ?
One such problem was diminishing returns to the extra investments stimulated by the fall in
the cost of capital funds. This fall had provided fresh opportunities for shifting to a higher
ratio of capital to labour in the production process. While the shift was taking place, and as
a result of it, the growth of productivity and real wages received a bonus ; but this bonus
ended once the shift to the higher capital-labour ratio was complete.
As the new investment opportunities were exhausted, and productivity growth slipped
back to the more normal rate consistent with the economy's underlying rate of technological
progress, a downward adjustment would also have been called for in the growth of real
wages, if full employment were not to be endangered. But the needed downward
adjustment would have had to battle with employees' expectations stimulated by the
experience of an unusually high rate of growth of real wages in the 1950s and 1960s.
Is there evidence that the economy ran into diminishing returns to investment? This is
provided by what happened in the 'Barber boom' of the early 1970s. The government then
embarked on a raft of avowedly 'Keynesian' measures to stimulate aggregate demand, but
aggregate supply proved unable to make an adequate response. This suggests that the
marginal productivity of the investments supporting the supply response had significantly
declined. Thus the economy had become less capable of absorbing extra demand, or in
other words more 'inflation-prone'.
The inflationary debacle of the 'Barber boom' was the internally-generated influence
which undermined confidence in the idea of a full employment 'policy' in the 1970s, and
was one cause of the switch that then occurred from a falling to a rising cost of capital
funds. At the same time, there was the externally-generated 'shock' from the rise in the
price of oil, which not only undermined confidence but imposed an additional increase in
production costs. To counter these twin shocks, and maintain full employment, employees'
expectations for real wage growth would have had to be curtailed even more severely than
(as indicated above) would have been required without them. In point of fact, real wage
growth did dwindle away for most of the 1970s, almost to nothing, but this marked process
of adaptation in the labour market still proved insufficient to counter the combined
unemployment-inducing effects of the internal and external shocks.
The sharp reduction in real wage growth, however, was sufficient to encourage the growth
of 'labour militancy'. While the collapse of full employment was initiated by the twin
shocks, it was subsequently completed by the determination of employees to reverse the
decline in the growth of real wages. Their efforts to do so were assisted in the early 1980s
by the unanticipated success of Mrs Thatcher's government in curtailing inflation by relying
on demand restraint while abandoning attempts to influence money wages. Thus a
'passive' kind of labour militancy joined with an 'active' kind to re-accelerate the growth of
real wages. The growth of labour militancy reflected the reaction of employees to the
severe disappointment of expectations for real wage growth in the 1970s, a disappointment
intensified by the contrast with the rapid growth experienced in the 1950s and 1960s.
Nevertheless, the drive by employees to rectify the situation, in a much less favourable
economic environment, compounded the successive shocks under whose influence
unemployment was driven to its peak in the mid-1980s.
The subsequent descent from the peak can be divided into two phases, of which the first
turned out to be abortive and the second effective. The first phase was dominated by the
'Lawson boom' of the late 1980s, which lowered unemployment as it waxed and raised it as
it waned. These movements in unemployment mainly reflected the way in which the
relaxation of controls on lending by financial institutions impinged upon the demand-side of
the economy, and led to a rise in the debt-to-income ratio which then proved unsustainable.
The rate of inflation rose and fell in response to these influences.
Productivity growth also rose and fell, reflecting the transitory bonus from the 'shake-out' of
labour induced by the new economic climate, in which the government disclaimed
responsibility for maintaining full employment. The small net reduction in unemployment
remaining after the boom had finally burst can be linked to a switch to a declining
incidence of taxes on the cost of labour to employers.
The second phase, on the other hand, from about 1992 to the end of the century, saw a
steady and substantial reduction in unemployment. The main influence behind this came
from the economy's supply-side, in the form of real wage increases which receded to well
below what had previously been normal. This must have reflected a significant decline in
'labour militancy'. The stage for this was set by earlier anti-union legislation and the
decline in the power of trades unions. But it was assisted by the government's adoption of
an explicit target for inflation, which enabled money wage claims to be based on firmer
expectations of what they would mean in real terms. This basis was further strengthened by
the 1997 decision to give the Bank of England a delegated responsibility for holding
inflation to the target, and by its developing success in doing so.
The argument finally turns from the interpretation of history to the on-going problem of
policies for employment. The approach is sceptical of the concept of a NAIRU and of
methods which purport to measure it. Instead of this, it asks : 'what policies can be applied
to move unemployment towards a level determined by social choice ?'. The main concern
is with supply-side policies which have recently come into vogue. But it is emphasised that
any such policies have implications for real wages, if they succeed ; and their power to
deliver a lasting reduction in unemployment at the same time will depend upon the extent to
which employees' expectations for increases in real wages can be appropriately contained.
The chapter concludes by discussing ways in which government policies might be adapted
to this end.
© Dick Sargent 2006